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|Nu Skin Enterprises|
|Revenue generator||Skin care products|
|Main competitors||Amway, Herbalife|
|Source: Fathom China research|
Skin-care company Nu Skin Enterprises (“Nu Skin”) saw its China sales quadruple in 2013 and contribute one-third of total revenue – and then disaster struck. In January 2014, Chinese media accused Nu Skin of running a pyramid scheme. Nu Skin sells through a distribution process called multi-level marketing (“MLM”) that is illegal in China but not in most other countries. Highly motivated salespeople create networks of face-to-face sellers, and commissions flow upward through a pyramid structure. Many multinational companies in China practice MLM, including Amway, Avon and Herbalife. Yet just when Nu Skin’s operations in China appeared doomed, a government investigation resulted in small fines. The question now is whether Nu Skin can return to business as usual. Available evidence says yes.
This report assesses Nu Skin’s prospects in light of these points:
- Back to MLM. Despite Nu Skin’s denials, the company pays sales bonuses based on an MLM model in which commissions flow upward through a pyramid-shaped structure.
- Illegal in China. MLM-style commissions paid by Nu Skin and others violate Chinese laws.
- Reluctant regulator. Chinese media articles have attacked Nu Skin in January 2014 as a pyramid scheme, but Nu Skin’s regulator seems reluctant to punish the company.
- Cosmetic changes. Available evidence suggests that recent cosmetic changes in Nu Skin’s practices are sufficient to protect its business license in China.
- Pyramid scheme? Whether Nu Skin and companies like it operate true pyramid schemes is a hotly debated topic inside and outside China, and is beyond the scope of this report.
Fathom China conducted key interviews with the following people:
Source One – Scott Warren, partner at the California-based law firm Wellman and Warren, which represents multi-level marketing companies.
Source Two – a former China-based Nu Skin executive who now works for another firm with a direct-selling business license.
Source Three – a China-based lawyer who represents many multi-level marketing companies.
Source Four – an “Elite” level Nu Skin salesperson.
Source Five – a China-based consultant who advises multi-level marketing companies.
Source Six – an entry-level Nu Ski salesperson.
Source Seven – an entry-level Nu Skin salesperson.
Source Eight – an entry-level Nu Skin salesperson.
In addition, Fathom China interviewed several more Nu Skin sellers, and several employees of local Administrations of Industry and Commerce, which regulates Nu Skin and other companies with its selling structure.
Nu Skin’s problems in China reached their zenith on Jan 15, 2014. On that day, the Communist Party’s flagship newspaper, People’s Daily, ran the first of three devastating front-page investigative stories.
The accusations lodged in the normally boring party mouthpiece made Nu Skin look like a mixture of profiteers, mad scientists and religious kooks. The articles accuse Nu Skin of using “brainwashing techniques” to lure people into “pyramid schemes”; selling unlicensed products that “reset genes” to “reverse aging”; and inventing positive reports about itself and attributing them to a Chinese state-run televisions station, Stanford University and international statesmen. That night’s news broadcasts showed hidden-camera footage of Nu Skin sales meetings with 20,000 attendees who had grown “hooked” on selling the product.
The shocking article seemed to catch government regulators flat-footed. The cabinet-level State Administration of Industry and Commerce (“AIC”), which regulates most businesses in China, immediately declared that it would investigate. Nu Skin’s operations in China effectively stopped – a painful turn of events for a company that derives one-third of its revenue from China. The company ceased holding sales meetings and stopped recruiting new salespeople.
Authorities “investigate suspicions that Nu Skin is pyramid scheme”
Nu Skin and companies like it engage around the world in a sales practice called “multi-level marketing” that bears many hallmarks of a pyramid scheme. The first well-known company to engage in multi-level marketing was Tupperware, which encouraged 1950s era American housewives to sell plastic kitchen storage containers to their friends at “Tupperware parties.” Entrepreneurial stay-at-home moms would recruit networks of salespeople and collect income based on all sales in the network. Current practitioners in China include Nu Skin, Amway, Herbalife, Melaleuca and many Asian companies.
The recruitment aspect of multi-level marketing ensures that even legitimate businesses bear a resemblance to pyramid schemes. In a classic pyramid scheme, paying participants each recruit two more paying participants, and returns are distributed to early participants with money contributed by later ones. Eventually, the base of new recruits becomes too small to support the growing tower of payments, and the pyramid collapses. “Ponzi schemes” are a similar variant. The most spectacular recent pyramid-style fraud, perpetuated by New York financier Bernie Madoff, collapsed in 2008 and cost investors US$18 bn.
Nu Skin sells youth, riches and V-shaped faces
The similarity between pyramid schemes and multi-level marketing extends to several areas. Multi-level sellers build an expanding network of new sellers, then receive commissions from sales made by everyone below them. Multi-level sellers often pay a sum of money up-front, usually by purchasing a predetermined amount of product. Peer pressure enters the picture as salespeople are urged to attend motivational meetings – many web sites describe the meetings as “cult-like.” And multi-level sellers generally hold out the promise of easy riches.
When a pyramid scheme collapses, its illegal structure is laid bare. Before the collapse, however, differentiating a pyramid scheme from a Tupperware-style network of commission-sharing salespeople is not at all easy. According to the US Bureau of Consumer Protection, what sets pyramid-scheme alarm bells ringing is too much emphasis on recruiting: 
In multilevel or network marketing, individuals sell products to the public — often by word of mouth and direct sales. Typically, distributors earn commissions, not only for their own sales, but also for sales made by the people they recruit.
Not all multilevel marketing plans are legitimate. If the money you make is based on your sales to the public, it may be a legitimate multilevel marketing plan. If the money you make is based on the number of people you recruit and your sales to them, it’s not. It’s a pyramid scheme. Pyramid schemes are illegal, and the vast majority of participants lose money.
Just ask American hedge-fund manager Bill Ackerman how hard it is to prove a pyramid scheme. As this report goes to publication, he had built a billion-dollar short position on the premise that Herbalife, a New York-listed seller of nutritional supplements, is a pyramid scheme. Mr. Ackerman has spent lavishly on anti-Herbalife publicity campaigns and to lobby US regulators to investigate Herbalife’s practices. And even in the US, where business is comparatively transparent and most facts necessary to determine Herbalife’s status are open to view, opinions remain divided. 
The Chinese government has long been wary of multi-level marketing companies. Pyramids flourished in the early 1990s, when get-rich-quick entrepreneurs built networks that sold weird overpriced items like home foot-massage contraptions that cost US$2,000. Such high-priced items were a thin cover for the empty fees paid in a classic, productless pyramid scheme. As those pyramids collapsed and destroyed the life savings of credulous salespeople, the government responded in 1998 by banning all multi-level marketing. The government no doubt also felt concerned that many sales networks maintained a cell-like grassroots structure, met frequently and exhibited an almost religious fervor – exactly the kind of mass organization that could someday shift its focus to anti-government agitation.
Many multilevel-marketing companies continued to operate in China anyway. Some used the fig leaf of brick-and-mortar stores to make their sales networks look more legitimate – pedestrians in Shanghai might walk past something that does not exist in the US: streetside Amway stores. In fact, such stores served more as distribution points where salespeople for companies that engaged in multi-level marketing would pick up their inventory.
Finally, in August 2005, the government passed regulations setting the stage for today’s industry. The new law, “Regulations for the Administration of Direct Selling,” explicitly banned the practice that Nu Skin and many other companies use around the world: multi-level marketing. No longer could sellers recruit new sellers, or create selling networks. Worse, another AIC regulation issued at the same time, “Regulations on the Prohibition of Pyramid Selling,” describes a pyramid scheme as exactly the practices employed by Nu Skin and other MLM companies: 
A pyramid scheme, as defined in this regulation, refers to the practice where organizers or operators recruit agents, calculate and pay remuneration to agents based on the number and sales performance of agents directly or indirectly recruited by the agents, or require agents to pay a certain amount of entry fees in order to obtain illegal profits.
Instead of MLM, the law does permit something called “direct selling.” Direct selling is little different from a door-to-door salesman. Salespeople may earn a commission selling products face-to-face Yet the law prohibits the most important part of multi-level selling: the ability of sellers to earn commissions based on all sales in their network.
Direct selling is legal but multi-level selling (MLM) is not
|Sales method||Legality||How it’s done|
|Direct selling||Legal||A sells to B, and A earns a commission.|
|Multi-level||Illegal||A sells to B, B sells to C, and A earns a commission on B’s sale.|
Source: Fathom China
The 2005 law clearly defines MLM practices. The main points are listed below:
- No commission chains. “Remuneration may be calculated only based on revenue from the agent’s direct sales to consumers. The total amount of remuneration…may not exceed 30% of the total revenues from the agent’s direct sales to consumers.”
- No recruitment by salespeople. A direct selling company and its branch institutions may recruit direct selling agents. Any institutions or individuals other than the direct selling company and its branch institutions may not recruit direct selling agents.
- Recruitment controls. “A direct-selling company and its branch institutions may not distribute materials that advertise sales remuneration for direct selling agents, or recruit direct selling agents by collecting fees or requesting candidates to purchase products.”
In fact, many observers believe that Nu Skin and its peers did indeed practice MLM. Fathom China interviewed many Nu Skin salespeople in 2012, more than a year before the People’s Daily articles. All Nu Skin salespeople we spoke with described an MLM structure that, in Fathom China’s opinion, violated the law. They described recruiting layered networks of people, multi-level commission structures, up-front purchases of expensive skin-care products as a prerequisite for becoming a salesperson, and even provided Fathom China with printed hand-outs explaining how commissions are shared through different levels of a sales network.
Source Three is a China based lawyer who has represented many MLM firms. The source says most MLM firms have found legal workarounds that allow them to pay multi-level commissions. For example, commission payments are often centralized at the company level, and are not passed up the chain from salesperson to salesperson. The way those commissions are calculated takes into account a multi-level structure. Salespeople understand that their commissions are based on the networks the build, but such calculations are not acknowledged publicly by the company. In this way, the the company can say it does only direct selling, when in fact it practices MLM. “They find some legal mechanism to be able to pay commissions beyond the first tier payment,” says Source Three. “MLM is a naughty word in China.”
Nu Skin has a history of trouble in China – and elsewhere
Source: Fathom China research
Nu Skin has enjoyed phenomenal growth in China. In 2013, its China revenue quadrupled to US$1 bn. And that surge came after Nu Skin had been operating in China for nearly a decade, implying that it was not a one-off gain starting from a low base. Indeed, Nu Skin’s China revenue had doubled in 2012. Assuming that the numbers were accurately reported, Nu Skin appeared to have cracked the China code. Even if Nu Skin could not maintain its exponential growth rate, it could still count on a billion dollars a year from sales networks in China.
China provides nearly a third of Nu Skin’s revenue (US$ bn)
Source: Nu Skin annual report 2013
And China’s growth pushes Nu Skin’s growth (US$ bn)
Source: Nu Skin annual report 2013
The People’s Daily articles and the government’s high-profile investigation into Nu Skin had a disastrous short-term effect on the company. Nu Skin acknowledges that it halted both recruitment and sales events. Because Nu Skin relies heavily in recruiting new salespeople to replace the ones that give up and stop selling its products, a sudden drop in recruitment can have a disastrous effect on revenue. Indeed, revenue in China dropped by nearly half in the first quarter of 2014 compared to one quarter earlier. Global revenue fell by even more.
Nu Skin’s revenue in Q1 2014 collapsed (US$m)
Source: Nu Skin statements
Nu Skin’s number of “sales leaders” has plunged*
*Nu Skin defines a “sales leader” as “independent distributors who have completed and who maintain specified sales requirements and…certain qualification requirements.”
Source: Nu Skin statements
A key question in gauging the speed of Nu Skin’s revenue recovery is how fast it can rebuild its decimated sales force. With that goal in mind, Nu Skin in April 2014 picked up the bill for flying 16,000 Chinese salespeople to Dubai for an all-expense-paid holiday and sales meeting. They traveled the city in a convoy of limousines, filled 40 luxury hotels, and booked out the Ferrari World theme park for days at a time. The total price tag has been estimated in the hundreds of millions of dollars, although Nu Skin has not confirmed a figure.
Nu Skin’s payoff for its largesse comes through marketing. The message it sent to prospective Chinese sellers is clear: Nu Skin is back in business, let’s all get rich together. To promote that message, the company issued several highly produced videos of the Dubai trip, including inspirational snippets of interviews with Nu Skin sellers saying things like, “Only through Nu Skin can you realize your dreams!” The videos are easily accessed on the Internet. 
Following the attacks on Nu Skin in the People’s Daily, many observers believed that Nu Skin would be forced to cease operations and might even face criminal prosecution. Three other big multinational companies that have faced similar high-profile investigations have been forced to revamp their businesses and have seen top-level executives detained by police: British pharmaceutical giant GlaxoSmithKline, public relations firm Edelman, and McDonald’s biggest meat processor, Shanghai Husi. The government has also opened anti-monopoly investigations into Microsoft and several foreign auto companies. Clearly, Beijing is in no mood to tolerate multinational companies that flout Chinese law.
And yet Nu Skin escaped with a slap on the wrist. In a short announcement on March 24, 2014, the AIC revealed a fine of barely more than a half-million US dollars. The tiny sum was less than 0.5% of Nu Skin’s revenue in China in 2013.
Significantly, the AIC never even mentioned the toughest allegations in the People’s Daily stories. The AIC’s punishment does not address pyramid schemes, brainwashing or illegal recruitment. It didn’t even say that Nu Skin engaged in illegal multi-level marketing. Through such omissions, the AIC’s ruling implied that the regulatory body considered Nu Skin’s infractions as minor. The only things Nu Skin did wrong, apparently, was to sell unlicensed products and exaggerate what Nu Skin’s products do: 
We found that Nu Skin is engaged in illegal activities including direct selling products unregistered for the direct selling channel and exaggerating product efficacy. We also found that some sales agents to have engaged in illegal actions including unauthorized direct selling, cheating, and misleading advertising.
In addition to the tiny fine issued by the national-level AIC, the city-level AIC office in Shanghai “requested an executive meeting with Nu Skin” and “ordered the company to implement changes, strengthen internal management, and conduct legal operations.” And in Beijing, the city-level AIC also ordered Nu Skin’s Beijing branch to “thoroughly investigate, rectify and regulate ‘studios’ [where meetings are held], shut down those allegedly involved in illegal activities, and enhance education, training, and supervision of sales agents.”
And that appears to be the extent of Nu Skin’s punishment. If the AIC or any other regulatory body demanded that Nu Skin alter its business practices in China, then those instructions were issued privately and have not entered the public domain. On April 19, Nu Skin announced that it would “immediately resume corporate-hosted business meetings and will begin accepting applications for new sales people on May 1, 2014.
The question now is whether Nu Skin has returned to business as usual, or has instituted changes that could affect its income in China.
Nu Skin appears to have resumed business operations more or less as they were before the People’s Daily articles accused it of violating Chinese law. It is recruiting new salespeople, and still uses a commission structure based on network sales, a hallmark of MLM practices. Government regulatory bodies seem unconcerned by Nu Skin’s actions.
Fathom China spoke with six people who sell Nu Skin products in China. All describe a commission system that is still based on MLM. In July, a high-level Nu Skin salesperson in Shanghai diagrammed the commission structure, and it takes a familiar geometric shape.
Nu Skin’s commission structure remains shaped like a pyramid
Source: Nu Skin “team elite” salesperson
The salesperson added that multi-level commissions, as diagrammed above, are not itemized when they are issued. Paying a lump sum maintains the fiction that all commissions are for direct sales. “The calculation is very complicated and we have professional accountants handling the calculation,” says the high-level salesperson.
A lawyer who represents MLM companies and has written legal briefs on MLM practices in China concludes that Nu Skin’s business in China is illegal. Scott Warren is a California-based lawyer who has for two decades represented and defended large multi-level marketing firms in the US. His firm cannot be considered a critic of MLM practices and commercial ideologies. Mr. Warren told Fathom China that the China operations of Nu Skin and others like it is illegal, even after the Nu Skin investigation: 
Nobody is doing single-level direct sales. They are all doing multi level – Nu Skin, Melaleuca, HerbaLife, all of them. It is not legal in China. What they do is hire lobbyists and fixers, and they go over there and take care of things.
To be sure, Nu Skin has made minor changes in its business practices. Yet the changes cannot be considered a departure from the company’s previous way of doing business. Nu Skin has altered some of its terminology, fiddled with its salary structure and no longer holds massive sales conventions in China.
Fathom China spoke at length with Source Four, a Nu Skin “team elite” salesperson. Team elite salespeople are Nu Skin’s highest-level sellers. They must have at least 16 sellers below them. In a sales network’s pyramid structure, they receive commissions to a maximum of six tiers below, and likely earn millions of US dollars a year. Source Four outlined the changes that Nu Skin has introduced since the AIC issued its fine in March: 
- Sales pitch. Nu Skin has toned down its convention-style meetings and sales pitches. It no longer allows large-scale inspirational meetings of thousands of people. It instead focuses on exhibitions that may still attract hundreds of people who sample Nu Skin’s products and may be recruited into sales networks.
- Remuneration. Nu Skin no longer mentions its remuneration system in advertising or speeches. “We introduce the details of our remuneration only after the person signs a contract with Nu Skin to become a qualified sales representative,” the lowest level salesperson, says Source Four.
- Payment scheme. Nu Skin now calculates pay monthly and quarterly. Monthly pay is based on individual sale performance. Quarterly pay is based on “contribution to the company.” Contributions to the company include the performance of “units” that seller has provided services to. “Units” are the same as network levels, says Source Four.
- Terminology. Nu Skin sales network members are no longer referred to as “upper level” and “lower level.” All are now “partners.”
- Science. When advertising its AgeLOC skin-care products designed to make skin look younger, Nu Skin changed its claims from “resetting genes” to “adjusting genes.” 
A recent sales meeting attended by roughly 3,000 people in Shanghai showed that Nu Skin is again revving up. Distributors invited prospective customers to attend the quarterly meeting, called the “Nu Skin Anti-Aging Expo.” The event filled the entire sixth-floor of an urban office building. Guests waited in line behind a red velvet rope before undergoing a “health and beauty test” to determine what Nu Skin product would make them most luminous. They experimented with Nu Skin face creams, and later Nu Skin distributors gave inspirational talks called “resetting life lectures.” The distributors in attendance will try to sell products to their guests and, presumably, recruit them into sales networks.
At the meeting, Source Six, a 25-year-old low level salesperson, explained that she has been selling since January – she joined a friend’s network after the People’s Daily articles released. She understands that to earn high figures, she needs to recruit a network of her own and earn commissions on its sales:
My friend explained very clearly what this business model is about. The core is to build and develop your team. You cannot just rely on your individual sales. You have to rely on the power of your team… I really believe in the platform and opportunity. I feel good about the products too. I did health testing today and my health conditions are much better than before I used Nu Skin products.
From speaking with salespeople, Fathom China believes that Nu Skin has resumed issuing commissions based on MLM practices. The company will likely deny doing so. Based on past practices, it is likely that Nu Skin calculates multi-level commissions for its salespeople, but does not publicly identify them as such. The office of Nu Skin’s spokesperson did not reply to Fathom China’s emailed interview requests.
Now that Nu Skin is back in action in China, a key question is why regulators have backed off. After all, Nu Skin is clearly using an MLM commission system, and has made only token changes to its business practices in response to its slap on the wrist from regulators. Why does Nu Skin’s regulator not seem to care?
The most plausible explanation is that Nu Skin’s regulator, the AIC, was never bothered in the first place about Nu Skin’s MLM practices but was instead prodded into action by the People’s Daily articles. A convincing piece of evidence for this line of reasoning comes in the AIC’s public statement that accompanies the fine. Whereas People’s Daily accused Nu Skin of exceeding the bounds of its direct-selling license and engaging in MLM, the AIC’s punishment never addresses the question of MLM, but focuses instead on the relatively minor transgression of selling some products without a proper license.
Furthermore, Nu Skin is known for its extensive government relations efforts. Without doubt, Nu Skin’s top executives have at every opportunity promised the Chinese government that they are uninterested in politics and religion, wish only to help Chinese sellers make money and are not a pyramid scheme. Source Two, a former Nu Skin executive who now works for another direct-selling company in China, says Nu Skin’s government relations efforts are a model:
If Nu Skin and Microsoft were both in trouble on the same day, and I had to bet my house on which one would be okay, I’d say Nu Skin. Why? Because when Microsoft wanted to come into China, it was welcomed with open arms. It provided jobs and helped build the technology industry. China wanted it. Nu Skin came in under different circumstances. The government didn’t really want it in the first place. So it had to work really hard on government relations. 
In an effort to determine whether the government might crack down on Nu Skin for MLM practices, Fathom China placed phone calls to the public numbers of AIC offices in several major Chinese cities. Those offices deal with complaints regarding direct selling companies, and are responsible for ensuring that Nu Skin and other direct-selling companies comply with Chinese laws – laws that clearly equate MLM practices with pyramid schemes. Local AIC offices may be considered the government’s front line in a crackdown on MLM practices. For example, in a foreshadowing of Nu Skin’s problems, the AIC office in the northern city of Harbin in 2007 accused Nu Skin of “pyramid selling practices” and fined the company US$650,000. (Today, Nu Skin still operates in Harbin.)
The theme that emerged in Fathom China’s calls to AIC offices is clear: they have no interest in policing Nu Skin. All referred to Nu Skin as a “direct selling” company and noted that it has a business license to practice direct selling. Several noted, accurately, that when the AIC punished Nu Skin, it did not punish it for the MLM practices, but for more minor offenses. In other words, because the accusations in the People’s Daily article were not echoed in the national-level AIC’s investigation, local-level AICs appear not to have received orders to investigate whether Nu Skin practices MLM. (In all calls, Fathom China identified itself and explained that information would be used in a report on Nu Skin.)
Even the Shanghai city AIC shows no sign of vigilance regarding Nu Skin. That was somewhat unexpected. As mentioned above, the Shanghai AIC in March issued a statement ordering Nu Skin to make unspecified changes to its business practices. The person at the Shanghai AIC who spoke with Fathom China, however, gave no indication that enforcement has tightened:
What are you talking about? Direct selling is legal, only pyramid schemes are illegal. Nu Skin has a direct selling license. Don’t you know that?
A consistent theme among the local AIC employees who spoke with Fathom China was that Nu Skin must abide by the AIC’s March ruling against Nu Skin. Yet because that ruling ignores the most alarming accusations in the People’s Daily articles, and omits any mention of Nu Skin’s MLM practices, Nu Skin appears to face little risk of a renewed investigation into its business. Another person at the Shanghai AIC office repeated that Nu Skin has made changes to its business practices in accordance to the national-level AIC’s punishment directive:
Check out the announcement of the punishment. Nu Skin made changes to whatever problems we found out and pointed out. We already announced all the problems we discovered about Nu Skin.
On a final note, readers may wonder why People’s Daily would launch an attack against Nu Skin without the support of the regulatory body, the AIC. Fathom China has no easy answer for that. We can only speculate.
Two points. First, the Chinese government is not as monolithic as it appears from a distance. Struggles between the state-run coal industry that wants expensive coal and the state-run power industry that wants cheap coal is one of many examples. Second, Chinese journalists do not consider themselves factotums. Even People’s Daily, which often runs stories dictated word-for-word by the highest reaches of the Communist Party, has its share of crusading reporters who write their own articles, albeit within the conservative parameters set by their employer.
The most likely explanation for the Nu Skin imbroglio is also the simplest: People’s Daily thought Nu Skin was operating illegally and published a big story. The AIC, which understood Nu Skin’s business model and had no objections, had to respond with an investigation. And in China, high-profile investigations must uncover something. So the AIC fined Nu Skin a small amount for minor infractions and hoped the problem would go away. So far, it has.
Nu Skin has escaped disaster. Evidence suggests that it enjoys the support of its regulator, so despite hideous publicity in January and a fine in March 2014, Nu Skin has resumed operations with only small changes to its business practices. Most important, it still engages in multi-level marketing. Whether Nu Skin can resume the amazing growth trajectory in China that it enjoyed before suffering the People’s Daily attacks is yet unanswerable. Early evidence suggests that it may. Another round of media attacks seems unlikely but not impossible; similarly, government action against Nu Skin’s business practices seems unlikely but not impossible. Nu Skin has been tried by fire, and now seems less flammable.
 Team elite in China: http://finance.people.com.cn/BIG5/n/2014/0116/c1004-24132856.html.
 Adjusting genes: www.cdsp.com.cn/NewsCenter/news-2014-04-28-201139867459155.htm
 The source’s comparison is now even more apt – the Chinese government on July 29 announced an anti-trust investigation into Microsoft, and 100 investigators raided its Beijing headquarters.