Editorial: In Herbalife ruling, FTC helps draw the line between legit methods and pyramid schemes

One of the basic tenets of consumer goods is that companies live or die based on the demand for their products. But some companies have charted a path to prosperity by selling something else: the lure of riches hidden in their products’ sales chain.

That’s been one of the keys to success for Los Angeles-based Herbalife, which sells nutrition and personal care products through a global network of ordinary people who act as distributors. But like many other companies of its ilk, Herbalife has been dogged by accusations that its distributors are actually victims of a scam designed to enrich the company and a few people at the top of the distribution chain.

Last week, the Federal Trade Commission announced a settlement with Herbalife that will change the company’s practices for the better, in addition to extracting $200 million in compensation for money-losing distributors. More important, though, the settlement will make it easier in the future to distinguish legitimate approaches to this business model from scams.

Known as multi-level marketing companies, firms like Herbalife typically produce household goods, cosmetics and health- and wellness-related products. But rather than wholesaling to established retailers, they recruit individuals to act as distributors by promising them a cut of the proceeds. For those people, profits lie not in selling small quantities to many customers, but in persuading friends and acquaintances to buy large supplies that they, in turn, distribute within their social circles.

And therein lies the problem, because the same approach is the hallmark of a pyramid scheme — a scam that doesn’t produce wealth, but simply transfers money from new recruits to those who signed up before them. At some point the supply of new recruits dries up and the scheme collapses.

Herbalife admits no wrongdoing, and in fact characterizes the settlement as validation of its business model. But the FTC’s complaint pulls together statistics from Herbalife’s own financial reports and statements to paint a damning picture of the company’s operations.

According to the complaint, the “overwhelming majority” of distributors who try to sell Herbalife products to actual consumers make little or no money doing so. And those who try to profit off the rewards the company offers for signing up new distributors largely fail to do so as well; more than half of Herbalife’s elite distributors in 2014 received an average reward payment of less than $300 for the year, according to the FTC. (Herbalife says the agency’s figures are inaccurate.) That helps explain why nearly half of Herbalife’s U.S. distributors quit each year, and why more than half of the distributors “stop ordering Herbalife products within their first year,” the complaint says.

The settlement with the FTC sets at least two key standards for Herbalife, and by extension every other multi-level marketing company that wants to avoid a lawsuit by the feds. The first is that the incentives offered to distributors have to be tied to sales of the product to bona fide consumers. In other words, distributors can’t be rewarded for funneling products onto other middlemen; companies must have a stake in the success of their products at the retail level.

The second is that the materials Herbalife uses to attract distributors can’t promise a better life than the company can actually deliver. The FTC’s complaint cites promotional videos by Herbalife that show “images of expensive houses, luxury automobiles and exotic vacations,” while offering testimonials from distributors who claimed to be making six- and seven-figure incomes. A pyramid scheme may be so desperate to recruit new participants that it has to grossly inflate its returns, but a legitimate business should be able to entice people with its actual results.

Sadly, the FTC’s investigation into Herbalife apparently was triggered by a complaint from a hedge fund manager, Bill Ackman, who bet more than $1 billion on Herbalife’s stock tanking. Although Ackman has said he was trying to stop a predatory company with “phantom, or fictitious, customers,” he stood to gain heavily if the FTC had sought to shut down the company. The end result leaves Herbalife in business, which won’t help Ackman, but with new strictures that will protect those who might be tempted to sign on as distributors — and, with the right amount of diligence by the FTC, anyone else trying to discern a real business opportunity from a pyramid scheme.

Follow the Opinion section on Twitter @latimesopinion and Facebook