Why Ackman targeted Herbalife’s nutrition clubs

Overview of the Herbalife situation

William Ackman, the founder and CEO of Pershing Square Capital Management, issued a presentation on Tuesday about global nutrition company Herbalife (HLF). He disclosed new evidence that focused on Herbalife’s nutrition clubs. Ackman has campaigned against Herbalife since December 2012. He has released numerous presentations and reports alleging the nutritional company’s multilevel marketing model is a fraud and a “pyramid scheme.”

Ackman, who spent $50 million on his campaign to shut down the Los Angeles-based Herbalife, said he launched investigations into 240 of the company’s nutrition clubs worldwide. These clubs accounted for 40% to 50% of the company’s revenue and were “entirely fraudulent” with “phantom or fictitious customers,” Ackman said. During the presentation, he compared Herbalife’s “illegal pyramid selling scheme” to Enron, Bernard Madoff, the mafia, drug dealers, and also the Nazis. He also said that Herbalife would collapse without these clubs.

The goal of Ackman’s undercover investigation of Herbalife’s nutritional clubs in multiple countries and in the U.S. was to reveal evidence that the clubs target lower income groups, especially from the Hispanic American community, who are misled into spending a lot of money in small increments to get certified as distributors. According to iamherbalife.com, self-identified Spanish-speaking members represented 45% of members in the U.S. during 2013, down from approximately 60% in 2011.

Under the company’s model, these potential distributors end up paying for the products they consume and are also encouraged to bring in new members, mostly family and friends, who pay to try these products. Ackman said that these distributor-owned clubs on average lose $12,000 each year and that the recruits spend at least $3,000 on trainings and shakes.

Supported by audio, video recordings, and leaked documents, Ackman concluded that Herbalife’s model was focused more on recruiting new members instead of sales. He claimed that there is no “fundamental demand for the product.” He also noted that many of the distributors lose money and give up, while only a select few “at the top of the pyramid” gain from the scheme.

Herbalife said in a statement that Ackman’s allegations about the company’s nutrition clubs are “completely false and fabricated.” It said, “We will continue to focus on our mission of bringing good nutrition and economic opportunities to communities across the globe.” It also said, “According to a recent study commission by the company, 87.5% of nutrition club operators feel good about the money they earn and 92% want to continue with their club.”

In a separate statement, Herbalife released the findings from research and analysis about its U.S. business operations. Dr. Walter H. A. Vandaele of Navigant Economics, LLC. conducted the investigation. Dr. Vandaele assessed whether Herbalife could be classified as a beneficial, legitimate Multilevel Marketing (or MLM) firm. He concluded that “Herbalife’s U.S. business operations are consistent with the socially beneficial MLM model and inconsistent with the socially harmful pyramid scheme model.”

Multilevel marketing is a type of direct-selling, but it has faced controversy over claims that some are pyramid schemes. According to the Securities and Exchange Commission, a pyramid scheme is “a type of fraud in which participants profit almost exclusively through recruiting other people to participate in the program.”

The Direct Selling Association said findings from its annual Growth & Outlook Survey for 2013 estimated retail sales for the direct selling channel in the U.S. were up 3.3% from $31.63 billion in 2012 to $32.67 billion.

Some well known MLM companies like Herbalife include Nu Skin Enterprises, Inc., (NUS), Usana Health Sciences, Inc., (USNA), Avon Products, Inc., (AVP), Tupperware Brands Corporation (TUP), and Amway. Nu Skin, which sells skin care products, saw shares fall earlier this year. It was fined, after an investigation in China, over the illegal sale of certain products and of making product claims that could not be verified.