The FTC Shut Down Vemma for Being a Pyramid Scheme -- Could Herbalife Ltd. Be Next?

Last month, the Federal Trade Commission shut down Vemma, seizing its assets and stopping its operations. Vemma's owners insist that the company is a legitimate multi-level marketing firm, but FTC regulators allege that it's an illegal pyramid scheme. Vemma's fate will depend on the outcome of a trial, but if it were a publicly traded company, its shares probably would've plummeted.

Like Vemma, Herbalife executives claim they're operating a legal multi-level marketing firm. Given recent moves from the FTC, however, investors should be aware of the potential consequences that could befall Herbalife shareholders if the FTC disagrees. The agency is currently investigating Herbalife, and though it may ultimately decide not to take action, there are many disturbing similarities between it and Vemma.

In its complaint, the FTC lists 45 different aspects of Vemma's business that, cumulatively, add up to a model that "reward[s] [Vemma] Affiliates for recruiting and for purchasing products ... rather than for selling products." Many of these complaints apply to Herbalife as well.

1. [Vemma] targets young adults, including college students ... Vemma's ... marketing materialsprominentlyfeature young, seemingly affluent individuals surrounded byconspicuous displays of wealth, such as luxury vehicles, jets, and yachts.

The FTC's issue with Vemma's target market may come down to a perceived sense of vulnerability -- unlike older, more established adults, desperate college students may make for easy victims. Herbalife is not known to target college students, but it has been criticized for going after impoverished immigrant communities. Herbalife's management team has admitted that about 60% of Herbalife Members are Latinos. The League of United Latin American Citizens (a civil rights group supporting Hispanic Americans) has criticized Herbalife for allegedly preying on undocumented Latino immigrants.

2. Defendants repeatedly tout that Vemma can provide anyone an easy path to financial freedom and independence.

Vemma uses the promise of financial freedom to entice individuals to become Affiliates. The same holds true for Herbalife. In a promotional video, Doran Andry, a member of Herbalife's Chairman's Club, boasts that, as a Herbalife Member, he became a millionaire in his second year with the company. "There's never been a better time [to become a Herbalife Member]. All of you, if you just dream, you ... too can have everything we have and much more."

Herbalife board member John Tartol makes similarly grandiose claims in another promotional video.

3. [Vemma encourages] individual[s] [to] become an Affiliate by purchasing an "Affiliate Pack," which costs approximately $500 or $600 and which contains a mixture of various Vemma Products, audio and video recordings, print materials, and Vemma branded items.

Like Vemma, Herbalife sells prospective distributors start-up packs. To Herbalife's credit, its member packs are considerably cheaper than Vemma's (just $60.70 or $94.10) but largely serve the same purpose and contain the same sort of materials.

4. [Vemma encourages its] Affiliate[s] to sign up for monthly "auto-delivery" in an amount sufficient to maintain eligibility for bonuses.

Herbalife's auto ship program is called HAP (Herbalife Advantage Program). Herbalife Members who sign up for HAP can have their Herbalife orders shipped to them regularly each month. If they do so, they qualify for discounts. It does not appear that Herbalife uses HAP to maintain bonus eligibility like Vemma, but the very presence of the service may alarm regulators as it may encourage Members to purchase excess product.

5. Affiliates have also created training and promotional materials related to Vemma. For example, Defendant Alkazin's website, www.myroadmaptosuccess.com, provides access to multiple training presentations, including a purchasable audio CD and training workbook titled "Roadmap to Success -- A Working Plan for Creating Wealth Through the Vemma Opportunity" ... [it] describes Defendant Alkazin's eight-step system for building a Vemma business.

In its complaint, the FTC calls out Tom Alkazin. Alkazin isn't an owner of Vemma but rather a top distributor -- a member of Vemma's Royal Ambassadors. What's interesting about this part of the FTC's complaint is that it suggests the agency may factor the behavior of particular distributors into its decision-making process. In the past, Herbalife distributors engaged in a practice commonly called lead generation -- they would collect the contact information of potential recruits, then sell them to other Herbalife distributors at around $100 per name. Obviously, such a practice supports the notion that the company's focus centers around recruitment rather than actual sales.

In 2013, Herbalife's management attempted to crack down on this process, according to The New York Post. As it wasn't Herbalife engaging in the practice -- but rather independent distributors -- some might have assumed that the FTC would overlook it. That may not be the case.

6. During company events and conventions, Vemma presents the select few top earners with large checks representing their yearly or lifetime earnings.

Herbalife has done this many times in the past. In fact, Michael Johnson -- Herbalife's CEO -- has regularly handed out bonus checks to Herbalife's distributors at annual extravaganzas. In 2010, Johnson handed out checks totaling $36.5 million, with the largest check for $2 million. Such a practice seems aimed at tacitly encouraging distributors to focus their efforts on recruitment rather than retail sales, as those receiving the checks have the largest pools of distributors operating beneath them.

7. Vemma['s] ... 2013 U.S. Disclosure Statement shows that in 2013, more than 93 percent of Affiliates earned less than $6,169; more than 87 percent earned less than $3,674; more than 40 percent earned less than $939; and less than 0.62 percent earned $92,181 or more ... In contrast to Defendants' numerous claims regarding profitability and the unlimited income potential associated with Vemma, the vast majority of Affiliates make no money.

A whopping 80% of Herbalife's Members receive no commission checks from the company, and 96% receive less than $5,000 per year.

8. Vemma's compensation plan includes many confusing and convoluted rules and requirements, and some bonuses or rewards impose additional restrictions or limitations.

"Confusing" and "convoluted" are clearly subjective terms, but I would argue that Herbalife's plan is just as complex as Vemma's. As of 2012, the document outlining its sales, marketing, and compensation plan was well over 100 pages, with dozens of rules and subsections. Here's one guideline Herbalife includes to help its Members "better understand" one such possible payment they could receive from the company.

9. The company also severely restricts Affiliates from selling Vemma Products, expressly prohibiting sales at business or retail outlets or offices, flea markets, swap meets, garage sales, home shopping networks, and online stores or auction sites, including eBay and Craigslist.

Like Vemma, Herbalifeexplicitly bans its Members from selling Herbalife products in "stores, open or enclosed markets, pharmacies, grocery, health food, or military stores ... malls, outlets ... swap meets, flea markets, open-air markets." Herbalife members are allowed to sell online, but online auction sites, including eBay, are prohibited. Herbalife argues that these restrictions are necessary to maintain its image and foster direct sales, but the FTC clearly finds them worrisome.

Obviously, Vemma and Herbalife are different companies, but the similarities between the two should at least be enough to give investors pause. Those interested in Herbalife should keep a close eye on Vemma as its case with the FTC develops.

The article The FTC Shut Down Vemma for Being a Pyramid Scheme -- Could Herbalife Ltd. Be Next? originally appeared on Fool.com.

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.