Key legal issues in MLM cases

Though it is not my primary objective in this report to prove that any given MLM is an illegal pyramid scheme (I am not an attorney), it is relevant to know whether or not an MLM displays the characteristics of a recruitment-driven MLM, or product-based pyramid scheme because such a model leads to horrendous loss rates among participants.1 Where data has become available, approximately 99% of participants lose money.2 The percentage of participants that lose money could be as high as 99.9% if estimates of attrition and minimal operating expenses and incentivized purchases are factored into the analysis.3

The Amway rules set a dangerous precedent.

From a legal perspective, pyramid schemes are considered illegal because they an unfair and deceptive sales practice.4 While in 1979 Amway was found not to be a pyramid scheme, that ruling was conditioned on Amway’s compliance with its “Retail rules,”5 which required that each distributor be able to prove ten customers per month (“the ten customer rule”), 70% of products sold every month (not stockpiled – “the 70% rule”), and allowance for return of unsold merchandise. Amway assured the FTC it had procedures in place to assure compliance with these retail rules.

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.

Other rulings are relevant to legal analysis of MLMs as possible pyramid schemes.

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 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:

MLM incentivizes an endless chain of recruitment of participants as primary customers.

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.

"Pay to play” purchases are used to finance pyramid schemes.

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.

Most MLMs, in fact, require purchases 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

[Note: When I worked my way through college selling World Book Encyclopedia, I never had to buy my own set. But I was able to get my own set for a discount – my own commission. JMT]

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, MEs 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

References

1 A more complete discussion of re-pyramiding and how major MLMs manage to avoid market collapse and endure for decades is found in my full 44-page report entitled “5 Red Flags: Five Causative and Defining Factors of a Recruiting MLM, or Product-based Pyramid Scheme.”

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)