With many entrepreneurs, having the capital to successfully launch their new business is one of the biggest hurdles to overcome.  This is no different when starting a network marketing or direct sales business.  One significant mistake, that I see time and time again, is a new Network Marketing company selling their top business positions in the genealogy for prices in excess of that which a normal distributor would pay to become a distributor. These positions usually have special names like “Founder Position” or “Super Affiliate Position” that designate these positions as more valuable than a regular business position.  The most common plan involves the company selling a handful of top positions for $10,000 or more.  This can quickly provide the company with $200,000 or more.  But, at the same time the company is exposed to serious liability for violations of the Federal Securities Laws and State Business Opportunity laws.

Securities Law Violations

The SEC defines a security as:

 … any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

Securities Act of 1933, Section 2(a)

Convoluted, right?  Well, this definition was drafted with one specific purpose… to be as broad as possible.  The SEC understood that a narrow definition would limit their ability to litigate against the bad guys violating the securities laws.  Essentially, the government thought that the bad guys were very savvy and would find a “loop-hole” if the definition of a “security” was too specific.  In order to clarify this matter, we must look to the court’s interpretation of the law.  Then in 1946, the Supreme Court of the United States gave us the clarification we needed in the landmark case of the Securities and Exchange Commission v. W. J. Howey Co. In this case, the Court gave us the Howey Test.  To simplify, an instrument qualifies as a security if there is (i) an investment of money (ii) in a common enterprise (iii) in which the investor has the expectation of profits derived substantially from the efforts of others.

When applying the Howey Test to the hypothetical NETWORK MARKETING selling top positions for $10,000 each, you will quickly see that these three elements are present in sale.  The new distributor is investing money (by paying $10,000), in a common enterprise (a position in the Network Marketing business), and the investor has the expectation of profits from others (he/she will receive commission or bonuses based on the work of the downline or the company).  Thus, the new Network Marketing company has just solicited for and sold a security.

Now the company is required to comply with the various state and federal securities laws; including the requirement that the company register the offering of the security or qualify the offering under one of the registration exemptions. Additionally, the Network Marketing company must provide the investor with adequate information to evaluate the proposed investment (commonly provided in the form of a Private Placement Memorandum).  Failure to comply with the various securities regulations can create serious liabilities for the company and even require the company to rescind the agreement (give the investor their money back) with interest thereon.

Now, I know that most of you reading this will argue that the investor is not making money from the efforts of others.  Rather, they are making money off of their own efforts in growing a downline, supporting their sponsored distributors, and selling the new Network Marketing company’s products or services.

However, this is not how the court is likely to interpret the scenario.  The counter-argument is likely to prevail on one simple question… Why did the investor pay $10,000 for the position when he could have simply joined the company for the standard distributor fee (e.g. $25.00)?

Most often the answer to this question is… Because the Network Marketing company sold the $10,000 position with the promise that the investor would make more money as a “Founder” than he/she would as a normal distributor.

In other words, the company has claimed that, all other factors being the same, the $10,000 position would generate more profits than a normal position without the investor being required to put forth any additional effort.  So the real purpose of the investor’s purchase of the $10,000 position was to make a profit off of some other party’s work.  With all three elements met, the new Network Marketing company has violated securities law subjecting both the company and possibly the individual owner(s) to a lawsuit and bunch of horrible PR.

Business Opportunity Statute Violations

Many States have Business Opportunity laws designed to protect unsophisticated individuals from loosing their start-up money in a home based business (also known as a “business-in-a-box.”  Here we will take a look at the California law as applied to our hypothetical Network Marketing company selling a $10,000 position.

In 1978 California began regulating small business opportunities. The Business Opportunity law in California is known as the “Seller Assisted Marketing Plan Act” or SAMP Act (Cal. Civil Code Section 1812.200 et seq.).  Generally, the requirements in California a similar to other states in that the law requires the company to register with the State Attorney General’s Office, to provide significant disclosure statements to potential buyers prior to signing any contracts, and to provide the buyer specific contractual rights after a purchase has been made.

In California a SAMP is basically defined as any sale or offer to sell a product or service which requires an initial payment of $500 to $50,000 in order to begin a business.  The law also requires that the company: (1) represented that the purchaser will earn, is likely to earn, or can earn an amount in excess of the initial payment paid by the purchaser for participation with the company, OR (2) represented that there is a market for the company’s product or services…  These requirements are very similar in many other states, although with minor variations.

If we apply the California SAMP Act to our hypothetical scenario, it is clear that the Network Marketing company has required a payment of more than $500 and less than $50,000.  Likewise, the Network Marketing company has probably stated that the investor will make more than their investment of $10,000 or, at a minimum, they have stated that there is a market for the company’s product or service.

Thus, our Network Marketing company has just violated the California Business Opportunity Law (SAMP Act).  Now the company and its principals face being held liable for the entire amount of funds that were wrongfully received by the company in violation of the SAMP Act.   In some cases, the company could also be fined in an amount up to $10,000 per violation.  Finally, in the more egregious cases, the regulators could pursue the matter criminally.  This means potential jail time for the company’s principals.

Conclusion

We have only touched on the possible federal securities and business opportunity implications that arise with the sale of a Founder Position in a Network Marketing company.  It is important to note that this plan may also violate State Securities Laws and possibly Franchise Laws.  Although the temptation will always be present for a new Network Marketing company to fund it’s start-up expenses by selling top positions at a premium, many times the rewards are outweighed by the rewards.  To this end, it is important that any Network Marketing company seek out the guidance of qualified, competent legal professionals in order to avoid creating unnecessary legal woes.