Pershing Square’s lawyer, David Klafter, Sends a Letter to Herbalife’s Chief of Compliance, Pamela Jones Harbour

AdviceDavid Klafter, Senior counsel at Pershing Square, wrote an extensive letter to Herbalife’s new chief of compliance, Pamela Jones Harbour. Before diving into the letter, the basics:

Pam Harbour was a former FTC Commissioner. The FTC is led by 5 commissioners, she was one of them for 7 years. She recently took a position as head of compliance at Herbalife. Based on public comments, she’s been given tremendous authority.

David Klafter is a lawyer. He’s obviously well qualified and talented. With that being said, in this arena, I think it’s safe to assume the following:

He’s never represented a network marketing company;
He’s never represented a distributor in a network marketing company;
He’s never represented a network marketing company against Federal regulators;
He’s never worked with a compliance department in a network marketing company;
He’s never given advice on the appropriateness of penalties for compliance violations;
He’s never sued a network marketing company;
He’s published no articles, neither academic nor online, relative to the network marketing industry.

I’m not saying he’s a bad lawyer. He’s actually a good one. But it’s important to step back and look at the full picture.

As for his employer, Bill Ackman: Ackman warns PwC

He’s vowed to “go to the end of the earth” with his assault on Herbalife;
He’s bet $1,000,000,000 on Herbalife’s demise, accusing them of being a sophisticated pyramid scheme;
He’s spent $50,000,000 researching / attacking Herbalife;
He’s being investigated by the SEC for Insider Trading;
He’s counting on the Federal government to bail him out of his bet with Herbalife, hoping for regulatory action;
He’s suing the Federal government over Fannie Mae and Freddie Mac;
He’s been busy bribing / lobbying Congress to stimulate regulatory pressure. There’s nothing illegal about bribing people in Congress…money in politics is a disgusting reality these days;
He secretly promised a disgruntled former Herbalife executive as much as $3.6 million over 10 years if he blew the whistle.

With all of that being said, it was very magnanimous of Pershing Square to offer assistance to Pamala Harbour.

Since you now have a little more context into the history, it’s time to dive into the letter (available here if you’re reading this via email).

I’ve always believed it to be important to understand from the critic’s point of view. When I process all of the information, both good and bad, I feel I’m in a better position to give advice and make decisions. The “we’re completely right and they’re completely wrong” attitude is held by many in the MLM industry, and it’s juvenile and stupid. This eyes-wide-shut mentality has led to the proliferation of countless scams, all operating under the guise of legitimate network marketing. The largest trade association of network marketing companies, the DSA, has failed to appreciate the enormity of this problem. It’s this failure to spot these issues both inside and outside of its walls has led some member companies to question their continued involvement.

To steal a word from Herb Greenberg, the industry is due for a reset. Based on methodologies, this reset will impact some companies more than others. But make no mistake about it, the screws are about to be tightened and companies will no longer be able to turn a blind eye to questionable activities in the field. The days of “faux compliance” are over.

The question that has analysts on Wall Street scratching their heads: How will this reset affect Herbalife’s revenue? Is the more responsible Herbalife capable of producing similar results as the pre-Ackman Herbalife?

The reality is that the industry absolutely needs to improve. It’s true that many of the sins being referenced by Pershing Square are indeed problematic. Do those transgressions warrant an injunction? No. Is Herbalife a pyramid scheme? No. Have they been caught in the middle of some embarrassing mistakes? Yes. Will they continue to grow? Yes.

In my opinion, unless he exits from his position, Ackman is not going to profit from his gamble with Herbalife. Instead, he’s made an investment that will ultimately benefit the entire network marketing industry, revealing the vulnerabilities and leading to eventual reforms.

Back to the letter…

It’s hard to take this letter seriously when it starts off by saying “[W]e believe Herbalife operates the largest and best managed pyramid scheme in the world.” And with that being said, Klafter proceeds to offer Harbour some free advice.

He does have some good ideas. His compliance recommendations, of which he makes 17, can be boiled down to 2 categories:

(1) Transparency
(2) Authority

Transparency

DisclosuresThe majority of the letter is dedicated to Herbalife’s purported lack of adequate income disclosures. According to Klafter, Herbalife’s current income disclosure document needs to be more robust. Klafter appears to think that more substantial disclosures will result in fewer enrollments and less revenue. He writes, “It is the image (true or not) of their financial success that motivates existing distributors to continue investing time and money, and arms these top distributors with an essential deception that they use to lure new recruits into the scheme.”

He accuses Herbalife of condoning a “fake it till you make it” culture. Earlier in the letter, he writes, “Consider what would happen if, in all meetings with potential recruits, the recruiters were required to remind the audience clearly of certain key facts, for example: 88% earn nothing from the Company; Most money goes to the top 1%; Members churn rapidly; Most distributors suffer net losses. . . ”

Cultures of hype and hyperbole are problematic and do exist. Is it inherent in Herbalife’s culture? Does Herbalife sanitize this sort of behavior with its income disclosure measures? It’s not for me to decide.

Will an increase in disclosures slow down enrollments? No.

I have had numerous clients become more aggressive with its disclosures of average earnings. I’ve seen a client go so far as to say, on camera, “there’s a good chance you’re not going to make any money in this business.” As it turns out, the majority of people aren’t stupid. People intuitively know that there are no guarantees in anything, especially with an income opportunity. When they hear clear messages regarding average earnings, their level of Trust for a company increases, which is actually good for business.

As pointed out by Plaintiff’s counsel in the proposed settlement order in the class action case, “Herbalife claims, and has produced some documents and information indicating, that, since it began publishing the information regarding the winners and losers in its 2012 Statement of Average Gross Compensation [which contained more information regarding the average results], the number of people becoming new Herbalife members has not declined at all. In fact, new memberships have increased. In other words, Herbalife argues that after it began disclosing more information about those who received no payment from Herbalife in its SAGCs, there was no ‘impact’ on the number of people who wanted to become Herbalife members.”

While Klafter is looking to give Herbalife a poison pill, one that he thinks will lead to their end, pressuring them to up their game with income disclosures is not it.

Regarding the sale of “recruiting materials,” Klafter might have traction here. In some companies, particularly the older ones like Amway and Herbalife, some sales leaders have historically made additional income selling “tools.” In some cases, this “additional income” dramatically exceeds the money provided by the MLM. With Herbalife, it has come out that some of their leaders have earned significant incomes from the sales of leads (an old practice, recently shut down) and tools. The issue: It can be construed as misleading when leaders are showing images of wealth at an opportunity meeting when the source of that wealth was not from the sale of products. Amway has bled because of this very issue, being the main driver for its $50M+ settlement to a class action case. If leaders are talking about yachts and mansions while they’ve only made $200,000 from an MLM and $2,000,000 from tool sales, it’s a problem.

Companies in the industry need to be better when it comes to MLM income disclosures. The rules are simple. Whenever money is discussed, the prospect needs to see the average earnings. Instead of simply checking a box where the new person asserts that he or she has seen the disclosure document, I recommend that companies be more clear and have the prospects assert “I understand that the average participant earns a net income of $20 in this business.”

Authority

BOSTON_BOMB3_2541703bThis other category of his compliance suggestions is far more interesting. And candidly, I had never considered these sorts of concepts. Basically, Klafter expresses his hope that Pamela Harbour will have enough authority to protect consumers, regardless of the impact it may have on her employer. This is made clear in the letter when he writes:

“You may find yourself at the fulcrum of choosing between protecting consumers or protecting the Company. Based upon our research, we do not believe you can do both.”

He wants Harbour to have the authority to act independent, free from company pressure, to protect consumers. I’ve seen this sort of conflict inside companies between compliance administrators and company executives. Field leaders will align themselves with company executives, insulating themselves from the big, bad compliance department. When it comes time for the compliance department to root out bad behaviors, the distributors run to mom and dad and ask for protection. And more often than not, they get protection.

He also pushes for the compliance department to have the authority to retain separate legal counsel and/or report wrongdoings to the proper authorities without fear of termination.

His compliance suggestions are summarized below:

Modifications to rules to allow online selling

This is a poison pill. Herbalife, along with every other network marketing company, has every incentive to protect its channel of distribution. Online selling (via eBay and other third-party sites) should never be allowed because it completely undermines the field’s ability to sell. And candidly, online selling amounts to less than 1% of all sales activity.

Public announcements of the imposition of sanctions.

I call this the “head on a stake” policy. I’ve seen companies do it and it’s effective.

Protections for compliance admin to allow them to work without fear of termination.

This is interesting. It’s important; however, I’m drawing a blank as to how to execute this at the employment level. People can be fired for anything (in most states); thus, it would be hard for a compliance officer to argue that he or she was terminated because of their actions against distributors.

Independence of compliance from senior executives and senior distributors, such that top distributors are prohibited from inserting themselves into investigations.

This is very important. I’ve never seen a compliance admin be given the ultimate freedom to sanction distributors without an executive’s authority. And executives are under tremendous pressure to protect the relationship with top-leaders; thus, there’s usually a bit of a conflict between protecting consumers and protecting the leaders.

An anonymous procedure for receiving and investigating wrong-doing.

I call this a “911 Mechanism” where people can report bad activity. Most companies already have this in place.

An extensive monitoring system to capture distributor promotional material.

These tools exist. It’s my understanding Herbalife has some cutting edge tools to search content on YouTube and other areas of the web.

Making top distributors responsible for conduct in their downline.

I like it. If the distributors are going to profit from the bad behavior, they need to also share in the consequences.

Imposition of material financial sanctions to those who profit from wrongdoing.

I like it. I would surmise that regulators want to see more than slaps on the wrist when fraud in the field is detected.

Authority for the compliance department to engage separate legal counsel.

This is interesting. I’m not sure how it would work logistically, though.

Authority for the compliance department to refer matters to Federal, State and local regulators.

This is also interesting. I actually agree with it, provided that this authority is used sparingly. I’ve seen clients of mine snitch on field leaders AFTER the leaders were terminated, to give the authorities a heads up. It’s a pro-active way of saying “If you see this knukcle-head, he’s not with us!”

Conclusion

Regarding Herbalife, these changes, if adopted, would not sink the organization as many critics hope. I have found that investments in tighter compliance processes leads to MORE growth, not less. Compliance kills pyramid schemes, not legitimate companies that offer real products. While Herbalife’s domestic revenue has slowed as the field is absorbing these changes, it’s not going to collapse.

Regarding the network marketing community in general, some of these suggestions are worth considering. If done properly, a robust compliance department can actually be really good for business.

It’s true that some companies operate with a “veneer” of compliance, without taking it seriously with the hopes of fooling regulators. Those days are long-gone. The sooner companies come to terms with this reality, the safer they’ll be. Build the ark before it rains.

What do you think? Do you think some of these ideas could fly?

Pershing Square Letter to Pamela Jones Harbour by kevin_thompson

Grace vs. Law: challenges faced by MLM companies when correcting distributor behavior

I wrote the article for the Obtainer Magazine last year.  The Obtainer is an international magazine dedicated to writing about the direct sales industry.  The article was well received by their readers and it’s now included below for your enjoyment and education.  How should a MLM company go about disciplining a distributor? Read below to find out!

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“Trent “Never Say Never!” Jackson has been an outstanding distributor for several years for a wellness MLM called “Mind Your Business.”  He’s built a $2,000 per month income, he’s diligent, ambitious, personable, attends all of the meetings, never missed an autoship, shows a great plan and throws fabulous demo parties.  With all of the MLM startups in the industry these days, they all want committed guys like Trent.  Later, Trent gets approached by his good friend, Geoffrey Gullible, and gets pitched about “Dewey Cheatham & Howe” business.  DCH is the latest and greatest cash investment program.  They’re an MLM with a unique selling proposition: they sell dollar bills for fifty dollars.  With each distributor that goes on a three dollar monthly subscription, the sponsor gets a substantial cash prize each month!  Trent is interested.  He thinks to himself, “Wow, if I can only transfer 20% of my MYB downline, I could be making some serious cash with the DCH compensation plan.  There’s no better business than one that sells cold, hard cash!”  Trent starts making some phone calls to people in his downline, he tells people about the awesome DCH pay plan and he talks a little trash about his other MLM.  He says, “Everybody wants money, and we’re selling it!  Who’s coming with me?” He’s successful in recruiting several key leaders from MYB and the rest is history.  Mind Your Business’s compliance department hears news of Trent’s behavior and calls a meeting.  What should MYB compliance do about Trent?  Do they lead with grace or should they lay down the law?  

Educate or Terminate

As crazy as it seems, these are the kinds of choices compliance departments make everyday in the MLM arena.  An entrepreneurial spirit, usually the greatest character trait that leads distributors to join a company, can sometimes be a challenge for MLMs seeking to retain the interest of a multi-talented group.  Regarding Trent from our fact pattern above, compliance departments will need to decide if they want to terminate, suspend or simply warn him about his behavior.  And doing nothing is always an option, too.  In my experience representing dozens upon dozens of MLMs, young and old, I see a common question when addressing compliance issues: do we educate or terminate?

In my opinion, compliance departments should be designed to serve two important functions: education and protection.  First and foremost, they exist to train distributors of the proper behavior when marketing the product and income opportunity.  When the sales force is properly educated, it leads to good behavior in the field, which leads to fewer complaints and better longevity for the company.  Secondly, when their education efforts fail with certain people, compliance departments exist to levy penalties to  protect the companies from legal troubles.  Remember when your father would say, “It’s for your own good…”  That’s not the case here.  When distributors get disciplined, it’s done for the good of the business.

Distributor Discipline

If you’re reading this as a distributor, I’ll share with you the top three reasons that lead companies to take corrective action.  Reason number one: distributors soliciting people in their downline for another MLM.  When a company provides support for its distributors to build the business, the distributors are positioned to learn the identities of a lot of people they never would have met but for the opportunity offered by the company.  The company has a legitimate interest in preventing its downline from being raided by other companies offering sweetheart deals to key leaders.  In the “Mind Your Business” scenario, Trent was leveraging his contacts in his MYB downline to build his Dewey Cheatham & Howe business.  It happens a lot in the space.  Reason number two: distributors making aggressive product claims, usually on unauthorized websites.  In their zeal to build a large business, some distributors can become too aggressive with their product claims i.e. “This pill cures cancer!”  If the company does nothing to curb aggressive claims, regulators will attribute the wrong acts of the field to the company.  If there’s a pattern of wrongful conduct and zero enforcement, it’s a recipe for problems.  Reason number three: distributors making aggressive income claims.  As with reason number two, in their haste to create momentum in their downline, distributors might resort to over-inflated income claims i.e. “earn millions of dollars in days with our new, revolutionary pay plan!”  It’s not common across all companies; however, it happens enough to where companies uniformly issue policies designed to prevent the behavior.  When regulators attack a company, they almost always quote distributors making aggressive (and unauthorized) income claims.

Survival of the Smartest

As the saying goes, “An ounce of prevention is worth a pound of cure.”  The best way for MLM companies to orchestrate solid behavior in the field is through proper education.  And education starts with having clear standards published in the polices and procedures.  I know, I know….nobody reads the polices and procedures.  But when there’s behavior occurring that reflects poorly on a MLM, it’s always best when a company can cite a specific provision in the policies and begin the education process.  I always compare the policies and procedures to the US Constitution…people might not have it committed to memory but it’s always in the background influencing behavior.  Clear policies is a good first step with education.  Secondly, companies should consistently communicate important standards to the field through all of its communication channels.  As an example, if a MLM is selling a supplement with an anti-inflammatory ingredient, they need to habitually remind the field to refrain from marketing the product as a treatment for arthritis.  As the great Napoleon Hill wrote, “Any idea, plan or purpose may be placed in the mind through repetition of thought.”  Without measures designed to lead to education, companies should never be surprised when there’s consistent bad behavior across multiple downlines.

What about Trent?

So what should we do about Trent, our protagonist from the fact pattern above?  Do we show him the door or extend some mercy?  In my opinion, I would advise the company to lead with grace, not law, and try harder to understand.  If Trent actually violated the agreement and caused harm to the business, the company should approach Trent with a cooperative spirit and try to meet with the intent of strengthening the relationship, not weakening it.  After all, Trent was and remains a committed distributor for the company, which makes him a valuable asset if he could get back on track.  If Trent refuses to get in compliance with the agreement and continues to solicit, termination might be appropriate.  If he acknowledges the behavior and makes a statement that he’ll get back in compliance, he should at least get a warning or a temporary suspension if the harm was strong. By handling all distributor disputes consistently and fairly, good companies can create a history of conduct that they can show regulators in the event they get in trouble for distributor misdeeds.  When a company says “We never condone this kind of product claim,” it’s always more believable when there’s a history of enforcement that backs up the statement.

Patience

Companies should never forget that for most distributors, it’s their first attempt at owning their own businesses.  They’re going to make mistakes and mistakes are part of the learning process.  If the company is too strict with their policies, compliance will never be an issue because all of the distributors will take their talents elsewhere.  And distributors should always remember that they’re engaging in a partnership with the MLM company.  As with all partnerships, there’s some giving and taking, which means distributors should trust their company and listen accordingly when the company is trying to curtail some behavior.  It’s a delicate balance between the company and the field when trying to enforce standards.  It’s more art than science and the ones that get it right enjoy decades of prosperity.

FTC Targets Acai Seller

The Federal Trade Commission has filed a complaint to stop LeanSpa, a weight loss company that has allegedly used fake news websites from affiliate marketers to promote its acai products.  LeanSpa parties apparently used affiliate marketers to drive interest to their program.  Allegedly, the affiliates used “fake news sites” to fein credibility about the products and drive traffic to the main site; thus, earning themselves commissions.  In its press release, the FTC states,

The complaint alleges that the defendants hired affiliate marketers who used fake news websites to promote the defendants’ products. The fake news websites used domain names that appear to be objective news or health sites, such as channel8health.com, dailyhealth6.com, and online6health.com. . . The fake news sites had links to the defendants’ own websites, where consumers were offered trial samples of two weight-loss dietary supplements: an acai-berry product and a colon cleanse product. The affiliate marketers earned a commission for each consumer who landed on their sites and signed up for a trial.”

There are three things that stand-out with this lawsuit that are relevant for the MLM community.

First, never outsource the creation of marketing materials without proper guidelines.

In the case mentioned above, the FTC highlighted the marketing practices leveraged by the affiliates.  The affiliates were obviously creating their own marketing materials, leading them to pretend to be objective reporters and using with legitimate-looking domain names. Although they were not agents of the company, the behavior still got the company in serious trouble.  With MLM companies, it’s more complex than a simple affiliate model.  With a MLM model, it’s specifically designed to not only recruit and retain first level affiliates, it’s designed to empower those individuals to sponsor and train other people. It’s an affiliate model on steroids.  With this in mind, it’s imperative for companies to at least maintain approval-rights before a leader can develop MLM training.  This includes restraining the field’s ability to create internet landing pages.  It seems harsh, but it’s the irresponsible 1% that can lead to the ship burning down.

Second, when making endorsements, affiliates must disclose their relationship

In the past, I wrote about the revised FTC guidelines.  In these guidelines, the FTC makes it painfully clear that when there’s a financial connection between an endorser and a business, the endorser is obligated it disclose the relationship.  Specifically, it requires disclosure when: “When there exists a connection between the endorser and the seller of the advertised product that might materially affect the weight or credibility of the endorsement (i.e., the connection is not reasonably expected by the audience), such connection must be fully disclosed.”  With LeanSpa, the affiliates were trying to pretend to be objective reports, which put the company at substantial risk.

Third, avoid the “Negative-Option Continuity” plan

This one is just plain common-sense.  A negative-option plan is one where a participant is automatically enrolled in an autoship and they need to specifically opt-out. With LeanSpa, apparently people were enticed into purchasing small samples of the product.  However, they failed to realize that they were also committing to a monthly $80 purchase of inventory. If a MLM business has an autoship program, it’s vital to ensure the distributor specifically chooses to participate in the program.  Do not allow the sponsor to enroll the distributor into an autoship program without express consent.  And be candid about the financial commitment involved.

Bonus: Playing dumb never works.

It would be easy for a company like LeanSpa to say, “we’re not able to control how these people market our products.”  At the end of the day, the FTC is not going to buy the argument. Companies cannot reap the benefits of misrepresentation without accepting responsibility from the methods by which the benefits were obtained. While it’s hard to run a tight ship, it’s incumbent upon every MLM company to do it right given the high stakes. MLM compliance departments are very important.

What are your thoughts?  Do you see any poorly run websites out there run by distributors?  How should the company monitor the web to prevent it?