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Battle Goes Beyond Herbalife, Hedge Funds

Patrick Fallon | Bloomberg | Getty Images

The battle among hedge fund giants and a Securities Exchange Commission's investigation of Herbalife have captured media attention.

Blogs debate the company, its products, multilevel marketing, pyramid schemes, and the motivations of financiers. However, the question bigger than Herbalife and shorted stock is: Why, after 65 years, have the same nagging legal issues dogged this industry?

Since 1948 multilevel marketing companies have faced questions of product efficacy and distributors have battled firms over non-compete agreements. However, the most feared legal problem is a federal pyramid scheme charge that, if successful, can mean the end of the company.

Where a Ponzi scheme grows as people voluntary invest to pursue high returns, a pyramid scheme grows by compensating recruits for recruiting others. Sophisticated pyramid schemes use upfront fees and/or the purchase of over-priced products and services to compensate participants. (Read More: 'Big Opportunity' for Herbalife: Hain Celestial CEO)

Company sales come primarily from purchases of high-priced products by distributors—always including a large batch of new recruits, the vast majority of whom will quickly become inactive.

Revenue does not come primarily from retail sales or from a stable distributor base. Instead, an ever-churning base of participants means compensation comes primarily from recruitment, coupled with distributor purchases required to qualify for recruitment rewards.

The courts have found multilevel marketing firms to be pyramid schemes when compensation for recruitment had no meaningful relationship with retail sales (termed the Koscot test). Other firms have faced this challenge. Amway successfully defended itself against the FTC in 1979. Beginning in the mid-90s, prosecutors successfully brought forward a number of pyramid scheme cases.

Among those brought by the FTC: Equinox, faulted like Herbalife for selling over-priced products in the context of ongoing recruitment, lost in 1999; Burn Lounge vigorously fought, then lost in 2012; and an ex parte legal action effectively shut down Fortune Hi-Tech Marketing in January 2013. Despite these successes, a pyramid scheme case takes years to prosecute and requires considerable resources. (Read More: Carl Ichan Boosts Stake in Herbalife)

Multilevel marketing companies need not be pyramid schemes. A legitimate multilevel marketing structure compensates distributors for recruiting, training, and supervising new distributors to sell products outside the distributor network. Current distributors build the sales force, lowering the parent firm's fixed costs and creating a potentially financially rewarding, home-based entrepreneurial opportunity requiring a flair for selling. Successful distributors create a successful parent firm.

The president of the Direct Selling Association (DSA) says pyramid schemes hide inside his industry, disguised as legitimate multilevel marketing companies. Yet, the DSA and member firms, including Herbalife, seem to resist with a take-no-prisoners approach every federal and state attempt to protect people willing to pursue an "opportunity."

Those who watch the industry have seen the harm. I co-wrote with a senior FTC economist the only academic paper that presents a model for distinguishing pyramid schemes from legitimate multilevel marketing. (Read More: In Herbalife 'Short War' Hedge Funds Miss the Target)

Separately, we have assisted in prosecuting multilevel marketing/pyramid schemes that resulted in the recovery of a portion (though often not much) of the ill-gotten gains, and prison terms for some perpetrators. Victims, embarrassed by their own naivet, often refuse to come forward to receive a small percentage of their losses.

Mr. Ackman has placed the problem center stage. Accusing Herbalife of operating a pyramid scheme, his stated goal is to see the company's stock price fall to $0. Mr. Icahn, taking the opposite view, increased his ownership position in a show of support.

Mr. Hempton, another investor, agreed with Ackman that Herbalife victimizes people, calling the company "scumbags" but financially sides with Icahn. His willingness to make money from the success of those he terms "scumbags" highlights what we readily infer— investment decisions are frequently amoral. It is just about the money. (Read More:

The underlying questions, however, are not amoral. Why have regulators failed to create, and the multilevel marketing industry vigorously resisted, an environment that "outs" pyramid schemes? When will multilevel marketing companies report information to show both consumers and investors that they do not primarily rely on recruitment and on the constant churning of participants?

Until we receive answers pyramid schemes selling actual products and services will continue to operate, often creating victims on an international scale.

William Keep is Dean of the School of Business at The College of New Jersey