The real thing or a house of cards?

Businesses around the world are falling prey to illegal pyramid schemes.

In December 2012, billionaire investor Bill Ackman began a campaign to prove that Herbalife International, a successful US-based multilevel marketing company, operates a pyramid scheme.

Ackman, founder and CEO of hedge fund Pershing Square Capital Management LP, announced his company was taking a significant short position on the publicly traded Herbalife, which develops, sells and markets a range of nutrition, weight-management and skin-care products throughout the world. The exact amount of Pershing Square’s gamble has fluctuated since 2012, but it is believed to be at least several hundred million dollars, down from an initial US$1-billion equity position.

In media interviews and documents published by Pershing Square, Ackman has argued that Herbalife’s primary business purpose is to recruit new investors. In an interview with CNN, Ackman said, "Only a tiny fraction of 1% of the people make a real living from working with Herbalife. Over 90% of the people quit in a short period of time." A pyramid scheme, he said, "is a modern-day version of a Ponzi scheme but more sophisticated. They hide the Ponzi features of it, if you will, in a product."

Pershing Square also released several documents critical of Herbalife. "Distributors earn more than 10 times as much from recruitment as they do by selling the company’s overpriced products to bona fide retail customers," it alleged in a 2012 paper. "As a result, Herbalife distributors are incentivized to aggressively recruit new participants to buy in to a system that, like a chain letter, ‘must end up disappointing those at the bottom who can find no recruits.’ "

In another widely distributed document, Pershing Square disclosed excerpts from an October 2005 company video that involved senior and mid-level Herbalife distributors as well as members of Herbalife’s board of directors, corporate management and corporate staff. According to Pershing Square, participants in the video, led by Chairman Club member Stephan Gratziani, "corroborate much of what Pershing Square has said about the company, including that ... distributors are trained by their upline and incentivized by the Herbalife compensation system to focus their efforts on recruiting new distributors into the scheme rather than selling Herbalife products to retail customers outside the distribution network."

According to Pershing Square, Gratziani acknowledges in the video that many of Herbalife’s distributors fear bringing in new recruits, saying: "They don’t want to. Who wants to bring their family into a struggle to make it? Who wants to bring their family into an eventual deception?"

In March 2014, the Federal Trade Commission (FTC) announced it would investigate Herbalife, a move ABC News said was motivated by complaints from the Hispanic community, whose members make up a significant proportion of Herbalife distributors. In response, Herbalife said it welcomes the inquiry given the tremendous amount of misinformation in the marketplace and will cooperate fully with the FTC. "We are confident that Herbalife is in compliance with all applicable laws and regulations." A month later, Reuters reported that the FBI had also begun looking into the company.

In July 2014, Herbalife, noting it has been around 34 years and has 7,400 employees and millions of members worldwide, released the findings "from research and analysis conducted by Walter H. A. Vandaele, PhD, of Navigant Economics LLC, regarding Herbalife’s US business operations." After listing Vandaele’s credentials, Herbalife claimed he had concluded that "Herbalife’s US business operations are consistent with the socially beneficial [multilevel marketing] model and inconsistent with the socially harmful pyramid scheme model."

On the website factsaboutherbalife.com, however, victims detailed the losses they incurred after signing up with Herbalife. One man said, "In order to be a success at Herbalife, I now believe you must be dishonest." Another website statement estimated that over the next 10 years, consumers will lose US$2 billion to US$4 billion through Herbalife’s practices.

Complaints about pyramid schemes are hardly new. They have likely existed for several centuries, but the modern variety can be traced back to the infamous Charles Ponzi, who took in some US$15 million, starting in 1919, when he offered 50% returns in 90 days on investments in his Boston-based Security Exchange Co. He maintained his scheme by paying Paul with Peter’s investments until the deception ultimately imploded.

Countless pyramid schemes emerged in the 20th century, including chain letters, in which recipients would send a dollar to the person named at the top of a list. The recipients would then add their names to the list and send it off to people they knew, who presumably would follow the same instructions.

Multilevel marketing schemes soon followed suit. Although some were genuine and focused on selling a real product, such as Fuller Brush and Mary Kay Cosmetics, many were nothing more than pyramids. Some had no product whatsoever.

A persistent pyramid scheme that has circulated in the past 15 years is aimed at women. Known by various names, such as the Women’s Gifting Circle, it preys on women who believe that they need to empower themselves financially to be free of the controlling involvement of men. The basic concept requires women to invest a certain amount of money and then move upward (and therefore get a greater amount of money back) as more and more women are recruited to join the group.

One of many such circles existed in Toronto’s Beach area around the start of the 21st century. No matter how often they were told that unless there was an actual product that generated a profit the pyramid would ultimately collapse, many well-educated women invested considerable sums of money.

In 2013, RCMP in northern BC warned that the scam had reemerged. Staff sergeant Marko Shehovac, commander of the Columbia Valley RCMP detachments, told of a group of eight women who were each asked to contribute $5,000 to the circle.

"You are told that there is no promise of obtaining a product or receiving anything for this wonderful gift," he wrote in a report. "[It] has to be clear you are giving a gift to the top person, which will add up to $40,000. [It] must be clear it is a gift you are giving, so later when you try to sue because you didn’t get your $40,000 as the Circle is intended to do, it was made clear it was a gift and hence no criminal intent or involvement. Wrong. The circle as described is a criminal act [under the Competition Act]." The concept, he explained, is for each of the eight women to form her own circle, with her at the top.

"In the Columbia Valley," he wrote, "I am hearing that the person starting the circle wants to be known as ‘the Dessert,’ two below her will be ‘the Entree,’ four below her will be ‘the Soup’ and ‘Salad’ and eight new people to sign on to the circle will be ‘the Appetizers.’ " Sounds so innocent and cute.

"The 12% who start this have a good chance to grab their $40,000 and financially empower themselves. They might even promise to help recruit people for you. My bet is that ‘Dessert’ will flash her $40,000 and go out and initiate another circle." The other 88%, however, "can kiss [their] hard-earned money away as well as some friends."

While the women’s scheme dealt in relatively small numbers, other Canadian pyramid scams netted far more money. In February 2014, a federal judge awarded $6.5 million to 2,000 investors who put their money into the UltraLife Club through a Mississauga, Ont., corporation called Business In Motion International, CBC News reported. "The company was run by Alan Kippax, who was first exposed in a CBC Marketplace investigation of a pyramid scheme that defrauded investors across Canada, including hundreds from BC."

People attending Kippax’s meetings were asked for a $3,200 fee to buy vacation packages worth $9,000 that they could then sell to others. "Kippax’s vacation packages weren’t even good deals," the CBC said. "There were cheaper travel packages on the Internet and his business continually needed more recruits to keep profits flowing to those at the top — a scheme the court described as a classic pyramid scheme." Kippax, who faced other legal problems, was charged with running the scheme (at press time he had not faced any formal legal proceedings).

By the end of 2014, Herbalife had also become engaged in some legal wrangling. In December, Reuters reported that the company had won preliminary court approval of "its US$15- million settlement of class-action litigation accusing [it] of being a ‘pyramid scheme’ that misleads distributors about how much money they can make. The accord also requires Herbalife to provide up to US$2.5 million to distributors who return unused products." The company didn’t admit any wrongdoing.

However, that outcome did not deter Ackman. On January 1, he announced he will continue his campaign against Herbalife, this time taking it directly to the Hispanic community.

While many aspects of the Egyptian pyramids remain a mystery, consumer pyramid schemes are easier to understand: if there’s a product that makes everyone selling it a reasonable profit, the company is probably legitimate. If the real product is the recruitment of other distributors, it’s not just an illegal pyramid scheme but a house of cards just waiting to collapse.

About the Author

David Malamed


David Malamed, CPA, CA•IFA, CPA (Ill.), CCF, CFE, CFI, is a partner in forensic accounting at Grant Thornton LLP in Toronto.

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