regulators

Herbalife and the FTC's uneven history with pyramid schemes

March 13, 2014: 1:39 PM ET

The primary regulator in charge of policing multi-level marketing frauds has only brought three new cases in the past 13 years.

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FORTUNE -- Bill Ackman's campaign to prove that diet shake company Herbalife is operating a pyramid scheme has finally paid a dividend.

On Wednesday, Herbalife disclosed that it was under investigation by the Federal Trade Commission. The FTC later confirmed the news. Shares of Herbalife (HLF) have fallen 12% since the news broke, and the stock is down 26% this year. Investors, though, could be overreacting to the news. The FTC's track record is uneven at best in policing pyramid schemes.

The lack of FTC prosecutions has long frustrated critics of multi-level marketing companies, which sell their products by recruiting individuals to sell to friends, family members, and acquaintances. Herbalife is one of the nation's largest and oldest multi-level marketing firms. Critics say that many MLM businesses are essentially pyramid schemes, ripping off new recruits. Last year, Fortune detailed the extensive fraud allegations against another large MLM company, NU Skin (NUS).

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"The chances that the FTC investigation against Herbalife will turn into something is almost nil," says Tracy Coenen, a forensic accountant who has been following multi-level marketing companies for nearly a decade. "Bill Ackman is wrong in thinking the government will shut down Herbalife."

The FTC won't say how often investigations lead to lawsuits or fines, but the answer seems to be not too often. Since 2001, the FTC has charged just five companies with running pyramid schemes, and three of those cases dated back to investigations that started in the 1990s. And all of those cases were against relatively small companies.

Other regulators do seem to have been a bit more aggressive. The Securities and Exchange Commission has charged two MLM companies in the past two years with running pyramid schemes. One of them, Rex Venture Group, which ran online auction company ZeekRewards, was as large as $600 million. In 2009, California shut down YourTravelBiz, calling the company, which sold access to travel deals, an "elaborate pyramid scheme." And the SEC opened an investigation into Herbalife last year, shortly after Ackman began to attack the company.

It is unclear how long the FTC has been looking into Herbalife. The company says it received its first notice of the FTC investigation on Wednesday in a letter. The company denies that it is breaking any laws, and it says it welcomes the investigation.

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Last October, a group of consumer advocates filed a petition urging the FTC to do more to regulate the MLM industry. Among the proposals was one that called for the FTC to require MLM firms to disclose the success rate and average profits of recruits. Other companies, such as franchisors, have to disclose similar statistics.

"I do think this is an under-regulated industry," says William Keep, who is the dean of the business school at The College of New Jersey and has co-authored studies with a top economist from the FTC to define the difference between a legal MLM company and a pyramid scheme.

Still, some see the FTC's investigation of Herbalife -- along with a case it brought last year against another MLM company called Fortune Hi-Tech, which shut down that company -- as a sign that the agency is becoming more aggressive on the issue. They say the changes are coming in part because of pressure from Ackman and others.

Keep and the FTC's Peter Vander Nat recently updated their research from the mid-2000s on MLM companies. Keep says Ackman and the controversy around Herbalife partly inspired the update.

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The new paper, which is scheduled to be published later this year, specifically mentions Herbalife. The authors write that Herbalife uses deceptive statistics in describing just how much its sales associates and distributors make. "[Herbalife's] website features success stories highlighting 'financial freedom' and 'being my own boss,'" write Keep and Vander Nat in their paper. "But in 2012 less than 2.7% of eligible distributors and sales leaders (0.47% of all distributors) earned more than $25,000 in annual compensation."

"I think the environment has changed," says Robert FitzPatrick, who runs the website Pyramid Scheme Alert. "More complaints about these companies are coming. It's going to be impossible for the FTC to sweep this all under the rug."

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