From High Energy Clubs to Dashed Dreams: Herbalife Tales

All Nicole Lopez wanted was a crack at the American dream and a chance to work at home closer to her kids.

Instead, she got a nightmare, losing thousands of dollars after trying to sell Herbalife, which makes weight-loss shakes and nutritional supplements.

Unwilling to recruit other people to sell Herbalife, which is how most Herbalife reps make money, she quit after 11 months and lost the $10,000 she invested.

"If you're an honest person and you want to do an honest business, there's no way you can succeed," Lopez said, sitting in the kitchen of her Utah home.

Herbalife has since reimbursed part of Lopez's losses and called her situation a result of "bad mentoring." But she isn't alone.

After a 10-month investigation into so-called multi-level marketing, CNBC found dozens of people with similar stories. Multi-level marketers sell products through a network of distributors, many of whom work at home and get paid by selling products, as well as recruiting other distributors.

Nicole Lopez
Nicole Lopez

Many of the people interviewed discovered that selling the products was harder than they thought. After hitting up family and friends to buy products, sellers often resorted to spending hundreds and even thousands of dollars buying sales leads, which sometimes led nowhere.

The real money, they found, is in recruiting others to sell the product, creating what's known as a "down-line" of distributors. The more distributors they recruit, the more money they are likely to make, based in part on a combination of bonuses and commissions. And the higher a distributor is in the pecking order, based on his or her purchases, the more likely he or she is to get a share of the profits.

(Read More: ' Don't Call Me a Multi-Level Marketer'.)

That has sparked a growing debate over whether Herbalife and other multi-level marketing companies, are essentially pyramid schemes. That's when distributors make more money recruiting other sellers, rather than selling the products themselves, with profits flowing to the very top at the expense of those at the bottom.

The debate has garnered the attention of Wall Street, with hedge fund titans now battling over Herbalife's stock.

On Wednesday, a regulatory filed showed that Third Point's Dan Loeb had taken an eight percent stake in the company, pitting him again another hedge fund manager, Bill Ackman, who has shorted more than 20 million shares of Herbalife, roughly a quarter of the shares outstanding — a bet that the stock will fall.

(Read More: Activist Investor Dan Loeb Takes 8% Stake in Herbalife)

Ackman has publicly called Herbalife a pyramid scheme, a position the company strongly denies. Herbalife has scheduled a presentation on Thursday to rebut Ackman's charges in detail.

(Read More: Herbalife Disputes Ackman's Claim of 'Pyramid Scheme'.)

Long Time Coming?

In the meantime, industry critics think regulatory scrutiny of the multi-level marketing industry is long overdue.

Like many who enter multi-level marketing, Perez is convinced if she works hard she can become a success.

Herbalife wouldn't allow attendance at other recruitment events, so CNBC took undercover cameras to a recruiting event near LaGuardia Airport in New York, run by a Long Island couple that has been selling Herbalife for more than 20 years. CNBC journalists used their real names and said they were considering joining.

The meeting, in a hotel ballroom, was sparsely attended, with what appeared to be more existing distributors than recruits, and with the blaring, upbeat music, the clapping, and the "Herbalife" cheers by current distributors filling the room.

After an introductory disclosure that the company can't make product claims, distributor after distributor — including one high school student — took the stage to give testimonials about how Herbalife had changed their lives. They talked about the weight they lost, the falling blood pressure, the energy boost — and how much money they were making.

CNBC heard claims of thousands of dollars a month — even $10,000, $20,000, and $65,000. One featured speaker, Olga Valencia, a successful distributor, recalled how "my first car was a Mercedes that I bought with Herbalife."

Companies like Herbalife claim they have strict sets of rules, but it's clear from CNBC's investigation that it can be tough to police the activities of millions of distributors around the world.

For example, distributors are required to certify that a certain amount of product is sold to genuine customers outside of the distribution network. But in a regulatory filing, 10-K, Herbalife said, "We rely on certifications from the selling distributors as to the amount and source of product sales to other distributors which are not directly verifiable by us."

On the regulatory level, there is no definition of pyramid.

"Based on pyramid scheme history and lax oversight, I can say with confidence there are multi-level marketing firms operating pyramid schemes that have been operating for many years," says William Keep, dean of the school of business at The College of New Jersey, an expert on multi-level marketing and pyramid schemes.

(Read More: Why Spotting a Pyramid Scheme Isn't So Easy.)

In 2002, along with Federal Trade Commission economist Peter Vander Nat, Keep co-authored what is now widely regarded as the landmark paper on how to distinguish a pyramid scheme from a legitimate multi-level marketer. (Click here to read more.)

"The current situation has energized me that we might finally shine some light on this industry," he said.

While many critics believe federal regulators aren't likely to do anything, there are signs that multi-level marketing is hitting the radar of politicians. The Washington newsletter TJ Strategies, which focuses on consumer issues, recently wrote that there appears to be growing interest in Washington of multi-level marketing.

"After discussions with Congressional staffers, we are hearing that there is research being done at the staff level on the MLM industry," the newsletter wrote. "The development is a further indication that Elizabeth Warren's election is prompting key Democratic senators to proactively take the lead on consumer issues in advance of Ms. Warren's arrival."

Adding to their likely interest, the newsletter said, is the popularity of multi-level marketers in the Hispanic community. Herbalife, for example, says that the Latin market generated 63.7 percent of its business.

(Read More: Before You Join: Six Questions to Ask.)

Overriding all of this are concerns about a high annual turnover rate, which industry critic Robert Fitzpatrick of the Pyramic Scheme Alert estimates is 99 percent. His estimate is based on his analysis of publicly available numbers.

Most multi-level marketers say that by its nature, direct selling has high turnover, as people try the business and then decide it's not for them.

Herbalife hasn't disclosed its turnover rate since 2005, when it said that "more than 90 percent of our distributors who are not supervisors turned over." (Most never make it to supervisor.)

Fitzpatrick likes to call this the "Main Street Bubble."

"Instead of taking a million dollars from 10 people like Bernie Madoff," he says, "multi-level marketing takes "$1 million from a million people," he says.

(Read More: Multi-Level Marketing Critic: Beware 'Main Street Bubble'.)

Herbalife strongly rejects criticism that the company is a pyramid scheme.

"You mention Bernie Madoff in there, for God's sake," Herbalife CEO Michael Johnson said during a recent interview at the company's Los Angeles headquarters. "What kind of question is that to say Bernie Madoff in there? These are immature questions."

Johnson compared Herbalife to his prior job as an executive at the Walt Disney. He explained how he moved up the organization.

"And at the top was sitting as CEO, Michael Eisner. Is that a pyramid? Is that any different than what failure rate we're doing here?" he said, adding that "we don't know for sure" how many distributors don't make it at Herbalife.

"We know that we've got the highest retention rate in the company that we've ever had of our supervisors," he said. "And it's growing even higher with some of the changes we've put into our marketing plan."

Johnson said that many of the criticisms of Herbalife fall "into this kind of Herbalife of a while ago. Not that there were bad things in that company. It's just different today."

Rise of the Clubs

As part of its investigation, several CNBC journalists went undercover with hidden cameras at Herbalife nutrition clubs as potential customers.

Started in 1999 in Mexico by a distributor, these clubs are now Herbalife's growth engine and an effort to veer from the past of knocking on doors and cold-calling to recruit.

Most are unmarked storefronts with no signs — only a green marker of some kind in Herbalife's green color —as a place to embark on a daily weight-loss program. In exchange for anywhere from $4 to $6.50 a day in cash, "members" get a weight-loss shake and a glass of tea.

The clubs visited by CNBC in largely Hispanic New York neighborhoods had few customers — a sharp contrast to the club in Inglewood, Calif. chosen for us to visit by Herbalife. Run by Angel Perez, whose father is also a distributor — and was Herbalife's first employee — the club was bustling the morning CNBC visited.

Perez, a college graduate, concedes that after two years, she grosses only $24,000 a year after expenses. That includes a small down-line payment from other "supervisor" level distributors she has recruited.

Joe Mariano, president of the Direct Selling Association, an industry trade group, said the difference between a pyramid scheme and legitimate multi-level marketing is fairly straightforward.

"The real key is compensation," he said. "If most of it comes from recruitment, you have a problem."

(Read More: How Multi-Level Marketers Dodged a Bullet.)

Nashville multi-level marketing attorney Kevin Thompson, however, says the regulations are "ambiguous" — and he blames the Federal Trade Commission.

Where's the Line?

The tricky part is how much recruiting-based compensation is too much.

"Distributors have to sell product to retail customers, and they can also recruit other participants, and earn commissions on that productivity," Thompson said. "Where the controversy comes into play is the balance. How much are you focused on retailing, how much are you focused on recruiting, and honestly ... we don't have an answer."

Regulators intentionally avoided creating a definition of pyramid scheme when they were drafting the recently revised Business Opportunity Rule, geared to work-at-home and other sales so-called "business opportunities."

In a report, the staff of the FTC wrote:

"The Commission reasoned that any definition of 'pyramid scheme' would provide bad actors with a road map for restructuring their businesses to skirt the definition, at least facially, and thereby provide them with a safe harbor that could undercut law enforcement efforts.

"Similarly, we believe that any definition of 'multi-level marketing opportunity' would allow fraudulent business opportunity sellers to manipulate their corporate structure to evade coverage by the Rule." (Click here to read the full report)

Historically, regulation of multi-level marketing has been the domain of FTC. But TJ Strategies says the Securities and Exchange Commission and the recently created Consumer Financial Protection Bureau could also show interest.

Notably, it says, the CFPB "has recently prioritized several investigations" in industries that have targeted "at-risk consumers."

It's the FTC that has the most authority. But, according to critics, it has shown the least amount of teeth for going after large multi-level marketers, especially over the past decade.

One reason, according to David Vladeck, who until recently was director of the agency's Bureau of Consumer Protection, is that there are few complaints.

Tiffany Rose | WireImage | Getty Images

"When we get consumers who are willing to tell that story, and the sufficient number of them who are willing to stand up and be counted, then we can do something about it," he said.

Trouble is, many tell us they were simply embarrassed to step forward, instead blaming themselves — people like Nicole Lopez and Sharon Shea, former Herbalife distributors.

Lopez started selling Herbalife in 2005 after inquiring about it on the Internet.

Shea, who had used Herbalife products decades ago to lose weight, thought she would try again after her husband died. She said she was swiftly recruited with high pressure sales tactics in 2010.

Shea said she spent $3,000 she didn't have to become a "supervisor." She didn't have a credit card, so she put the amount on her debit card. Lopez, who was also convinced to sign up early on as a supervisor, also paid with her debit card.

Lopez said she told recruiters that she didn't know much about business and was told not to worry — Herbalife uses a "proven" plan that anybody can use to become successful. And she believed it. Shea said she was told that she could use the Internet to sell and recruit.

But both realized this involved buying sales leads. Lopez said she spent $1,000 for 10 leads until she quit seven months later, leaving her $10,000 in the hole.

Shea lost $15,000 after just a few months.

"My whole goal and my whole purpose wasn't to become amazingly wealthy, to become rich, to never have to worry about working again," she said. "It was just to be able to bring in and help my family survive."

After CNBC contacted Herbalife detailing what happened to Shea and Lopez, Herbalife reimbursed them for some of their losses, blaming their failures on "bad mentoring."

"We don't feel good about what happened to them," Johnson said during the interview with CNBC. "Nobody would. Their opportunity was not realized."

While that may take away some of the sting, the wounds were still evident when CNBC visited with Lopez last summer.

"What they're doing is preying off poor and middle class families," she said. "I gave $10,000 of my money, and I see them on their videos portraying to be, you know, this wonderful company who's saving and helping lives. And that's not the case. All the people down-line for them are paying for their lifestyle. And to me, that's fraudulent."

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

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