In this video, I explain what it means when our firm is retained by a network marketing client. The fact that I’m retained should never be viewed as an endorsement of the program. There’s a lot that goes one when I’m working with a client and I make it very clear that my name is never to be used in a promotional sense i.e. “We hired Kevin Thompson and he says we’re a great company.” I want you to have a better understanding of what it means when I’m retained by a client. Watch this video to understand more.
With the recent buzz of Federal Trade Commission v. Fortune Hi-Tech Marketing, Inc. slowly coming to a close, I wanted to write an article to reiterate the importance of proper income claims. Statements regarding a network marketing company’s income opportunity go to the heart of the Federal Trade Commission’s (“FTC”) mission to extinguish deceptive, unfair, or unsubstantiated claims made by a company and its distributors. And let’s be honest here, it’s not the distributors’ fault. The majority of income claims made by a distributor are more likely than not truthful statements, but the FTC is not JUST concerned with the truth. Promises of riches and an opportunity to live the American Dream can cloud even the most reasonable person’s judgment. With this in mind, the FTC wants to ensure that all potential distributors make a fully informed decision before choosing to join an MLM program.
In this article, we discuss the legality of income claims made by MLMs and their distributors while using the recent Fortune Hi-Tech (“FHTM”) case as a framework. In Part 2 of this series, we’ll use what we learn in this article to help develop solutions that meet the FTC’s requirements.
What Was All the Fuss About?
Among other reasons in its case against FHTM, the FTC alleged that FHTM’s distributors misrepresented the income opportunity. Specifically, the FTC argued that FHTM violated Section 5(a) of the FTC Act which prohibits “unfair or deceptive acts or practices in or affecting commerce” by misrepresenting or omitting material facts in its income claims. In my opinion, the FTC’s argument about FHTM operating as a pyramid was weak. There’s not much to be learned there. But there’s a lot that can be learned by analyzing its argument regarding improper income claims. The FTC based its allegations off of recorded video and audio presentations, pictures on social media networks, and Twitter posts uploaded by various distributors. These facts underscore the importance of properly educating distributors on how to make clean product and MLM income claims online.
Examples cited by the FTC include the following:
Recorded Video Presentations
- The FTC alleged one distributor claimed in a recorded video presentation on her Vimeo website dedicated to her FHTM business that “four months into the business [with FHTM]… I had actually quadrupled what I have ever made as a Registered Nurse.”
- The FTC alleged a distributor claimed on her Vimeo site that distributors who reach the National or Executive Sales Manager levels “are making thirty-, forty-, sixty-, seventy-thousand a month.”
- The FTC alleged distributors frequently made lifestyle claims, such as highlighting extended family vacations to exotic locations, driving nice cars, and purchasing large homes with luxurious amenities.
Recorded Audio Presentations
- The FTC alleged a recorded conference call posted on distributor’s team website stated that another distributor earned over $50,000 in his sixth month with the company alone and that he “earned millions and millions beyond that” in subsequent years.
- Regarding another conference call, the FTC alleged a distributor posted on his team’s website that another distributor was earning “over $100,000 a month” after three years with the company.
- The FTC alleged a distributor posted on her Twitter account about a recruiting meeting, encouraging people to “Bring ur friends & learn how 2 make $100k aYR.”
- The FTC alleged that at a national convention, 30 top earners were called to the stage to be presented with a mock check for $64 million to represent the amount of money they earned with the company. Several distributors later shared a photo of the presentation on social networking sites.
Sound familiar? No matter how long you have been involved in the network marketing industry, chances are you’ve heard claims similar to the examples above on a regular basis. I’m not trying to point any fingers at distributors. The statements referenced above could potentially all be true. The key is whether those distributors shared legally sufficient income disclosures to the prospects immediately after making the claims. When it comes to these income disclosures, the FTC preferences are confusing and they require a lot from all marketers. In most cases, distributors are simply unaware of how to promote their opportunities appropriately. That’s just the nature of the beast, and it all ties back to compliance training. It’s important to understand the FTC’s top priority is ensuring income claims are adequate. With that being said, the best place to start when learning how to play a game is studying the rules.
The Rules of the Game
The FTC used the following legal argument to make its case against FHTM:
Any income claim that is considered to be deceptive needs a disclosure. The FTC considers an income claim deceptive where information that would affect a reasonable consumer’s judgment is misrepresented or omitted. There is a presumption that all information regarding earning potentials affect consumer’s judgment, even when you do not guarantee they will make any money. Out of those claims, it is also presumed to be reasonable for consumers to rely on statements you expressly make, regardless of whether you tell them making “big money” is a sure thing or not. In other words, all income claims that are atypical need adequate disclosures.
The FTC says that any income claim made is regarded as what consumers will “general[ly achieve . . . .” In other words, what you represent as potential money to a prospect is what a reasonable prospect will expect to earn. IF YOU LACK SUBSTANTIATION (aka, you have no proof) that the majority of your distributors earn the amount represented by a few high earners, you must give a clear and conspicuous disclosure indicating exactly the percentage of distributors who earn at least the amount you represented. And you must also disclose the average earnings. If you’re a distributor that’s working with a particular company, if they do not provide adequate income disclosures, DO NOT MAKE INCOME CLAIMS. The pressure is on them to provide the data.
If you are the motivated (or self-burdening) type, I’d like to challenge you with a little homework project. Look at the examples cited by the FTC against FHTM above and determine what type of disclosure is necessary using the rules we discussed in this article. In our next installment, we’ll discuss our own solutions and ideas for the proper ways to make income claims.
 See FTC v. Bay Area Bus Council, Inc., 423 F.3d 627, 635 (7th Cir. 2005); FTC v. World Media Brokers, 415 F.3d 758, 763 (7th Cir. 2005); Kraft, Inc. v. FTC, 970 F.2d 311, 322 (7th Cir. 1992), cert. denied, 507 U.S. 909 (1993); FTC v. QT, Inc., 448 F. Supp. 2d 908, 957 (N.D. Ill. 2006).
 FTC v. Febre, No. 94 C 3625, 1996 WL 396117, at *2 (N.D. Ill. July 3, 1996) (conditional earnings claims would be understood to represent typical or average earnings and are therefore deceptive).
 See World Travel Vacation Brokers, 861 F.2d 1020, 1029 (7th Cir. 1988).
 FTC v. Five Star Auto Club, Inc., 97 F. Supp. 2d 502, 528 (S.D.N.Y. 2000).
 16 C.F.R. § 255.2(b) (Guides Concerning the Use of Endorsements and Testimonials in Advertising); see also In re Cliffdale Assoc., Inc., 103 F.T.C 110, 173 (1984), 1984 WL 565319 (F.T.C.), at *16 (testimonials presumed to represent typical experiences).
 In re Nat’l Dynamics, 85 F.T.C. 1052 (1975).
In the last article, FTC’s Disclosure Guidelines for Online Marketing: How to get it right (Part 1), we walked through the Federal Trade Commission’s recently published .com Disclosure Guidelines (fully included below). In this installment, we’re going to walk through five hypothetical examples of common marketing claims made in the MLM industry. The goal of this post is to provide you with practical, easy-to-understand tips on how to make proper claims.
The format is simple: I’m going to give you common fact patterns of how claims are made in the MLM industry. Then I’ll show you what most distributors would WANT to do as far as making disclosures. Then I’ll show what they SHOULD do, as per the .com Disclosure Guidelines. These guidelines apply whether the company is an MLM startup or a well-established company.
Ready? Go time!
UPDATE: This article has been updated after further research. The .com Disclosure Guidelines are over 50 pages and it never mentions income claims. The analysis below is based on my interpretation of their guidelines.
EXAMPLE 1: CHECK WAVING
Kyle is very excited about his involvement in a new cosmetics company, Wrinkles-B-Gone. After six months of hard work, he received his first check in the mail for $4,500. Overcome with excitement, Kyle gets an idea. He decides to post a picture on his Facebook profile showing off his check. Kyle figures it’ll be a great way to “flex his muscles” while demonstrating the power of his new company. It is clearly visible in the picture that the check is for $4,500. In his Facebook post, Kyle says, “Boom, playa! Check me out! Want to learn why this company is throwing money at me? Give me a call.”
Kyle does not include a disclosure of the average earnings for Wrinkles-B-Gone distributors. The average is $345 per month per distributor.
What Kyle wants to do:
Kyle, in no attempt to be deceitful, would want to provide a naked link to the company’s income disclosure in the caption. He figures, “Hey, they can click on the link and see all of the numbers at their leisure.”
What the FTC wants to see:
In the caption of the photograph: Please click this link to see our average earnings: www.wrinkles-b-gone.com/earningsdisclaimer
The FTC allows marketers to provide a link to a disclosure IF the disclosure is not integral to the claim being made. “Integral” as defined by meridian is “essential or fundamental.” Is an income disclosure integral to an income claim? Sadly, the FTC does not give us any examples that involve income claims. But they did specify that issues related to health or higher costs would certainly require disclosure near the claim itself (not via a hyperlink). In an example in the guidelines, there was a refrigerator that was unable to maintain a cold enough temperature to prevent bacteria growth. In that example, a disclosure by the ad itself is required. Is the risk associated with an earnings claim on par with food borne illnesses? I doubt it (but I’m open for a discussion).
The FTC further states that disclosures made via hyperlinks are permissible when the data is too complex to disclose next to the ad itself. With income disclosures, the data can be very complex. Plus, the average earnings changes each month; thus, making it nearly impossible to get the entire field to properly disclose the averages immediately after their claims. It’s only practical, in my opinion, to get the field to provide a link to a full earnings disclosure. Keep in mind, providing the link by itself is insufficient. The link must be clearly labeled to adequately inform consumers. Inserting “Please click this link to see our average earnings” sends a clear signal.
If you allow your distributors to make income claims, it’s imperative that you educate them on the proper ways to make those claims. Also, it’s a good idea to display the income disclosure form at some point during the enrollment process. This will help “clean up” in the event your leader fails to provide a disclosure.
EXAMPLE 2: Weight Loss Claim
Gronk has been using “Slim-Me-Cave” for the past 30 days. Miraculously, Gronk lost 30 pounds in this short period of time. Incredibly happy with this weight loss product, Gronk decides to post a blog on the Internet. In the article, he writes, “I lose 30 pounds in 30 days with Slim-Me-Cave! It best weight loss product!!” The average customer of Slim-Me-Cave loses about 1 pound per week, so Gronk’s results are certainly above average.
What Gronk wants to do:
*Results Not Typical.
What the FTC wants to see:
Typical loss is 1 pound per week for Slim-Me-Cave customers. Results will vary depending on diet and exercise.
Your disclosures must give a “reasonable customer” sufficient information to make a decision. “Results Not Typical” does not provide enough information. When making a testimonial about a product that’s “above average,” the average needs to be disclosed (as per the FTC guidelines). Back in the old days, “Results Not Typical” used to work. But now since everyone is a potential marketer, the FTC wants disclosures to be more specific. Does “Results Not Typical” mean a customer will lose only 20 pounds in 30 days? 15 pounds in 30 days? What results can the average customer expect? When possible, provide the averages.
EXAMPLE 3: YouTube Income Claim
Stephanie is giving a video testimonial on YouTube about the benefits of her network-marketing company’s pay plan. She states that “In this business, when I recruited just 20 people, I was making over $2,000 per week!” In that particular program, the average distributor earns $235 per month.
What Stephanie wants to do:
Stephanie would probably not want to provide an income disclosure at all. I’m just being candid. Rarely in videos prepared by distributors do you see any kinds of income disclosures.
What the FTC wants to see:
The FTC states that the manner you communicate your claim should also be the manner you communicate your disclosure. Therefore, a YouTube video should contain a disclaimer in both video and audio formats. Where should the disclaimer be? Sadly, there’s no clear answer. But if we look at the FTC’s definition of “Clear and Conspicuous,” I think the safest bet is a text disclosure displayed simultaneously to the claim in question in addition to a more detailed audio and video formatted disclosure at the end of the testimonial. Or Stephanie could provide a “visual cue” during the video to communicate to the viewer that disclosures can be found at the end of the video.
Without question, it’s now required (in my opinion) that distributors end their videos with a properly formatted video segment. At the end of the testimonial video, a separate video disclosure should be included to illustrate the average incomes. The video file should include an image of the company’s income disclaimer (usually in spreadsheet format). While the image is on the screen, there should be audio narration regarding the average earnings. If a company is going to permit distributors to use YouTube to promote their businesses, the company should provide this kind of file freely on its website AND educate distributors on how to use it.
While it sounds complicated, it’s not difficult for companies to provide this sort of video file. However, if the company is unwilling to properly arm the distributors with sufficient tools to make good claims, they should restrict distributors from using YouTube (which is not realistic AT ALL).
There are several questions this kind of hypo raises:
Should companies require leaders to insert a clear and conspicuous textual disclosure to appear on the screen when the claim is being made?
It depends. In a perfect world, yes, it’s a good idea to provide the disclosure during the claim. But in reality, most reps lack the technical skill to do this right. This is what we know: disclosures should be as close as possible to the claim being made. Is it sufficient to provide a video file containing a full disclosure at the end of the video? In my opinion, the answer is yes. But in the abundance of caution, it would be better if there were a text disclosure provided during the video in addition to a video file being used at the end.
Is it a good idea to even allow reps to make these sorts of claims to begin with?
Are you able to produce a quality disclosure for your distributors to use? Do you trust your distributors to “color within the lines” and end their videos with a video? Do you have a solid compliance department to catch and correct the distributors that do this poorly? If the answer to those questions is “yes,” then you’ve got a shot. If, on the other hand, you answered “no” to any of those questions, it might not be worth the risk.
If you are going to allow reps to make videos that contain income claims, be careful! When it comes to videos, it’s difficult to walk the tight rope. When it comes to income claims in videos, there’s not much margin for error. With this in mind, I would advise companies to require tight compliance. At a minimum, companies should provide distributors with a professionally produced video file that all distributors can include at the conclusion of their videos. If you know leaders are going to make claims in YouTube videos, or any other video platform, it’s wise to properly arm them with adequate disclosures. A video file will give the needed audio disclosure as well as additional visual disclosure to the income claim in question.
EXAMPLE 4: YouTube Product Claim
“Sports Minded” is a company that sells organic products that improve mental focus during physical activity. Adam is a distributor for Sports Minded and he decides to do a self published a YouTube video to give a testimonial about how he can now focus for 8 hours straight while playing golf without additional supplements. However, studies performed by Sports Minded indicate users can experience an average of 4 hours of improved focus. Adam is being honest regarding his experience with the product. He’s like Mr. Miyagi for 8 hour straight! Since it’s a true statement about his personal experience, is he required to provide substantiation and disclose the average results?
What Adam wants to do:
Adam would likely try to provide a disclosure via a hyperlink in the video description, in text at the end of the video or in a brief audio message at the end of the video.
What the FTC wants to see:
They want a “clear and conspicuous” disclosure that contains the average results. Just like with the income claim example above, the disclosure needs to be in both audio and visual format.
It would be ideal if the distributor had the skill to inject the disclaimer immediately after making the claim i.e. “I know that the company says the average person experiences 4 hours of increased focus, but that was NOT the case for me!” In order for this to happen consistently in the field, the company needs to take compliance education very seriously.
As you can see with all of these disclosures, it’s a lot more art than science. We previously mentioned that the manner you communicate your claim should also be the manner you communicate your disclosure. Technically, the FTC wants to see the disclaimer in both audio and visual formats (even for videos produced by the field). With that being said, it’s unrealistic to expect sales people to get this right when they’re making product testimonials. And I think the FTC understands this (I’m at least hoping they do). With product testimonials, I think a text disclaimer inserted into the video would be a sufficient disclosure. But this approach would NOT be sufficient for income claims. Because money clouds judgment, the FTC is much more strict in that category (and they should be).
EXAMPLE 5: Tumblr Blog
Mary publishes an article on Tumblr about “N-ERGY SAVER,” a utility service MLM where customers can save money on their electric bills throughout the year. Mary, a representative, claims that she saved $50 per month by signing up with the company. While Mary’s claim is 100% true, the company’s data shows that the average homeowner saves $15 per month on their electric bill.
What Mary wants to do:
She wants to tell her story! She wants to say “I saved $50 a month with this service and so can you!” Since it’s a true story, Mary sees nothing wrong with her sharing her personal experience.
What the FTC is looking for:
The FTC wants to see a disclosure in close proximity to her claim. So if she has written text about her savings with N-ERGY, she needs to include a disclaimer in the same font and format as the text that triggered the claim. The disclaimer can say “The average homeowner saves between $10 and $20 per month, depending on their energy consumption patterns.”
Same as Example #2, except suppose Gronk wants to make the same claim via Twitter.
What Gronk wants to do:
I saved 30 LBS w/ Slim-Me-Cave in 30 days! bit.ly/f56/productinfo [linking to the product page that includes the average results]
What the FTC wants to see:
Twitter allows for 140 characters per tweet. If there’s sufficient space for a disclosure, it’s ok to use to twitter. Otherwise, it should be avoided. With Gronk, providing a link is insufficient. But the FTC provides a little hope in this category: as long as the average results are provided in the tweet, twitter can be used. The FTC provides an example of a permissible weight loss claim below:
Should Twitter be allowed for income claims?
No! There’s just not enough real estate to provide an adequate income disclosure. As I mentioned above, providing a hyperlink by itself is insufficient.
Twitter is tricky. If the distributors are properly trained, they can use twitter for good product testimonials. But with respect to income claims, Twitter should not be allowed AT ALL.
It’s going to be tough for network marketing companies to walk this tight rope. On the one hand, they want to give their distributors the freedom and flexibility to aggressively market the products and pay plan. On the other hand, they need to “pump the brakes” to ensure that the distributors are doing things right. In my opinion, the real challenge is going to be with online video. While it’s very easy for anyone to create a video with a webcam, it’s very difficult for people to insert proper disclaimers during and/or after the video. In the future, proper education in the field is going to be absolutely crucial. Companies that commit to field education are going to be the ones that pass the scrutiny. Companies that take their hands off the wheel and expect leaders to get this stuff right are walking on thin ice. The FTC’s expectations are out there. Ignorance is no longer an excuse.
This article was written in collaboration with our stellar summer associate, Jake Perry.
The world we live in today is changing at a rapid pace. Technological developments have revolutionized the way we communicate and live. We can now complete our Christmas shopping lists from the comfort of our recliners. But while these technological advancements bring great convenience, they also create serious problems for marketers. Bottom line: technology is growing faster than the law can keep up. It was easy to regulate marketers back in 2000 when the original guidelines were written. Few people had the ability to publish…anything. But today, it’s a different ballgame. We all have the means of production in the palm of our hands with our mobile devices. With communication tools such as YouTube.com, Facebook, Twitter and WordPress, it’s been really difficult for network marketing companies to create clear policies for their salespeople. Luckily, the Federal Trade Commission clarified much of the confusion. The FTC has recently published the .com Disclosure Guidelines (fully included below). Essentially, the guidelines provide a “how to” guide for giving adequate disclosures in online advertisements. This is a good thing. The FTC has recognized that this area of the law is fuzzy, blurry, and every other synonym for “unclear” you can find in Merriam-Webster.
These guidelines are extremely helpful and a step in the right direction for our industry. But….the document is over 50 pages long. This is why I have decided to boil them down in a way that makes sense for you all. The purpose of this series is to give you specific instructions on how to stay within the boundaries of these guidelines. While the guidelines never referenced any MLMs, I’ll be providing examples using fact patterns that are common to our industry.
Before we get into those fact patterns, it’s important to understand the basics of these guidelines. There are several key themes to keep in mind when providing “adequate disclosure.”
1) Required disclosures must be “clear and conspicuous.”
A clear and conspicuous disclosure is:
i. One that is within close proximity to the relevant claim in question.
ii. One that is not hidden in a bunch of senseless words.
iii. One that is prominent and easy to spot i.e. clearly visible.
iv. One that is in plain language that your target audience will understand.
v. One that is not accompanied by other distractions in the advertisement.
In other words, do not bury the disclosure in the fine print. It needs to be seen. Period. Keep in mind, the manner you communicate the relevant claim should also be the manner you communicate your disclosure. Therefore, a YouTube video should contain a disclaimer in both video and audio formats.
2) Do not partake in “unfair or deceptive acts or practices.”
While this should go without being said, it’s important to remember that “honesty” is always the best policy. Never try to hide the ball or position your product or service in a way that’s inconsistent with reality. Transparency with customers is actually good for business long term.
If the claim is untrue, there is no amount of disclosure or substantiation that can “sanitize” the statement. For example, an advertisement states that an individual lost 100 pounds taking a new weight loss supplement when in reality she only lost 75 pounds. In this scenario, no disclosure or amount of substantiation can qualify or limit the claim being made because the claim is blatantly false. Therefore, in this scenario, the claim itself must be modified, i.e. individual X lost 75 pounds using the dietary supplement.
3) Claims must have “substantiation,” regardless if they originate from the company or the field.
Substantiation refers to evidence that backs up your claim. The FTC states in the guidelines that before distributing an ad, advertisers must have “appropriate support for all express and implied objective claims that the ad conveys to reasonable consumers.” In other words, if a company or its sales people make aggressive marketing claims, those claims need to be backed up with reliable data. Research studies, expert opinions, and other types of data must be used to support any type of claim you make.
With MLM companies, distributors are also required to provide substantiation when promoting a product or service. As made clear in the Endorsements and Testimonials Guidelines published in 2011, the company can be held responsible for any false or misleading claims made by its distributors. Therefore, it’s vitally important to ensure the field is educated on ways to properly market the products and services. It’s crucial that the field understands when and how to provide substantiations and income disclosures. This is where compliance training becomes a key factor. If you care about the longevity of your business, you’ll make the investment to make sure your reps are adequately trained.
4) Would your disclosure give a “reasonable customer” notice of the information?
A reasonable customer is a hypothetical person who contains the necessary intelligence, judgment, attention, knowledge, and experience required to function in our society. For example, where a disclaimer is located at the bottom of a website in 30 lines of small text titled “LEGAL TERMS AND CONDITIONS,” a reasonable person would never expect to find a disclosure about the product they are buying buried there. A reasonable person would expect to find the disclosure somewhere within close proximity of the statement in question. When you’re creating promotional materials, use common sense when figuring out the location and form of your disclosures.
5) Research and follow-up on the effectiveness of your disclosure.
The FTC states that the ultimate test to determine the adequacy of a disclosure is whether the information intended to be disclosed is actually conveyed to consumers. While this is not a requirement made by the FTC in making an adequate disclosure, be forewarned that you will run the risk of having your disclosure declared inadequate. The FTC recommends conducting controlled side-by-side research experiments to determine where the average consumer does and does not look on a computer screen to test the effectiveness of your disclosures. The FTC also recommends assessing the effectiveness of a disclosure via hyperlink by monitoring the link’s click-through rate and make adjustments accordingly. If you know of an analytics geek that’s good with tech, it’s time to pay him or her. That data is going to be very important.
6) If you cannot follow the FTC guidelines in your advertisement, do not make the claim in question.
Where it is not possible to follow the FTC’s guidelines in giving adequate disclosure to customers, the claim in question should NOT be disseminated. This further reiterates point #1 and #4. A disclosure is not adequate simply because it is the best you can do under the circumstances. The disclaimer must actually convey the qualifying or limiting information to the ultimate consumer.
A perfect example of when it is not possible to ensure compliance with the FTC’s guidelines is when a distributor makes an income claim via Twitter. The character count allowed per “tweet” is simply not high enough to ensure that adequate disclosure is given to the consumer. As an example, a proper disclaimer could take up half of the tweet: “the average person can expect to earn between $300 and $500 per month.” While it’s true that a hyperlink may be included within a tweet, a reasonable consumer will not likely realize that “bit.ly/f56” leads to a disclosure of the statement made. Therefore, it is best to completely avoid making income claims on Twitter altogether.
Be careful. With companies that exercise tight control over their marketing efforts, complying with these standards will be easy. But for network marketing companies that rely on the creativity of a volunteer army, it’s going to be incredibly to walk this tight rope. Compliance training is going to be incredibly important to ensure sales leaders really understand how to do things right. Proper behavior in the field is not going to happen by sending out a single newsletter once a quarter or referencing the “C” word (compliance) at an annual convention. It’s going to take commitment. In Part 2 of this series, I’ll provide you with specific instruction on ways to do this right. I’ll be sure to use fact patterns that are common in the MLM industry.
If you’re reading this via email, please click here to review the full .com Disclosure Guidelines.
Guest post by +Cole Dowsley, Thompson Burton litigator. This is controversial subject in the network marketing profession. When independent distributors join a network marketing program, should they be “stuck” by way of a noncompete? Short Answer: legally, noncompetes are enforceable (in most cases, not all). When two adults sign a contract, it’s hard to get provisions thrown out. But, in my opinion,….the market might soon demand that companies remove these restrictions. Cue, Cedrick Harris. Harris, one of ViSalus’s top leaders, publicly (and respectfully) resigned from the company. His main gripe: the lack of flexibility to work other programs. As distributors get more educated in this area of the law, they’re going to start demanding that companies remove the restrictions. And when that happens, the restrictions will disappear. — Kevin Thompson
Most people think of non-compete agreements as a contract between an employer and an employee. However, this is not the only relationship where covenants not to compete may be valid. There are a number of other relationships in which courts have enforced non-compete agreements, including non-compete agreements between a business and an independent contractor and non-compete agreements between a buyer and seller of a business. Covenants not to compete may be included in or ancillary to a variety of business contracts, such as MLM distributor agreements and joint marketing agreements.
One of the most common questions is whether a business can require a “1099” independent contractor to execute a non-compete, and if so, whether the agreement is enforceable as to the independent contractor.
As noted in my recent blog post regarding the general enforceability of non-compete agreements, the law governing non-compete agreements is state specific. In Tennessee, the Court of Appeals has determined that covenants not to compete may be applicable to the independent contractor relationship.Baker v. Hooper, 1998 WL 608285 (Tenn. Ct. App. 1998). Courts in other states have reached the same conclusion. In the independent contractor context, non-compete agreements will generally be treated in the same fashion as employer/employee agreements. The U.S. District Court for the Middle District of Tennessee explained the law, as follows:
Although these provisions [with independent contractors] arise outside the employment context, and are entered into between companies with relatively more bargaining power than the average employee, they are still restraints on trade, and the Court concludes that Tennessee courts, if called upon to consider these provisions, would view them in essentially the same light it views non-competes in the employment context.
As such, the provisions are enforceable under Tennessee law only if they are reasonable under the circumstances. Tennessee courts have instructed that the factors to be considered in assessing reasonableness include whether the covenant not to compete seeks to protect a legitimate business interest, the economic hardship imposed on the restricted party, and whether such a covenant would be inimical to the public interest.
For a general discussion of the factors courts in Tennessee consider when determining the reasonableness of non-compete agreements, see my recent article on the subject. In the independent contractor setting, courts will likely place an emphasis on whether there is a legitimate protectable business interest under the circumstances of the case. The cases in Tennessee emphasize that there is no legitimate interest in protection from competition, only from unfair competition. In making this determination, a business must show the presence of special facts above and beyond ordinary competition that would give the independent contractor an unfair advantage when competing with the business. Such facts might include whether the independent contractor had access to confidential or proprietary information, such as business secrets, confidential pricing information and confidential customer lists. Unfortunately, there is no simple rule to easily determine whether or not an independent contractor non-compete agreement is reasonable and enforceable; it is a highly fact-driven analysis and the determination will depend on the unique circumstances of each case.
Do you have questions or concerns regarding a non-compete agreement? Contact the Business Litigation & Dispute Resolution Attorneys at Thompson Burton PLLC, who are regularly called upon to prepare, review, negotiate, and litigate non-compete agreements on behalf of businesses and individuals.
See below for the FTC’s latest effort to protect people across the country.
Begin Press Release
The FTC has been commissioned to address the growing belief that shorter men can actually compete at a high level in professional boxing. In fact, after conducting surveys over a period of four years, speaking with numerous experts (none of whom have actually boxed), the FTC has ultimately concluded that the empowering message of the Rocky franchise to be misleading for prospective boxers throughout the country. This report is intended to provide guidance for coaches and trainers going forward when they’re soliciting involvement from young fighters.
As per our newly published guidelines, trainers and coaches are required to obtain separate signatures on a disclosure document from prospective fighters before they begin training. The disclosure document addresses numerous myths associated with the Rocky character as well any false expectations held by prospective fighters. The disclosure document must contain a “purpose statement,” which is included below. The purpose statement must be included in red, 16 pt san serif font, center justified, all caps bold. The purpose statement must also be read aloud in English, Spanish, Mandarin and Russian.
THERE ARE BETTER WAYS OF EARNING A LIVING. WE, THE COACHES AND TRAINERS, STRONGLY ENCOURAGE YOU TO GET REAL JOBS. BUT IF YOU DECIDE TO PROCEED WITH A DREAM OF MAKING IT AS A BOXER, THIS IS A REQUIRED DISCLOSURE BY THE FEDERAL GOVERNMENT
The disclosure must state:
The average annualized income for all active Boxers during this period (before expenses) was $8.37. The average boxer can expect to suffer much and earn little.
Regarding the Rocky franchise: Rocky Balboa is a fictional character. Statistically, a 5’8″ Italian man over the age of 30 has zero shot of winning a heavyweight boxing title. Chasing chickens has not been scientifically proven to make you faster. There has never been a man that could really piss lightning or crap thunder. Pounding frozen meat has not been validated as an effective way to improve hand strength. After our medical advisory board reviewed the original Rocky film, they concluded that Rocky Balboa would have suffered 27 concussions at the hands of Apollo Creed before the final bell.
There are no guarantees of income as a fighter. Boxers that fail are condemned socially, labeled “wishful thinkers.”
As a refresher, in early February of 2013, the FTC got an injunction issued against Fortune Hi Tech Marketing. The summary of the lawsuit can be found here: FTC vs. Fortune Hi Tech.
Since the lawsuit was filed, I’ve had a lot of time to study the FTC’s arguments against FHTM. In particular, I closely studied the FTC’s expert report prepared by Dr. Peter Vander Nat. The FTC’s entire case hinges on the validity of Peter Vander Nat’s report.
In the lawsuit, the FTC passed for the scalpel and picked up the sledgehammer. In summary, they’re no longer relying on Vander Nat’s convoluted math formula, which I discussed in my last article regarding the FTC’s economist. If you’re following the news with Herbalife, I think you’ll find this next point interesting. Currently, there’s a lot of bickering back and forth between MLM proponents and critics alike over the interpretation of Vander Nat’s formula. People are discussing how Herbalife stacks up to the standard. With one word, I can put the entire debate to rest for both sides.
Are you ready for it?
The word is:
The formula is irrelevant. In Vander Nat’s lengthy declaration used against Fortune Hi Tech, the formula is never mentioned. Not once. Why? The answer is obvious. The FTC is distancing itself from it because the formula is too broad and too confusing. The FTC’s case against BurnLounge (sued in 2006) is jeopardized due to the ambiguity of this standard. The case is currently under appeal. The main source of contention: Vander Nat’s qualification as an expert. Vander Nat had never studied an MLM that he concluded was legal. Where’s the fairness in using an objective standard to measure right from wrong when you never find anything right? There’s no wisdom in designing a water-filter if there’s no opportunity for water to pass through.
In his declaration, Vander Nat opines and argues that FHTM was operating as an illegal pyramid scheme. Instead of relying on his formula, he bases his finding on a few assumptions. Those assumptions are all addressed in Charles King’s declaration (available below). Dr. King was retained by FHTM as its expert in their effort to dissolve the injunction. Out of Vander Nat’s assumptions, there’s one that should be concerning for all people in the network marketing industry: commissions triggered via internal consumption are “recruitment bonuses.” In other words, rewards triggered via distributor consumption are illegal. This argument represents a dangerous and irresponsible strategy employed by the FTC. In one of the footnotes in his declaration, Vander Nat writes, “…I also understand that the ultimate users of the products – for purposes of the Koscot test – are people who are not participants in the business venture.” With this framework, he pulls out all revenue garnered from distributor consumption. He then compares the money left over (not much) with the money paid out in bonuses. He then concludes that the pay plan is underfunded and relies on “recruitment bonuses” to survive. Charles King sums it nicely when he writes:
Since Vander Nat is not counting commissions generated via internal consumption, it creates the impression that the plan lacks sufficient revenue from product sales to support the commissions. He treats the difference between revenue available for commissions and the amounts paid as recruitment bonuses. Using his own definition of “end user,” he’s able to dramatically shrink the commission pot; thus, creating the false impression that the Commission Plan is insufficient and underfunded.
Vander Nat also relies on an economic theory known as “Optimal Scenario.” Using the Optimal Scenario framework, Vander Nat assumes that if EVERYONE were to hit the high levels in the FHTM business, the plan would be underfunded. The reality: not everyone hits the levels nor does everyone try. While Vander Nat acknowledges that breakage exists (money in the plan from un-earned commissions), he ignores it completely. In network marketing, the participants operate with various goals. There are some that want to earn a few hundred dollars a month, some do it for social reasons, some want to save money on product, some are supporting a friend or relative, etc. They’re not all trying to “max out” the pay plan. This assumption was faulty and led to a faulty conclusion.
What does all of this mean?
Change is coming. Stay tuned. In 2004, the FTC said that the amount of internal consumption is inconsequential for pyramid scheme analysis. Based on their recent case against FHTM and various posts on their website, the FTC appears to be back-tracking. It’s going to take strong leadership to steer this conversation in a favorable direction for the industry. And strong leadership requires that we at least acknowledge the areas where we’re weak. Cultures of hype need to stop. Product value matters. Without question, the industry is going to look different within 18 months. How different? We’ll see.
If you’re reading this via email, click this link to review the declaration prepared by Charles King.
As most of you know, the FTC has filed a lawsuit against Fortune Hi-Tech Marketing, alleging them to be a pyramid scheme. This is the first action taken by the FTC against an MLM since December of 2006. The most informative pleading that shows the FTC’s position is the memorandum supporting the FTC’s motion for an injunction. WARNING: It’s 54 pages…and boring. When describing these cases, I’ve found that it’s always best to give a brief summary of the business model.
Fortune Hi-Tech Marketing (“FHTM”) Business Model
FHTM is a network marketing company that specializes in selling nutritional supplements and beauty products. It also dabbles in selling cable and telecom services. Participants join FHTM by paying a $250 administrative fee. In order to qualify their positions, these “Managers” are required to move (buy or sell) 1,000 volume points. This usually costs between $100 and $400 per month, totaling at least $1,200 annually in product sales / purchases.
Managers can advance to “Regional Sales Managers” by recruiting six additional Managers. RSMs can advance higher by recruiting additional Managers. RSMs are eligible to earn $100 for each new Manager in their downline. While the new Manager doesn’t generate $100 worth of margin based on his or her product purchase, I doubt FHTM is using money from the $250 enrollment for the $100 bonus (which would obviously be a recruitment bonus). Instead, they’re probably allocating some of the breakage in the plan from unpaid commissions from product sales i.e. the majority of reps do not hit the RSM rank; therefore, there’s plenty of money in the pot for the bonus. Using Vander Nat’s “perfect scenario” theory, assuming everyone were to hit the RSM rank, the plan breaks. The FTC is exploiting this as a weakness in the plan.
The FTC’s thesis is simple: the FHTM products are merely incidental to the money making opportunity. The FTC makes itself clear: while FHTM talks about “selling product,” the references to sales are cosmetic designed to conceal a money transfer scheme. Additionally, the FTC is arguing that the structure of the pay plan itself is turbo-charged to reward recruitment over legitimate product sales.
FTC’s Purported Expert a/k/a the Kraken
The FTC’s attack dog throughout the years has consistently been its economist, Dr. Peter Vander Nat. Vander Nat co-wrote an article titled “Marketing Fraud: An Approach for Differentiating Multilevel Marketing from Pyramid Schemes.” In the article, Vander Nat publishes his math formula that he uses when reviewing a multilevel marketing program. Vander Nat is an interesting anomaly in the MLM industry. In my opinion, he’s similar to the the Kraken in Pirates of the Caribbean. In the movie, the Kraken is a large beast residing in the depths of the ocean, only to surface when called upon by its master to destroy a vessel. And when the job is done, it vanishes…
Vander Nat operates in simliar fashion. While the FTC recognizes the legitimacy of the MLM industry, their chosen expert does not share the same sentiment. I suspect they keep him locked behind closed doors for years, only to use his services when they need to sink a ship fast. Can you blame them? Vander Nat has never once found an MLM legal using his math formula. I’m not kidding. In the FTC’s case against BurnLounge, Vander Nat’s credibility as a witness is being contested at the appellate level. In its brief, BurnLounge references Vander Nat’s deposition transcript and writes:
Vander Nat had never studied any MLMs that he concluded were legal. He could not testify that using his analysis, one would ever find an MLM to be legal. . . Nothing was presented to show that his test had gained widespread acceptance. He likewise admitted that he did not know if his test complied with the Koscot/Omnitrition test.”
If you want the full text, check out page 43 of BurnLounge’s Appellate Brief.
I’m not making this up. The FTC’s expert, the man charged with distinguishing good companies from bad companies, has created an impossible standard. And furthermore, if you review his math formula published in his article, it requires a doctorate in quantum physics to truly understand. As if that’s not enough, central to his formula is this definition of “retail sales.” He writes, “We rely on Omnitrition’s findings that for purposes of pyramid analysis, the sale of product to ultimate users means the sale of product to those who are outside the organization.” In other words, for purposes of his formula, commissions triggered via internal consumption are considered “recruitment bonuses.” When you control the terminology, you control the outcome.
On a side note, his reliance on Omnitrition is misplaced. Omnitrition was never held to be a pyramid scheme. But I digress…
What does the FTC say on the issue of MLM internal consumption? Unlike Vander Nat, the FTC takes a softer stance on the subject when it writes, “In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme.” Clearly, there’s some incompatibility between the FTC’s public statements and their arguments made in litigation. Do they reserve the Kraken for what they perceive to be the most egregious of companies? It appears to be the case.
Why Fortune Hi Tech Marketing
Just to be clear, I’m not defending the Fortune Hi Tech model. I lack adequate information to form an opinion one way or the other. I’ve learned that it’s ill-advised to form an opinion based on the initial complaint. But I do know this: FHTM is isolated. The DSA rolled them under the bus and it only took them 24 hours after the FTC filed its lawsuit. FHTM is not part of the tribe, which means they’re not going to score many sympathy points from industry participants. Will this hurt them? I think so. If they survive the injunction (very high bar there), there’s not going to be enough positive press to keep their sales force engaged. The industry, traveling in a pack, will keep moving in a herd knowing full well that occasionally, some get eaten.
The FTC’s allegations can be summarized in two small sections.
(1) Recruitment Culture.
FHTM heavily emphasizes recruitment over sales. In fact, the FTC commonly places sales in quotes i.e. “sales.” They know that there’s a theoretical opportunity for sales, they just dismiss it as fake. They allege that as a requirement for participation in the plan, Managers must buy (or “sell”) a certain amount of inventory each month. This amount averages over $1,200 per year. Are the prices inflated? The FTC never says one way or the other. The FTC also accuses FHTM of overstating the benefits of their partnerships with nationally known brands i.e. DISH Network, Xoom Energy, etc. The FTC alleges that Managers in FHTM tout these partnerships as validation of the model; however, there’s very little commission to be gained from those sales because those partnerships are just “run-of-the-mill affiliate agreements.”
(2) Income Claims.
FHTM allows its sales force to make inappropriate income claims. The FTC provides a number of crazy claims made by leaders and executives. These statements were taken from all over the place, including company meetings, YouTube videos and, most surprisingly, Twitter. If you’re an executive for an existing MLM, pay attention. Compliance matters. While FHTM has an income disclosure document, the FTC is alleging that FHTM never made it a priority to get it in the hands of prospects. Also, the FTC alleges that the income disclosure document uses fuzzy math to reach its numbers because it excluded a large population of the sales force.
Does it make you nervous knowing that the Federal government can shut down a long-standing business without a judicial hearing? Critic or not, it’s disturbing. If FHTM is a flaming pyramid, it would never have survived a hearing. After being in business for over a decade, where is the imminent threat referenced by the FTC in its motion for an immediate injunction? The Critics, who commonly take a “win at all cost” approach, even if it means heralding a felon as their champion, will say “serves them right!” But be careful…
“And when the last law was down, and the Devil turned ’round on you, where would you hide, sir, the laws all being flat? . . . And if you cut them down, and you’re just the man to do it, do you really think you could stand upright in the winds that would blow then? Yes, I’d give the Devil benefit of law, for my own safety’s sake!” Sir Thomas More, A Man For All Seasons.
If you’re reading this via email, please click this link to view the FTC’s memorandum in support of its motion.
As most of you know, Herb Greenberg prepared a story about Herbalife for CNBC. The 20 minute documentary was titled Selling the American Dream. Herb worked for a very long time on the story, interviewing several people all throughout the country. I was interviewed by Herb in the CNBC studio in July of 2012. If you blink in the video, you miss me. I was only on for about 10 seconds, right around the 16 minute mark.
While Herb was working on the story for over a year, the catalyst for CNBC airing the story was the saga between Bill Ackman and Herbalife. There’s a great guest post on my site about the impact (or lack thereof) of Ackman’s Bear Raid on Herbalife.
Personal Views on Greenberg
He’s a very pleasant person. And he’s very intelligent, surrounded with a great staff of people. And unlike a lot of MLM critics, he actually gives a little airtime to BOTH sides of the agrement. While he certainly favors the negative side by providing links to MLM critics, he at least tries to inject some pro-industry commentary. I believe he’s spoken with the DSA, he interviewed Herbalife’s CEO and he also interviewed me. He dove deep and did his homework. In his own words, “After 10 months of independently digging into Herbalife and the industry, culminating with the CNBC documentary, “Selling the American Dream,” I can say with a fair degree of certainty: Multi-level marketing, which has been dogged by the same legal questions and controversies for 65 years, needs to be cleaned up.”
While not everyone shares this view with me, particularly leaders in the DSA, I actually agree with Herb on the need for change. I’ve written in the past about the MLM industry’s problem with self deception. Burying our faces in piles of money, pretending there’s not a problem is a sure path to irrelevancy. Paying commissions on internal consumption is fine. But we need to create better standards to alleviate the growing problem of “opportunity driven demand.” Opportunity driven demand exists when people purchase products they never would buy at prices they never would pay with the expectation of recovering their “investment” by recruiting additional participants (to repeat the cycle).
There needs to be legitimate value in the products and services changing hands. The popular sentiment that “all pay plans driven by product volume are legal” falls short of common sense and fails to account for opportunity driven demand. Under the influence of a pay plan, people will literally pay $1,000 for an ounce of lemonade. If you drive a pay plan from such sales, is it legal? Of course not. It’s this distinction that’s leading to so much confusion on Wall Street. We can attack the short sellers for manipulating the market. But really, they’re just exploiting the ambiguity in the law. And until the law is cleaner, it’ll keep happening whether at the hands of short sellers, class action attorneys, regulators, FTC, whoever.
My role in Herb’s story was simple: I was to discuss the laws in place distinguishing legitimate MLMs from illegitimate pyramids. While we discussed a lot of the positives in the industry, there’s none of that content that made the final cut. I’m not complaining. I’ll take the exposure when I can get it. But I’m just letting you know, I tried. The interview was an intense thirty minutes. The questions came at me rapid-fire the moment I hit the seat. It was fun.
Greenberg’s View on MLM
If you’re not able to tell by reading Herb’s stories about Herbalife and the MLM industry in general, he has a bad taste in his mouth. Intellectually, he’s not able to really “feel” and understand the benefits of the distribution channel. In an article Herb Greenberg posted on LinkedIn, he extends his focus away from Herbalife and discusses the potential challenges facing the entire industry. In his view, he predicts some regulatory activity against some of the larger companies. This would, in turn, trickle down and affect the smaller companies. While Herb senses a disturbance in the industry, he’s not able to put his finger on it. In his mind, it makes no sense for people to buy an arguably inferior product via MLM. This rationale assumes that the product is inferior and discounts the benefit of joining a community of people that share a common goal. In Herbalife, that common goal is weight loss and nutrition. Notorious short seller, John Hempton, summarized it well when he said,” Herbalife works in the same way as alcoholics anonymous – by supplying (and in this case selling) a support group to help you kick the ‘fat addiction’.” There’s power (and value) in community.
One thing is certain, as Herbalife’s stock continues to climb, Ackman will get desperate and start lobbying Congress (if he has not done so already). Will he be able to get the regulation he needs to save him from a stupid bet? It’s unlikely. And even if regulation does come, it’ll likely affect the smaller MLMs significantly more than companies like Herbalife. In my opinion, Ackman’s prayer for a government savior will go unanswered.
Conclusion, Lessons Learned and Special Thanks
I learned a lot from this experience. First, if someone with a platform invites you to participate in a conversation, show up. There seems to be this fear of the media by professionals in the industry. While there’s certainly the potential for bad, the upside outweighs the risk. We need more professionals willing to put their necks out there, communicating the benefits of the model. Second, the critics are becoming more organized. The internet is sticky and their content is spreading. The critics are getting in the ear of hedge fund managers, investment bankers, journalists and politicians. They’re like like Agent Smith in the movie The Matrix. If you’re not a tech nerd like myself, Agent Smith was like a computer virus, hell bent on destroying the very program that gave him life.
I want to extend a special thanks to Len Clements of MarketWave. Len is a great friend, and someone I trust very much. He took the time to help me prepare for the kinds of questions that are common from people skeptical of the model. His insight was key. I also want to thank my partner’s wife and Thompson Burton litigator, Melissa Burton. She literally reviewed my notes beat me up for over an hour on the issues. She has a good mind for poking holes in arguments and was invaluable for my preparation.
I’ve included some pictures below from my trip to New York. It’s such a fun place. My wife and I got a babysitter and left the three kids at home for a few days. I hope you enjoy the pictures.
Herb Greenberg of CNBC said it best on his twitter feed:
“ackman/loeb is classic: two smart guys, same set of books/info, totally different analyst. that’s what makes markets!”
Billionaire Dan Loeb places a $300,000,000+ bet AGAINST Ackman in favor of Herbalife, arguing that Ackman’s short-thesis is “preposterous.” In Third Point’s Q4 letter to investors, Loeb explains his optimism for the potential of Herbalife ($HLF). The full letter to investors is included below. The key sections dealing with Herbalife have been cut and pasted below for your convenience. Take care and stay tuned. There’s bound be some collateral damage when Wall Street giants collide. Note, Herbalife is scheduled to issue a rebuttal on January 10th regarding Ackman’s pyramid allegations. .
Excerpts from Loeb’s Letter to Investors
Herbalife is a leading provider of weight management and nutritional supplements
operating in more than 80 countries through a network of independent distributors. The stock declined by nearly half last month following controversial assertions made by a short seller about Herbalife’s business model and practices. Third Point has a different view and holds about 8% of Herbalife outstanding common stock, which we acquired mostly during the panicked selling that followed the short seller’s dramatic claims.
Based on its strong financial performance, Herbalife is a classic “compounder” – a well-managed company that sustains consistent top-line growth, has a leading market position, and steadily increases margins, earnings per share and free cash flow while demonstrating shareholder-friendly behavior. Since going public in 2004, Herbalife has increased revenue at a double digit rate for seven of the past eight years, expanded gross and operating margins, leveraged operating expenses, and introduced more premium products. Earnings per share have increased by approximately 20-50% each year since 2004, with the exception of 2009. Led by CEO Michael Johnson, management has also used the company’s ample free cash flow to de-lever its balance sheet and shrink the share count by nearly 25%. This type of steady non-cyclical growth is hard to find and puts Herbalife at the head of the compounders’ class.
With results like these, the case against Herbalife rests on a bold claim that the company is a fraud. The short seller’s lengthy argument against the Company can be boiled down to three principal smoking guns: the first, a claim that Herbalife has been operating an “illegal pyramid scheme” under the nose of the Federal Trade Commission for the past 32 years; the second, that Herbalife’s loyal customer and distributor base has been exploited and harmed despite the low number of consumer complaints and generous company return policies; and the third, a claim that Herbalife’s products are commodities sold at inflated prices not supported by sufficient levels of advertising or R&D.
Taken in reverse order, the third claim misses an essential truth that invalidates the indictment. No one believes Starbucks is a scam because you can buy a cheaper cup of coffee at your local bodega. A key contributor to Herbalife’s growth has been its distributor-led “Nutrition Clubs”, where consumers can purchase single servings of the Company’s signature beverages. The short seller’s assertion ignores the significant value customers place on every consumer brand and its community “experience” – whether at a Herbalife Nutrition Club, a Starbucks, or a corner bar. The markup is merited by community and brand identity, not by the commodity itself.
The second claim seems similarly dubious. The FTC, by all accounts, receives a very low volume of complaints annually about Herbalife – fewer than forty per year – and we find it hard to believe the short seller’s theory that hundreds of thousands of people who have been scammed supposedly are too ashamed to speak up. Herbalife is well-known for its generous return policies, buying back product from exiting distributors for up to twelve months. The Company repurchases an average of only 1% of sales volume pursuant to this policy. It is difficult for us to understand why the buyback volume would be so low if there are in fact so many unsatisfied consumers and distributors who presumably would not hesitate to be reunited with their cash.
The pyramid scheme is a serious accusation that we have studied closely with our advisors. We do not believe it has merit. The short thesis rests on the notion that the FTC has been asleep at the switch, missed a massive fraud for over three decades, and will shortly awaken (at the behest of hedge fund short seller) to shut down the Company. We find this thesis to be preposterous, particularly since the FTC has been sensitive to frauds of this kind. Since 1997, the FTC has brought 13 separate cases against alleged pyramid schemes. None of the companies that the FTC pursued had been in business for more than ten years and 11 of the 13 companies involved were less than five years old, suggesting the FTC actively protects consumers subjected to this type of behavior. The FTC has also aggressively pursued enforcement actions against similarly odious “deceptive business opportunity schemes” [see www.ftc.gov/opa/2012/ll/lostopp.shtm] under the “Business Opportunity Rule” (although this rule does not apply to multi-level marketers such as Herbalife).
. . . We also understand that Herbalife has a series of internal policies in place (based on a 1979 case involving Amway) designed to reduce the possibility of abuses that have been identified in other MLM structures.
Do such policies eliminate all possibilities of bad behavior? Most likely they do not, especially at a company with so many distributors. By the Company’s own admission, past irregularities and misbehavior have been detected and corrected. While the short seller’s presentation was lengthy, it presented no evidence to show that Herbalife has crossed a line that would compel regulators to shut it down. Indeed, there was very little “new” news in the presentation and when pressed in later interviews, even the short seller conceded that the FTC was not looking at Herbalife’s practices. In our experience, expert regulators like those at the FTC do not respond to sudden pressure from hedge fund whistleblowers by acceding blindly to their demands. Finally, even if there were some regulatory intervention that changed how the company does business, we are comforted by the fact that 80% of Herbalife’s revenues come from overseas.
So we return to our compounder thesis, available at an attractive discount, probably for a limited time only. We believe that continued strong operating performance combined with disciplined capital return could easily send the stock back towards its April highs. Let’s not forget: the business itself is performing well. Volume, revenue and earnings are all growing double digits and the balance sheet is largely unlevered. Management has a history of returning 100% of net income to shareholders in the form of dividends and buybacks. If management were to deploy its existing $950 million buyback authorization in the $40-45 range (only taking leverage to approximately 1.5x), we estimate that run-rate EPS for 2013 could be $5.50-5.70 using the reduced share count. Applying a modest 10-12x earnings multiple suggests Herbalife’s shares are worth $55-$68, offering 40-70% upside from here and making the company a compelling long investment for Third Point. Given that the Company has historically traded more in the 12-14x range (and traded at 16-20x earnings through much of 2011 and early 2012), the opportunity for the Company to tell its side of the story tomorrow at its Analyst Day in New York, and the significant short interest, we believe shares could even trade well above our current price target.
If you’re receiving this message via email, please click this link to review Loeb’s full letter to his investors.