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Multilevel Marketing: How to Avoid Building the Pyramid

The most popular multilevel marketing (“MLM”) companies and brands have attained near-cultural icon status: Amway, Herbalife, Mary Kay, and Shaklee.  Many Americans are familiar with these brands, as well as some of the lesser-known variations that might have been introduced by an overzealous acquaintance, through an infomercial, or via the Internet.  The popularity of the multilevel marketing method is no fluke; direct sales can be a profitable business model.  However, caution is warranted for prospective market entrants, for there is a network of state and federal laws and regulations that must be navigated in order to ensure that a given multilevel-marketing operation is not deemed to be an illegal pyramid scheme.

Pyramid Denial

There is a fine line between a legitimate MLM business and an illegal pyramid scheme.  To illustrate, both offer participants the opportunity to earn commissions, and both often require new members to make an initial investment.  Among other factors, the fundamental differences between the two business methods come down to the amount of the initial investment that is required by the participant, the means by which the constituent products or services are sold, and the basis on which commissions are earned.

While the distinctions between the two business methods can seem relatively minor, the degree of contrast between them may prevent program operators from becoming the subject of a regulatory proceeding, or becoming defendants in litigation.

The Rules of the Road Regarding MLMs

Existing standards and restrictions on MLMs have evolved through developing case law and statutory requirements, on both the federal and state levels.

State by State

Every state has adopted laws that, in one way or another, regulate MLM entities and prohibit pyramid schemes.  However, the method of regulation varies.  Some states have enacted specific anti-pyramid statutes. Others merely require registration under specific MLM statutes. And others regulate MLMs by way of lottery, consumer-protection and/or anti-fraud statutes.

Several states have MLM registration requirements, and some go so far as to require that the MLM obtain a surety bond prior to opening their plan up to participation, while others are less demanding.  By way of example, Wyoming simply requires that the MLM file a Notice of Intent to Conduct Business.  In contrast, Texas requires that the MLM file, in addition to other items (1) a financial statement; (2) a complete description of the program participant-compensation structure; (3) disclosure of all persons with a 20% or greater ownership interest in the MLM; and (4) copies of all program promotional materials.  At a minimum, the states that require MLM filings generally require that the MLM appoint the Secretary of State as its agent for service of process.

Federal Regulations

On the federal level, regulation has largely come through actions initiated by the Federal Trade Commission (FTC), Securities and Exchange Commission (SEC) and U.S. Postal Service.  The seminal FTC MLM decisions are In re Koscot Interplanetary, Inc., 86 F.T.C. 1106 (1975), and In re Amway Corp., 93 F.T.C. 618 (1979).  In both of these cases, the FTC sought to identify and distinguish the characteristics of a legitimate MLM from those of an illegal pyramid scheme.

Separating MLMs From Pyramid Schemes

Pyramid schemes are characterized by the requirement that participants pay money in return for two things: (1) the right to sell a product or service; and (2) the right to receive, in return for recruiting other participants into the program, rewards that are unrelated to the sale of applicable products or services to ultimate retail customers.  In other words, pyramid schemes predominantly compensate participants, either directly or indirectly, for the recruitment and enrollment of other participants.

Two red flags that regulatory agencies often look for in ascertaining whether an illegal pyramid scheme exists are: (1) “inventory loading,” in which a company’s incentive program forces recruits to buy more products than they could ever sell, often at inflated prices; and (2) a lack of retail sales, so that sales only (or primarily) occur between people in the applicable marketing venture or to new recruits, not to consumers in the general public.

In contrast to an illegal pyramid scheme, a legitimate MLM has a real, marketable product or service to sell –one that is sold to the general public without requiring consumers to pay an additional fee to join the MLM program.  MLMs may pay commissions to a long string of distributors, but these commissions should be paid for actual retail sales, not for obtaining new recruits.

Initially, a two-pronged analysis is helpful in determining whether a given marketing plan could be considered to be an illegal pyramid scheme.  First, determine whether the subject plan, as written, appears to compensate participants merely for recruitment, or instead, to compensate them for the retail sale of goods or services to end consumers.  If the program compensates participants solely for sales to retail consumers, it will pass the first prong of the test.

The second prong of the test involves an operational analysis to determine what type of activity the plan induces; specifically, this second prong asks, “What do distributors spend their time doing?”  It is often more difficult to reach a definitive conclusion with respect to this prong of the analysis, than with respect to the first.  Several different factors may contribute to the determination of whether the second prong’s test is fulfilled, but the basic question is, “What does the plan emphasize?”  If the plan emphasizes recruitment, even though distributors do make retail sales, it may be found to be an illegal pyramid scheme.  Incorporating the safeguards that are set forth in the following paragraphs will help your program pass the second prong of this analysis.

Safeguards

In addition to distinguishing a legitimate MLM program from an illegal pyramid scheme, the FTC’s decision in Amway also sets forth several “safeguards” that should be incorporated when endeavoring to establish and operate legitimate MLMs:

  1. There should be no entry or “headhunting” fees;
  2. There should be no large inventory purchase requirements;
  3. The venture should adhere to the “70% Rule,” whereby each distributor should be required to sell, at wholesale or retail, at least 70% of its purchased inventory each month;
  4. The venture should adhere to the “10 Customer Rule,” whereby each sponsoring distributor should be required to make at least one retail sale to each of 10 different customers each month;
  5. Inventory Buy Back: Distributors should be required to buy back any unused and marketable products from their recruits upon request. Legitimate MLMs should have a 60-day, 100% money-back guarantee.  After 60 days, the MLM should accept returned inventory (unless perishable or seasonal) with a 10% restocking fee.  This helps to mitigate against a charge of inventory loading; and
  6. Legitimate MLMs should not falsely represent, expressly or by implication, the amount of earnings or income that can be, or which are likely to be, derived from participation in the applicable MLM.

Further, pursuant to statutory guidelines and existing case law, MLMs must disclose the following:

  1. The number and percentage of current participants who have not received any commissions, bonuses or overrides;
  2. The median amount of commissions, bonuses and overrides received by all participants, together with the percentage of participants that have received less and those that have received more;
  3. The average amount of commissions, bonuses and overrides that have been received by all participants; and
  4. For each level and rank within the plan, the number and percentage of current participants that have reached that level or rank, and the average length of time it took to reach that level.

Practice Makes Perfect

It is important to note that even if your written MLM policies comply with all applicable federal and state guidelines, it is the actual, ongoing conduct and performance of the MLM within its program structure that truly matters.  If, despite its written policies, the program sponsor operates the business in a way that is closer to that of an illegal pyramid scheme than that of a legitimate MLM, regulatory agencies are more likely to view the plan as an illegal pyramid scheme.

While the regulations applicable to multilevel marketing are complex and nuanced, with the proper planning and knowledgeable legal guidance, these marketing methods can be lucrative and efficient.

Please note that this is only a brief overview of some of the legal issues that you will be faced with when preparing to launch an MLM program.  Remember to obtain guidance from experienced counsel prior to embarking on such an undertaking.

David O. KleinDavid O. Klein is a partner with the firm of Klein Moynihan Turco LLP in New York, NY, where he practices Promotions Law, Gaming Law, Fantasy Sports Law and Internet Marketing Law. He can be reached at (212) 246-0900 or via e-mail at dklein@kleinmoynihan.com.
Jonathan E. TurcoJonathan E. Turco is a partner with the firm of Klein Moynihan Turco LLP in New York, NY, where he practice Promotions Law, Gaming Law, Fantasy Sports Law and Internet Marketing Law.
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