New York state Sen. Jeff Klein believes Herbalife (NYSE:HLF) is operating an illegal pyramid scheme. Late last month, the Democratic Bronx representative released a report detailing the alleged fraud the multi-level marketing firm promotes, and he promised to introduce new legislation that would rein in the company -- and others like it -- in the state of New York.
Klein's assessment mirrors that of hedge fund manager Bill Ackman, who has accused the company of running an illegal pyramid scheme since 2012.
Extravagant income claims and false promises
Klein's office, in partnership with the non-profit, Make The Road New York, conducted a study of Herbalife nutrition clubs located in various parts of New York City. Nutrition clubs are gathering centers for Herbalife members, where they can purchase prepared Herbalife shakes and other products, socialize, and receive coaching and weight-loss tips. Herbalife explicitly forbids operators from selling packaged product at the club, but they can be used to introduce perspective members to Herbalife's offerings. Critics, including Ackman, have alleged that they operate as little more than recruitment centers, helping Herbalife add new victims to the bottom of its pyramid.
Klein's office sent undercover investigators to several clubs. In some cases, they recorded footage using hidden video cameras. Often, they found club operators violating Herbalife's own rules and government regulations.
In one instance, an investigator found a distributor claiming that Herbalife's products can help cure migraines; another distributor promised that Herbalife products would help alleviate a rash. Herbalife's dietary supplements are not intended to diagnose, treat, prevent, or cure any disease, and marketing them under those pretenses is illegal. FDA guidelines explicitly forbid dietary supplement companies from making such claims.
Klein's office isn't the first to discover this problem. Last year, an Herbalife distributor told an ABC News reporter that the company's products helped cure a brain tumor. Herbalife's management condemned the claim and punished some distributors in response, but evidently the problem hasn't gone away.
Investigators also found several Herbalife distributors making extravagant income claims. In one instance, an Herbalife distributor gave a presentation stating that after just one or two years with the company, an Herbalife supervisor can expect to earn as much as $8,000 per month. In reality, 89% of Herbalife members receive no commission checks at all from the company.
Waiting on regulators
In the wake of the investigation, Klein plans to propose legislation that would clamp down on multi-level marketing firms in the state of New York. New regulations would force Herbalife (or any company that sold health products and used a franchise system) to implement rules to ensure greater compliance. If passed, the legislation could make it more difficult for Herbalife to operate in New York and limit the demand for its products.
But Herbalife is a global company, with significant international sales. Last quarter, only one-fifth of its net sales came from North America.
Still, this adds even more pressure to a company that is already heavily embattled. The Federal Trade Commission and several state attorneys general are looking into Herbalife's activities. In August, the FTC seized the assets of Vemma, a different multi-level marketing firm, accusing the company of operating a pyramid scheme. While the possibility that a similar fate will befall Herbalife may be unlikely, claims like Klein's could increase the probability.
Sam Mattera owns put options on Herbalife dated January 2016. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.