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Multi-Level Marketing Critic: Beware 'Main Street Bubble'

Robert Fitzpatrick's interest in pyramid schemes goes back to his own involvement in a pyramid-like scheme in the 1980s. He didn't lose money, but he witnessed first-hand how you can get sucked into the euphoria of what he calls "delusional behavior."

That company eventually was raided by police and Fitzpatrick, a former business consultant, went on to write a book called "False Profits: Seeking Financial and Spiritual Deliverance in Multi-Level Marketing and Pyramid Schemes."

He also launched a website called the Pyramid Scheme Alert. And more recently, wrote a paper headlined, "The Main Street Bubble: A Whistle Blower's Guide to Business Opportunity Fraud."

(Read More: From High Energy Clubs to Dashed Dreams: Herbalife Tales.)

Fitzpatrick has since become a leading expert on pyramids, often as an expert witness in court case. He sat down with me at his home in Charlotte to discuss pyramids. The following Q/A is edited.

Q: What is a pyramid scheme?

A: The pyramid scheme is a great mystery in America. Very few people understand the math. It's simple math, but it's elusive. So we do a lot of trying to explain the trick. You know, what's behind the curtain? (Read More: Why Spotting a Pyramid Scheme Isn't So Easy.)

Q: What's the math?

A: The math is a distortion, a manipulation of what they call exponential expansion. Exponential expansion is two times two times two times two. And almost all of these schemes tell you that you can make money by just recruiting three or four, five, let's say, five. Then you let the five do their five. That gives you 25. That's the exponential expansion. That's the trick of the whole thing. What they don't show you is that you can only do that 13 cycles. And you would exceed the population of the earth. So it can't work. But even as long as it works, the vast majority are always in the bottom positions, which have not yet and never will, in most cases, extend the chain so that they can get their money. And so it always dooms the vast majority and it can never keep going, so it's unsustainable.

Q: If it can only multiply itself, say, 13 times before taking over the world's population, how have some of these companies been able to continue and prosper for 10, 20, 30 years?

A: Well first of all, we're talking about trickery, deception and fraud. If I induced you to put money into a business in which the track record was that 99 percent had lost before you, for years. And I kept telling you it's the opportunity of a lifetime. That's not fair business, right?

Q: So what is a multi-level marketing organization?

A: Well multi-level marketing today would be called a new business model. And we're talking about quite a new business model. Most people didn't encounter it until the 1990s, although it was around in the '80s and even in the '70s. But it didn't really grow to this ubiquitous, everywhere phenomenon in America. You can't find a family today that hasn't been solicited to join one of these. But essentially, it offers you two opportunities to make money. One, it's a sales company. And that's its core business allegedly, that you have a large number of consumer sales people. And they sell the product to friends, neighbors and many others and now, many others online.

Dimitri Vervitsiotis | Stone | Getty Images

But you can also make money by authorizing and recruiting other people to become salespeople. You make money off their investments, their own investments, the recruits who are salespeople, inventory purchases and so on and any sales they make. Not only that, you can make money on the people that they recruit. So you become put in a position where potentially, you can be at the head of this very large, exponentially unlimited, no cap sales force below you. Every person is told the same story. No recognition of market saturation. No recognition of limited numbers of people available for this sort of thing. So this is a new model. It has inherent flaws in it, of course. It has inherent tendencies to fraud. (Read More: 'Don't Call Me a Multi-Level Marketer'.)

Q: But it's legal.

A: It is questionably legal. It is not a settled matter at all. And in fact, we have no law in the United States explicitly defining a pyramid scheme or explicitly defining multilevel marketing. The Federal Trade Commission did consider a rule recently, this past year, that would define multi-level marketing but it was ultimately dropped.

Q: How many multi-level marketing participants fail?

A: Ninety-nine percent don't ever make a net profit.

Q: How do you know that?

A: Well, I studied the income disclosures that are available from representative companies. And many of them have been forced by lawsuits and regulatory actions to present some basic data. It's presented in a very insufficient manner, but with a little analysis, a little extrapolation, the data is there. (Read More: How Multi-Level Marketers Dodged a Bullet.)

Q: If 99 percent lose, 1 percent does make money. But where does that money come from?

A: It would show that it came from the people's-- that lost the money. It came from their investments. It would disclose that nobody is actually earning a net profit from what the business claims to be -- retail selling, direct selling -- that in fact, the money they made came from the investments of the other distributors who had joined and failed.

Q: You wrote something called "The Main Street Bubble." In there, you said that you believe that the MLM industries-- losses are substantially greater than the Madoff affair. Explain.

A: Well, we're talking millions of people. Madoff conned a relatively small number of people with investment money. Multilevel marketing is using a different system. Instead of taking a million dollars from 10 people, you take $10 from a million people. That's the way the system works. I'm just using that analogously. But the numbers add up to be staggering amounts, year upon year upon year.

Q: You talk about the amount of money that's being lost. How much money is being lost?

A: Ten-- tens of billions.

Q: How do you know that?

A: Well, again, you just take the numbers of people who are involved. Look at how many could and have earned a net profit. Therefore, you can determine the losses. Multiply those losses over years. And you're up into the tens of billions of dollars, far more than Madoff's one single hedge fund scam.

Q: Are all multilevel marketing organizations bad?

A: Well, I haven't studied every one of them. But I think they can be graded somewhat as to the levels of deception and the levels of ultimate consumer losses. The party plan companies where people gather in homes and they demonstrate the product cost significantly less. (Read More: Before You Join: Six Questions to Ask.)

Q: Like Tupperware?

A: Yeah, the difference would come in the harm that it could cause, because the Tupperware's business plan requires holding these parties. And then those parties will generate legitimate customers, who will come in and they will buy the product. The product is a known quantity. It's competitively priced. Okay, now that would be at the upper end of the multilevel marketing.

Q: All right, where's the magic line for a multilevel marketing company?

A: The line is determined by asking one question. Where does the money come from? It's a business opportunity, a business opportunity based on what? Is the money coming from external to the chain? This is the same question, by the way, asked of all Ponzi schemes. Where did the money come from that you paid those earlier investors with? Did it come from later investors, or did it come from profitable business that you were transacting?

Q: How do you determine that?

A: Well, somebody has to ask the question to the company. That's what the business opportunity rule was supposed to be partly about, to figure out "what's this business really?" Because think about this: This company, the multilevel marketing, has the capacity for generating revenue in a most powerful way. (It) would not be legitimate, but it could be done to sell a business opportunity based purely on endless recruiting of other investors.

Herbalife
Tiffany Rose | WireImage | Getty Images
Herbalife

Q: Where is Herbalife in this? Where does it fit? (Read More: Activist Investor Dan Loeb Takes 8% Stake in Herbalife.)

A: On the spectrum-- that we've described of where does the money come from, I would put Herbalife at the far end of the money coming -- from the investors' side. That is the salespeople's direct, personal investments to join the business is the primary source of revenue coming to the company. From the studies that I've done of it, there's no tangible evidence of successful, widespread retail sales occurring by their 2.7 million person sales force.

Q: Is Herbalife a fraudulent company?

A: Well, that would be for the regulators to determine. (Read More: Herbalife Disputes Ackman's Claim of 'Pyramid Scheme'.)

Q: You've been doing this for a long time. You've been raising red flags everywhere. I can't help but think that the industry thinks you're a crackpot, that the fact is you keep talking about the same thing. Nothing's done. So you're sitting here telling me, these things are possibly, you know, on the wrong side of legal. And it just goes on and on and on. So I don't understand. Either you're sitting here, not telling us the correct information, or somebody's not taking action.

A: Well, why would we be surprised that nobody took action? We had a famous whistle blower spend eight years trying to get the SEC to look at Madoff. How many whistle blowers asked the SEC and the federal government to look at the banking industry during the run-up and the mortgage industry, to look at the sub-prime mortgage industry? How many asked the government to look at the government loans to students for private universities that were gouging students? So-- okay, I'm a whistle blower, but this is the response that I get is typical, isn't it, of whistle blowers? (Read More: Madoff Aside, Financial Fraud Defies Policing.)

Q: Thank you.

Herbalife strongly rejects Fitzpatrick's claims.

—By CNBC's Herb Greenberg; Follow him on Twitter: @herbgreenberg and Google

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  • Herb Greenberg is the editor of Herb Greenberg’s Reality Check, a subscription newsletter for investors focused on risk.