Christine Richard on the 'Herbalife (HLF) business' that isn't a business.

Warning

More than half a century of quantifiable evidence, proves beyond all reasonable doubt that what has become popularly known as 'Multi-Level Marketing' is nothing more than an absurd, cultic, economic pseudo-science, and that the impressive-sounding made-up term 'MLM,' is, therefore, part of an extensive, thought-stopping, non-traditional jargon which has been developed, and constantly-repeated, by the instigators, and associates, of various, copy-cat, major, and minor, ongoing organised crime groups (hiding behind labyrinths of legally-registered corporate structures) to shut-down the critical, and evaluative, faculties of victims, and of casual observers, in order to perpetrate, and dissimulate, a series of blame-the-victim closed-market swindles or pyramid scams (dressed up as 'legitimate direct selling income opportunites'), and related advance-fee frauds (dressed up as 'legitimate training and motivation, self-betterment, programs, recruitment leads, lead generation systems,' etc.).

David Brear (copyright 2016)

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Are Investors Underestimating The Risks To Herbalife's International Business?

By Christine Richard

Summary

While investors seem complacent about the operation of Herbalife’s business outside of the US, we believe a pattern of sales into unopened markets creates undisclosed risks.

Our research found numerous instances of Herbalife distributors and third parties selling into supposedly unopened markets, among them Ecuador, where we saw evidence of 60,000 Ecuadorians registered as US distributors.

That raises uncertainties about Herbalife’s compliance with customs, tax and health regulations around the world and poses more questions about the deceptiveness of the business opportunity.

LifeVantage, a Utah-based MLM, recently concluded an investigation into its international sales practices – including sales in unopened markets – resulting in a crackdown and a drop in sales.

Nearly seven months ago, we wrote about US Customs data that indicated Herbalife Ltd. (NYSE:HLF) had shipped the equivalent of 32 million canisters of Formula 1 to Lebanon in 2014. Herbalife told us the data should not be relied upon, yet, the third-party data remained uncorrected for months after it was brought it to Herbalife's attention. You can read about the issue here.

Since the article ran on May 26, Datamyne, which provides information on US exports by company, still has not received any information from Customs or Herbalife that would allow it to correct the Lebanon shipment information, according to a company representative. As a result, Datamyne's database continues to indicate that Herbalife made hundreds of shipments of its products from the US to Lebanon via the Netherlands. Lebanon remains, according to Datamyne, Herbalife's largest export market in 2014.

After the article ran, one person put forward a theory about where those Lebanon-designated shipments ended up, which we share below. We don't know if his explanation is correct, but it raises an important question for shareholders and one that we have been pondering since we began our research on the company: Does Herbalife have a smuggling problem?

John Hempton Makes a Suggestion

Two days after our Lebanon article ran, we received a possible explanation for the mysterious Lebanon shipments. It came in an email from Herbalife shareholder John Hempton, who seemed to suggest that we were missing an innocent explanation:

May 28

John Hempton

To: Ackman, me

I do you a favour by identifying the Lebanon issue.

a. The only Middle Eastern country in which Herbalife operates is Israel and I think Lebanon.

b. There are herbalife clubs throughout the middle east - mostly set up by migrant workers. I went to one in Doha (Qatar). The product was consumed happily and shipped the country by the workers who run the clubs.

c. The route for shipping used to be through Lebanon. Members ship it on there own.

d. A war in Syria closed that route off. It probably goes through the subcontinent now.

Just explaining for people who do not travel much in that part of the world.

We've seen evidence of that as well, and the problem here is that it's not as innocent as it might seem for Herbalife products to end up in markets in which Herbalife isn't officially registered. For starters, when a company is not formally doing business in a country, but its products are making their way across that country's borders, it raises the possibility that customs and taxes aren't being properly assessed and paid. Governments tend to take a dim view of that.

Mr. Hempton's explanation also seems to exclude Herbalife from any active role in the unauthorized business: Herbalife doesn't make the shipments into these unopened countries, but rather migrant workers do, he says. That narrative just doesn't hold up.

First, the Datamyne data show that Herbalife was the shipper on the Lebanon-designated transactions, so one can assume, under Hempton's scenario, that the company or its representatives were aware that Herbalife was sending an extraordinary number of shipments into the Middle East. If the shipments did indeed go to Lebanon, then it seems that either: 1) Lebanon had become a massive market for Herbalife products, good news which one would have expected the company to share with its investors, or 2) Lebanon had become a gateway into other markets.

As a multi-level marketing company, Herbalife must be more aware of who is buying its products and where they are located than your typical consumer products company. After all, Herbalife's products are attached to a business opportunity. It's not just the products that are smuggled into unopened markets, but the business opportunity as well.

In order to manage that business opportunity, Herbalife oversees a complex system that records sales and tracks wholesale commissions, royalty overrides and production bonuses owed to layers of upline distributors on every sale. If distributors are operating in unopened markets, Herbalife has to figure out how to classify, track and pay them. Our research indicates there is a well-established system for doing just that.

Herbalife's Early Opening Process

We've talked to numerous former Herbalife employees and distributors who have described a pattern of Herbalife products getting into markets before the official opening. This occurs even though recruiting in, selling in or even prepping a market through advertising prior to the official opening is forbidden under Herbalife rules.

Here's how former employees have explained the process to us: Top distributors recruit new distributors in a closed country, signing them up with Herbalife as residents of an open country, for example the US. These recruits place their orders and have products shipped to a freight forwarding company in the US, which then consolidates the orders and sends them into the closed country.

We have heard repeatedly over the course of our research that Herbalife pays distributors operating in unopened countries as if they were US residents. Herbalife withholds taxes on these payments as if it were paying US residents. Later, the distributors file forms with the IRS certifying that they are not running a business in the US and get the withheld amounts refunded.

This creates a hard-to-follow paper trail. If distributors are operating a business in a foreign country, they should owe taxes there. But how do local tax authorities know about this income? Herbalife's willingness to sign up distributors and pay them in the US, knowing that they don't actually operate a business there, makes it easier for the company's distributors to evade taxes in the countries in which they are actually operating.

Herbalife has never, to our knowledge, detailed the early market opening process for its investors. From the outside, it appears that Herbalife sets a date for a new country opening, gets its infrastructure and all necessary approvals and product registrations in place and then on "Opening Day" fires the starting gun, setting off a frenzied but fair scramble to recruit and sell in the new market. Yet we've stumbled upon, as Mr. Hempton did during his trip to Qatar, example after example of a different process.

Mongolia to Trinidad

At the very beginning of our research, back in 2011, we watched an online presentation by a top distributor in Mongolia. She told the audience how her Nutrition Club network in Mongolia had grown from six clubs at the end of 2008 to 65 by the end of 2009 and 100 as 2010 drew to a close. She didn't mention that the Mongolian market wasn't officially opened for business until 2011. In the upper corner of the documents she displayed, the name of her sponsor and fellow beneficiary of all this pre-opening activity, Herbalife Founder's Circle Member Leon Waisbein, was visible.

During a phone interview, a distributor in Trinidad & Tobago explained to us how distributors set up their businesses in that country in the years before the official opening, arranging for freight forwarders to bring products in through Jamaica. This distributor and his organization, which included 5,000 distributors and 240 Supervisors, received US-dollar checks by mail for any commissions or bonuses they were due from Herbalife and were treated as US distributors by the company, which withheld US taxes on those payments. The distributors later filed for and received refunds from the IRS by certifying that they did not live and work in the US.

When the Trinidad market officially opened, all the distributors operating in that country were converted from US distributors into Trinidad distributors, and Herbalife began withholding taxes on behalf of the Trinidad government rather than the US government. This mass conversion suggests Herbalife was aware that the distributors it had been sending checks to in Trinidad were actually working their businesses in Trinidad.

We attended a presentation in Ecuador at which a former airline hostess told the story of how her upline - the now-deceased Mexican Founder's Circle member Eduardo Salazar - sent distributors into just about every Latin American country before the opening to get a foothold and build a downline in those places.

A former employee described for us watching as country after country in Eastern Europe was opened through unofficial channels, leaving him and his fellow employees with questions about the compliance of the business under numerous local laws. Those who tried to bring the issue of early openings to the attention of Herbalife management found they were uninterested in fixing the problem, according to the employee.

We later viewed a document showing that Herbalife was aware that third-party logistics companies had created distribution networks in a number of these unopened countries. Kazakhstan, for example, had walk-in sales centers in 12 cities, according to the document, though it wasn't officially opened for business. The document also indicated that third parties conducted all sales in cash, refusing to take credit cards, as some of these third parties were not properly registered with local tax authorities and, as a result, sought to avoid interactions with the banking system.

In addition to tax and customs issues, the shipping of products across borders by distributors and others raises product registration issues. Obtaining approval to sell nutritional supplements in many countries is an expensive, years long process and not one an individual distributor would likely be able to orchestrate. A Venezuelan distributor who sold products in Guatemala prior to the official open told us that the company's protein shakes had to be brought across the border from Mexico for years because Guatemalan health authorities had not yet approved the products as safe for consumption.

Early Opening in Ecuador

Perhaps the most blatant example we encountered of products being sold in a country ahead of a market opening took place in Ecuador. Herbalife announced the official opening of the Ecuador market in 2008, yet interviews and internal documents we viewed show distributors exported millions of dollars of products from the U.S. into that country in the years before the official opening.

Herbalife not only permitted this activity; it tracked it, according to those documents, which show that, by the time the market officially opened, Herbalife already had 24,162 Ecuadorian distributors registered in its database and another 37,899 "desertions" or distributors who had signed up but stopped ordering.

Herbalife didn't ship directly to Ecuador during this period, but rather shipped huge amounts of products to a handful of addresses in Miami, New York and Illinois, where the products were consolidated by freight forwarding companies and sent on to Ecuador. Ecuadorean distributors were initially entered into Herbalife's tracking system as US residents. Later, after the market formally opened, Herbalife converted these "US distributors" to Ecuadorian distributors.

On the day the market officially opened for business, Ecuador already had nine President's Team members. Meanwhile, new recruits who signed up on the first official day of business, believing that they were getting in at the start of an opportunity, had already lost the race. This is another issue with early market openings - they disadvantage recruits and deceive them about their already slim chances of success.

The Middle East

Meanwhile, bolstering Mr. Hempton's view that Herbalife distributors are unofficially selling throughout the Middle East, we found a mention of Dubai, an unopened market, in divorce documents filed by Chairman's Club member Doran Andry's wife in California. She lists Andry's business in Dubai as supporting the couple's opulent lifestyle:

Respondent is very proud of the 10 cars (including a Mercedes Benz SUV, MBW, Tesla, Fisker, Ferrari, Maserati, 2 Bentleys and Rolls Royce) and 4 motorcycles we currently own. I believe we have business interests in no less than 18 different business entities, including Herbalife interests in Dubai, Japan, Korea and Vietnam."

We sent questions to Herbalife regarding the status of its business in Qatar and mentioned John Hempton's observation that Nutrition Clubs are operating across unopened markets in the Middle East. Herbalife told us it believed that John Hempton's observations were not accurate.

We also received some documents from Herbalife purporting to show that product had not been sent to Lebanon. These documents contained information about shipments with transaction numbers that matched the transactions Datamyne identified as bound for Lebanon. The documents stated that the final destination of the shipments was the Netherlands. We sent Herbalife some follow-up questions to try to determine how and why these documents differed from the ones used by Datamyne to create its database and whether the documents had been submitted to Customs but never got a response.

LifeVantage Investigation

The specifics of Herbalife's international business, in all those far-flung locations, may seem easy enough to ignore. But as investors in LifeVantage Corporation (NASDAQ:LFVN), a Utah-based MLM, learned last week, questionable practices, even when they happen beyond US borders, present a very real risk.

LifeVantage was forced to delay the release of its financial statements for several months and conduct an investigation after employees in its tax department raised concerns about how the company's products were purchased and sold in some international markets and the impact of those practices on taxes and tariffs associated with the sales.

"The type of activities reviewed included our products being purchased for personal consumption and being taken into markets where they had not been approved for resale," Gary Mauro, LifeVantage's Chairman of the Board, said during a December 13 conference call.

As a result of the investigation's findings, LifeVantage has cracked down on certain practices, affecting about 8% of sales, according to management. This, in turn, has led to a weakening of the company's sales.

LifeVantage's assessment that 8% of revenue or around $17 million in sales in fiscal 2016 were linked to questionable international sales practices is significant. That amount represents 100% of the company's revenue growth over the prior year. LifeVantage reported revenue of $207 million in 2016, up $17 million from $190 million in 2015.

The Problems with Unofficial Markets

Allowing distributors and third parties to pre-open markets and move products across international borders has likely lowered the cost of expanding Herbalife's business to nearly every corner of the world. That's because top distributors and others have established the business in unopened countries at their own expense and risk.

In exchange, these distributors operate at a competitive advantage by getting in before anyone else. They also have plenty of opportunity to evade customs and taxes because the business is operated through unaccountable channels. This tradeoff has profited Herbalife's management, shareholders and top distributors, but it also has created risks that investors, complacent about the international business, might want to consider:

· It's unfair and deceptive to allow top distributors to open markets early.

· It's illegal to sell products that haven't been approved by health authorities.

· It's fraudulent to evade taxes and custom duties.

· It's poor practice to routinely sign up distributors in countries in which they don't operate as that facilitates income tax evasion.

· It's unconscionable to put migrant workers in the position of violating laws, particularly in Middle Eastern countries where penalties for lawbreakers can be extraordinarily harsh.

· It's an omission of material facts not to share an expansion process and its risks with your investors when that process has been repeatedly employed to open market after market around the world.

But maybe it's not such a mystery why Herbalife doesn't want to talk more about that Lebanon data.

Christine Richard (copyright 2016)