In discussing MLM legal issues (though it is not my primary objective in this report to focus on any particular MLM as a product-based pyramid scheme), it is relevant to know the characteristics that make MLM as a business model inherently flawed, unfair, deceptive, viral, and predatory – and technically illegal in most jurisdictions. MLMs lead to horrendous loss rates among participants.1 Where data has become available, approximately 99% of participants lose money.2 In fact an averaging of 99.7% lose money if estimates of attrition and minimal operating expenses and incentivized purchases are factored into the analysis.3
In spite of MLM being such an unfair and deceptive practice, regulators such as the FTC leave consumers with very little protection against these schemes. For a thorough background on how this came about and related MLM legal issues, read chapters 2, 10 and 11 of the eBook “Multi-level Marketing Unmasked“ Also, as reported in Chapter 8, a review of over 110 typical MLM misrepresentations used in MLM recruitment will help your see that MLMs obtain their revenues by a whole set of misrepresentations. Taken together, they could constitute deceptive sales practices or simple fraud in virtually any jurisdiction. (Serious students in law enforcement or regulation of MLM’s will want to read the entire book.)
Read also “Frequently asked questions and straight answers about MLM” and A brief history of MLM and of pyramid schemes.
Click on the items below to open and read a clear explanation of the issues (and click to close):
Critics of the Amway decision charge that the “retail rules” have never been enforced and that though many MLM companies have policies in place to show compliance with these rules, they are rarely if ever enforced.6 Both company officials and participants employ a “wink-wink, nod-nod” attitude towards compliance with the “retail rules.”
As discussed elsewhere on this site, MLMs typically incentivize an endless chain of recruitment of participants as primary customers. Dependent on endless chain or infinite recruitment in finite markets, they are inherently flawed, uneconomic, and deceptive. In focusing on the (sales) behavior of participants, the FTC’s Amway decision failed to address these inherent structural flaws that should have led to a decision that MLM is fraudulent and per se illegal as an unfair and deceptive practice.7 The end result is an 800-pound gorilla in the Commission chambers. Thousands of MLMs have sprang up since 1979, resulting in losses of literally hundreds of billions of dollars suffered by hundreds of millions of participants world wide.
Without going into detail here, if the MLM is characterized by rewards paid primarily for recruitment of a downline and by purchases primarily by participants rather than by non-participants, it can be considered a pyramid scheme.8 At the very least it is a fraudulent scheme, presented as a “business opportunity”, when in fact it leads to almost certain loss except for those at the top of a pyramid of participants. It is also a transfer scheme, transferring money from those at the bottom of the pyramid to those at the top; i.e., from losers to winners. Rewards can be in the form of commissions from purchases on a monthly basis to meet requirements to qualify for commissions and bonuses. As James Kohm, Acting Director of Marketing Practices, wrote in a Staff Advisory Opinion:
“The Commission’s recent cases, however, demonstrate that the sale of goods and service; [sic] alone does not necessarily render a system legitimate. Modern pyramid schemes generally do not blatantly base commissions on the outright payment of fees, but instead try to disguise these payments to appear as if they are based on the sale of goods or services. The most common means employed to achieve this goal is to require a certain level of monthly purchases to qualify for commissions. While the sale of goods and services nominally generates all commissions in a system primarily funded by such purchases, in fact, those commissions are funded by purchases made to obtain the right to participate in the scheme. Each individual who profits, therefore, does so primarily from the payments of others who are themselves making payments in order to obtain their own profit. As discussed above, such a plan is little more than a transfer scheme, dooming the vast majority of participants to financial failure. . .
“The purchase of goods and services is not merely incidental to the right to participate in a money-making venture, but rather the very reason participants join the program. Therefore, the plan does not simply transfer money from winners to losers, having the majority of participants with financial losses.”9
In a prepared statement by Debra A. Valentine, General Counsel for the U.S. Federal Trade Commission on “Pyramid Schemes,” is the following statement:
“Pyramid schemes now come in so many forms that they may be difficult to recognize immediately. . . Some schemes purport to sell a product, but they often simply use the product to hide their pyramid structure. There are two tell-tale signs that a product is simply being used to disguise a pyramid scheme: inventory loading and a lack of retail sales. Inventory loading occurs when a company’s incentive program forces recruits to buy more products than they could ever sell, often at inflated prices. If this occurs throughout the company’s distribution system, the people at the top of the pyramid reap substantial profits, even though little or no product moves to market. The people at the bottom make excessive payments for inventory that simply accumulates in their basements. A lack of retail sales is also a red flag that a pyramid exists. Many pyramid schemes will claim that their product is selling like hot cakes. However, on closer examination, the sales occur only between people inside the pyramid structure or to new recruits joining the structure, not to consumers out in the general public.” 10
To be more specific, following are two issues that apply to typical MLM programs:
The F.T.C.’s position on pyramid schemes was originally set forth in the In re Koscot Interplanetary, Inc. case. On page 1181, the Koscot court noted:
“The Commission has previously condemned so-called “entrepreneurial chains” as possessing an intolerable capacity to mislead. Holiday Magic, Inc., Docket No. 8834, slip op. pp. 11-14 [84 F.T.C. 748 at pp. 1036-1039] (Oct. 15, 1974); Ger-Ro-Mar, Inc., Docket No. 8872, slip op. pp. 8-12 [84 F.T.C. 95, at pp. 145-149] (July 23, 1974), rev’d in part 518 F.2d 33 (2d Cir. 1975). Such schemes are characterized by the payment by participants of money to the company in return for which they receive (1) the right to sell a product and (2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of the product to ultimate users. In general such recruitment is facilitated by promising all participants the same “lucrative” rights to recruit.”
This comment was also quoted in the Webster v. Omnitrition case., in which also was found:
“The key to any anti-pyramiding rule in a program like Omnitrition’s, where the basic structure serves to reward recruitment more than retailing, is that the rule must serve to tie recruitment bonuses to actual retail sales in some way.” (Webster v. Omnitrition, IIB, filed in the Appeals court for the U.S. District Court for the Northern District of California, March 4, 1996.)
The “basic structure” likely refers to the potential for growth of an expanding downline, or pyramid, of participants in exponential fashion so that – even though the commissions from each downline participant is small, the aggregate commissions can grow to rapidly increasing amounts with each additional level of participants. This makes retailing of products to non-participants in the scheme apparently a comparative waste of time for those seeking to maximize their gain.
As discussed above, MLM incentivizes endless chain or infinite recruitment within finite markets, and as such is inherently flawed, uneconomic, and deceptive. It should be per se illegal as an unfair and deceptive practice, but the MLM lobby has managed to camouflage the inherent fraud.
On the FTC web site is an article entitled “The Bottom Line about Multi-level Marketing Plans.” Under the heading “Evaluating a Plan, the following advice is given: “Beware of plans that ask new distributors to purchase expensive products and marketing materials. These plans may be pyramids in disguise.
MLMs, in fact, require purchases and/or recruitment minimums in order to participate in the financial rewards outlined in the compensation plan. This is one of the earmarks of a pyramid scheme, as opposed to a legitimate direct selling program.11
While the cost of the actual enrollment fee, which includes a sales kit, may be small and likely not a for-profit item, the cost to qualify for commissions and bonuses can be substantial. In fact, participants are encouraged to satisfy their minimum “pay to play” requirement by purchasing enough products to satisfy their monthly minimum to qualify for commissions. This “pay to play” feature of an MLM compensation plan assures that, given the low amounts of commissions and bonuses received for 99% of distributors, it would be extremely rare for any distributors to realize a profit – after minimal operating expenses are subtracted along, with their purchases from company.12
Comparative analysis of MLMs with all other forms of business activity reveals that MLMs use a top-weighted commission structure that rewards those at the top of the pyramid of participants from commissions on sales to those they have recruited into their downlines. approximately 99% of whom lose money after subtracting incentivized purchases and other expenses. Rewards in MLM compensation plans are upside-down from pay plans that were used by legitimate direct selling programs of the past, such as publishers of encyclopedias that were once sold direct to consumers. Even retail operators typically receive the lion’s share of the retail markup, with sales managers above them receiving far less per sale. A more complete explanation of this important difference is found in Chapters 2 and 10 of the book Multi-level Marketing Unmasked, which can be downloaded from this web site.
1 A more complete discussion of re-pyramiding and how major MLMs manage to avoid market collapse and endure for decades is found in Chapter 3 of my book Multi-level Marketing Unmasked, which can be downloaded free of charge from this web site.
2 “The Myth of ‘Income Opportunity’ in Multi-level Marketing,” by Robert FitzPatrick, Pyramid Scheme Alert, 2008.
3 “Which Does the Greater Harm,” by Jon M. Taylor, Ph.D.
4 Letter from Robert Frisby of the FTC, citing section 5(a)(1) fo the Federal Trade Commission Act, 15 U.S.C. 45 (a)(1). See also Koscot Interplanetary, Inc., 86 F.T.C. 1106 (1975)
5 In the Matter of Amway Corp., 93 F.T. C. 618 (1979)
6. “The Case for Reopening the Amway Pyramid Scheme Case,” by Robert Fitzpatrick, Fitzpatrick Management, Inc.: Charlotte, North Carolina, 1999
7 Letter from Bruce Craig, former Assistant Attorney General for the state of Wisconsin, to Robert Pitofsky, FTC Chairman, February 25, 2000.
8 In re Koscot Interplanetary Inc., 86 F.T.C. 1106, 1181 (1975), aff’d.,Turner F.T.C., 580 F. 2d 701 (D.C> Cir. 1978); Webster v. Omnitrition,79 F.3d 776, 781 (9th Cir. 1996); United States v. Gold Unlimited, Inc., 177 F.3d 472, 480-81 (6th Cir. 1999); F.T.C. v. Equinox, Int’l. Corp., 1999 U.S. Dist. LEXIS 19866, *15 (D. Nev. Sept. 14, 1999); People v. Cooper, 166 Mich. App. 638, 651-52; 421 N.W.2d 177 (1987); Koscot Interplanetary, Inc. v. Draney, 90 Nev. 450, 530 P.2d 108 (1974); Section 5 of the FTC Act; M.C.L. 750.372; N.R.S. 598.100, et, seq.
9 Letter from James Kohm, Acting Director of Marketing Practices, expressing a Staff Advisory Opinion to Neil Offen, President of the Direct Selling Association, January 14, 2004
10 Statement by Debra A. Valentine, General Counsel for the U.S. Federal Trade Commission on “Pyramid Schemes,” presented at the International Monetary Fund’s Seminar on Current Legal Issues Affecting Central Banks.
11 re FTC v. Amway (1979 – 142-145), Webster v. Omnitrition (Discussion on “Pyramid”), and FTC v. Skybiz (29)
12 “Which Does the Greater Harm,” by Jon M. Taylor (op cit)
13. See Chapter 10 of Multi-level Marketing Unmasked, by Jon M. Taylor, which can be downloaded from this web site.