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California Judge Dismisses Lawsuit Alleging Fraud Against Multi-Level Marketing Company

Pyramid_scheme.pngA federal judge recently dismissed a putative class action lawsuit claiming that a multi-level marketing (MLM) company was, in reality, operating an illegal pyramid scheme. Awad, et al v. Herbalife Ltd., et al, No. 2:14-cv-02850, memorandum (C.D. Cal., Mar. 16, 2015). The plaintiffs alleged that the company misrepresented its activities in order to increase its stock price, in violation of § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. 15 U.S.C. § 78j(b), 17 C.F.R. § 240.10b-5. They sought to certify a class of shareholders who purchased common stock during a period of roughly three years. The court found that they failed to plead elements required by the Private Securities Litigation Reform Act (PSLRA), 15 U.S.C. § 78u-4, and Ninth Circuit precedent. It dismissed the complaint without prejudice, giving them about three weeks to amend.

The difference between an MLM and a pyramid scheme is subtle, but very important. Both involve selling a product or service for commissions and receiving compensation for recruiting additional participants. MLMs are considered lawful business and marketing models, while pyramid schemes are generally regarded as fraud. In a pyramid scheme, a participant usually must pay to join the company, and the income they receive is based largely on the fees paid by the people they recruit. Participants are often required to purchase large quantities of the inventory they sell, and to make additional purchases, or pay additional fees, to maintain “good standing” with the organization. A legitimate MLM might only require a minimal investment of time and money from participants, with the understanding that more investment brings the opportunity for greater returns.

The defendant, Herbalife, sells nutritional, skin-care, and weight-loss products using an MLM business model. The plaintiffs were owners of Herbalife common stock, and they asserted a class of people or entities who purchased stock between February 23, 2011 and July 29, 2014. They alleged that various disclosures by the company between May 2012 and July 2014 revealed that the company was a pyramid scheme, which caused the stock price to drop. They identified various “corrective disclosures” that they claimed revealed the fraudulent nature of the company and established “loss causation.” Awad, mem. at 3. These included statements or reports by several hedge funds concluding that the business was operating a pyramid scheme, and a U.S. Senator’s call for investigations by government regulators.

The defendants moved to dismiss the plaintiffs’ amended complaint, arguing that they failed to establish three elements of a claim under § 10(b) and Rule 10b-5: “(1) a material misstatement or omission, (2) scienter, and (3) loss causation.” Id. at 2. The court noted the other three elements established by the Ninth Circuit: “a connection between the misrepresentation and the purchase or sale of a security,” “reliance on the misrepresentation,” and “economic loss.” Id. at 1, citing Loos v. Immersion Corp., 762 F.3d 880, 886-87 (9th Cir. 2014). It also noted that the PSLRA requires plaintiffs to “state with particularity the circumstances constituting fraud,” using the higher pleading standard found in Federal Rule of Civil Procedure 9(b). Under this standard, the court ruled that the plaintiffs had not met the pleading requirements for the element of loss causation.

Business litigation attorney James G. Schwartz has represented Bay Area businesses and business owners for more than 38 years. To schedule a free and confidential consultation with an experienced and skilled business advocate, please contact us today online or at (925) 463-1073.

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Photo credit: By Security and Exchange commission, U.S. Federal Govt. This vector version by Mysid [Public domain], via Wikimedia Commons.