pyramid schemeBy:  Scott Warren, David Van Sambeek, Scott Wellman*

There has been a recent surge of enforcement actions by governmental agencies claiming that that certain network marketing companies are illegal pyramid schemes.  The most notorious of these recent actions is the action filed by the U.S. Federal Trade Commission (FTC) against Vemma.  But this is just one of the actions and investigations brought by both the FTC and the U.S. Securities and Exchange Commission in recent time.  In order for your MLM company to avoid the same fate and regulatory scrutiny, it is essential that you (1) gain an understanding of the crucial role retail sales play in the determination of what is a legitimate MLM company versus what will be considered to be an illegal pyramid scheme, and (2) implement any needed changes immediately.

When Will a MLM Company be Considered an Illegal Pyramid?

An illegal pyramid scheme is legally defined as a program characterized by the payment of money for (1) the right to sell a product and (2) the right to receive compensation for recruiting other participants where the compensation is unrelated to the sale of products to ultimate users. (Koscot Interpanetary, Inc. 86 F.T.C. 1106 (1975); Webster v. Omnitrition International, Inc. 79 F.3d 776 (1996)).   For MLM companies, the important part of this definition is the second part which asks whether compensation is being primarily paid for (1) recruiting other distributors; or (2) the sale of products to ultimate users. (FTC v.Burn Lounge 763 F.3d 787 (2014))

We are often asked how can a MLM company with a tangible product and where the compensation is calculated based on the products actually purchased ever be considered an illegal pyramid scheme. The real answer lies with an analysis of (1) who is purchasing the products, and (2) how do commissions relate to retail sales.

Part 1 – Who is purchasing the Products?

A MLM company’s product revenue should be primarily derived from the purchases of REAL retail customers.  For the purposes of a MLM company, REAL retail customers are generally defined as those purchasers outside of the MLM opportunity.  If a MLM company can demonstrate that the product sales revenue comes primarily from these REAL retail customers, then the MLM company can demonstrate that the product that they are selling is a real, legitimate product.  However, a MLM company that cannot demonstrate that the majority of the product sales revenue is derived from REAL retail customers, stands a substantial risk of the FTC seeing their product as mere window-dressing used to disguise paying commissions for the recruitment efforts of others.  Simply put, if a MLM company has a legitimate product, then a substantial amount of purchasers should want the product  for the sake of the product itself (without also wanting to become a distributor).  To illustrate this point, lets think of your favorite pizza restaurant.  They may have the best pizza in town, but very few customers ever call the pizza restaurant  to become pizza delivery drivers, right?  Instead, they call the restaurant to order the pizza as retail customers.  If you can establish that the majority of the product purchases come from REAL retail customers, then you must still examine the commission structure as set forth in Part 2.

Part 2 – How  do commissions relate to retail sales?

If a MLM can demonstrate that they have a legitimate product as set forth above, then the next analysis looks at the compensation plan and how the distributors get paid commissions. The distributor compensation must derive primarily from the sale of products to ultimate users. (Koscot Interpanetary, Inc. 86 F.T.C. 1106 (1975); Webster v. Omnitrition International, Inc. 79 F.3d 776 (1996)).  Do the commissions that are actually being paid to the distributors generate primarily as a result of REAL retail customer purchases, or is the MLM company paying commissions primarily based upon the recruitment of other distributors.  It is a substance over form analysis. That is, governmental entities and the courts will look to the MLM company’s specific commission data and determine how the MLM really operates in practice.  (FTC v. Burnlounge).  If a significant amount of compensation is calculated based solely on purchases by other distributors (for example, based on large initial package purchases by other distributors), then the FTC may take the position that selling these packages are actually disguised recruiting fees not true retail purchases.

If the distributors can join the program, buy some product, and earn commissions simply by recruiting other distributors to make similar purchases, then the reason why the distributors are joining has very little to do with the retail distribution or consumption of the product.  Such a MLM  runs the risk of being considered an illegal pyramid scheme because “[t]he short-term result may be high recruiting profits for the company and select distributors, but the ultimate outcome will be neglect of market development, earnings misrepresentations, and insufficient sales for the insupportably large number of distributors whose recruitment the system encourages.” Koscot.

This does not mean that sales should never be made to distributors within the network.  However, the magnitude of sales to distributors should be monitored to verify that the distributors are either selling the product on a retail basis are actually consuming the product themselves.

What Does a MLM Company with Retail Sales problems Look Like?

MLMs that run the risk of being considered an illegal pyramid scheme as a result of a lack of retail sales will often exhibit one or more of the following characteristics:

  1. A large amount of product sales to independent distributors instead of outside retail customers.

  2. A compensation plan that pays a significant amount of commissions for purchases by independent distributors versus verified purchases by retail customers.

  3. Large amounts of inventory front loaded by independent distributors.

  4. A mandatory requirement that independent distributors be on an auto-ship program where they must purchase each month regardless of the amount of inventory they are holding.

  5. A restrictive inventory buy-back policy.

  6. A compensation plan that provides financial incentives for distributors to purchase large amounts of inventory (like the expensive “builder” kits) when they join.

What Should be Done to Reduce the chances of Regulatory Scrutiny or Regulatory action?

The consequences of being considered an illegal pyramid scheme are disastrous.  The company faces not only a take over by the FTC or the SEC, but also class action lawsuits by private attorneys. When such actions are brought by the government or by private attorneys, they typically do not limit the relief they are seeking to the company involved.  They will also target the principals and officers of the company as well as the leading distributors.  Moreover, merely the public disclosure of an investigation by the governmental entity may send signals that will reverberate with the field of independent distributors causing wholesale desertions by the distributors.  The bottom line is that every MLM company should implement safeguards to ensure that it will not be considered an illegal pyramid scheme.

Some of the safeguards that should be considered are as follows:

  1. Have your compensation plan carefully reviewed by a MLM professional or attorney to ensure that the plan is ultimately based upon REAL retail sales.

  2. Draft and enforce safeguards to ensure that the distributor inventory purchases are actually being retailed to customers.

  3. Compensation plans which encourage or require large inventory purchases should be avoided.  There is no reason for a new distributor to make large initial purchases and these forms of front loading are looked upon as a disguised recruitment fee.

  4. The company should follow a liberal buy-back policy. If a distributor has unwanted inventory, then the company should agree to repurchase it.

  5. The ability to autoship product or inventory should be OPTIONAL, never mandatory.  A distributor should be able to reach the highest ranks in the MLM company by successfully selling the products without any requirement to purchase themselves.

Conclusion

The consequences of being deemed an illegal pyramid scheme must be avoided.  This takes constant, on-going monitoring of your MLM programs and compensation plans, NOT just an initial review.  With proper monitoring and the institution of carefully crafted internal safeguards, your MLM company should be able to steer clear of the perils of being deemed an illegal pyramid.

*Scott Warren, David Van Sambeek and Scott Wellman are attorneys with the firm of Wellman & Warren, LLP.  Wellman & Warren, LLP specializes in network marketing law and has advised MLM companies for more than two decades.