Last week, Judge Dale S. Fischer dismissed a federal class action lawsuit against Herbalife, Ltd. (“Herbalife”) and three of its corporate officers, who were accused by Herbalife shareholders of operating the company as an illegal pyramid scheme. The lawsuit alleged that Herbalife artificially inflated its stock price by misrepresenting that the company was a legitimate multi-level marketing company (“MLM”).
How did Herbalife pull off the win, and can the supplement company rest easy after its latest legal victory?
Herbalife’s Marketing Plan
Herbalife sells nutritional supplements in more than 90 countries through a network of independent distributors. The company operates under a business model whereby each distributor is encouraged to enlist other distributors to join his or her team. Herbalife claims that its marketing plan pays out up to 73% of product revenues to its distributors in the form of profits, royalties and other various incentives.
Many critics have argued that compensation for Herbalife distributors is largely dependent on how successful they are in their recruitment efforts, rather than on the sale of actual product. Likewise, others have complained that, while some distributors are able to profit under the Herbalife model, the vast majority end up losing money.
Federal Court Dismisses Herbalife Class Action and Pyramid Scheme Allegations
In the federal securities class action, filed in the Central District of California on behalf of all persons or entities that purchased the common stock of Herbalife between February 23, 2011, and July 29, 2014, the lead plaintiffs alleged that Herbalife violated federal securities laws by misrepresenting the nature, scope and legality of its business practices and operations. More specifically, the lawsuit claimed that, by self-identifying as a legitimate MLM (instead of an illegal pyramid scheme), Herbalife violated section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 of the U.S. Securities and Exchange Commission (“SEC”), respectively, which prohibit any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security.
Last Monday, the court outlined the six elements that constitute a violation of section 10(b) and Rule 10b-5:
- A material misrepresentation or omission;
- Scienter (i.e., intent to deceive, manipulate or defraud);
- A connection between the misrepresentation and purchase or sale of a security;
- Reliance on the misrepresentation;
- Economic loss; and
- Loss causation.
Judge Fischer based his analysis primarily on the element of loss causation. The plaintiffs argued that a number of events, including a call to action by Senator Edward J. Markey last January, constituted corrective disclosures that revealed Herbalife’s fraud and established loss causation. However, the court found that the cited events were insufficient to constitute corrective disclosures and dismissed the lawsuit.
Herbalife won the battle, but the war may not be over quite yet. Judge Fischer, giving the plaintiffs until April 8 to amend their complaint to address its deficiencies, remarked that “Herbalife operates in the ‘gray area’ between legitimate MLM and unlawful pyramid scheme.”
Multi-Level Marketers: Take Note
The federal securities violations alleged in Herbalife’s lawsuit are just two examples of the many legal risks involved with multi-level marketing. To minimize the risk of adverse legal action, MLMs should ensure that their marketing practices comply with applicable state and federal regulations.