Business engaged in multi-level marketing need to ensure they are not conducting an illegal MLM pyramid scheme! Multilevel marketing plans are evaluated by the method which the products or services are sold and the manner that participants are compensated. Essentially, if an MLM plan compensates participants for sales by their recruits, and their recruits, that plan is multilevel. If a program compensates participants only for bringing new recruits into the plan, it is an illegal pyramid scheme. Pyramid schemes are illegal under the FTC Act and under specific state anti-pyramid and MLM laws.
Pyramid Marketing Schemes
There is no federal anti-pyramid law in the United States. However, through enforcement actions, the FTC has defined pyramid schemes generally as “the payment by participants of money to the company in return for which they [the participants] 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 re Koscot Interplanetary, Inc. (1975)). According to the FTC, direct sellers should pay commissions for the retail sales of goods or services, not for recruiting new distributors. Any type of opportunity or system that involves paying compensation to members primarily if they recruit new members is a Pyramid scheme and a deceptive practice under the FTC Act.
Prohibited marketing schemes can be pyramid schemes, ponzi schemes, chain marketing schemes or other deceptive marketing plans or programs. New investors must buy into the “opportunity” and those funds are actually the primary (and usually only) source of income for those higher up in the pyramid. In order to fall below the minimum threshold of the Franchise Rule or Business Opportunity Rule, sellers are careful to charge less than $500 to buy into the “opportunity.” So, the Franchise Rule does not apply in these instances and the seller has no duty to disclose any information. In addition, the wholesale and training buy-back exceptions are also used to avoid invoking the requirements of the Franchise Rule. This does not mean you are free to use untrue or unsubstantiated earnings claims, as I discuss later.
The Amway Safeguards
Scams falling within the exceptions to the Franchise or Business Opportunity Rule are attacked by the FTC generally as unfair or deceptive acts. However, in a landmark case, the FTC decided Amway’s business model was not an illegal pyramid scheme and created what are known as the “Amway Safeguards.” (In re Amway Corp. (1979)). According to the FTC, Amway was not a pyramid scheme because of the following consumer protection safeguards: (1) Amway bought back goods of terminating distributors, (2) it required distributors to have sales to at least ten customers per month, and (3) it required distributors to sell seventy percent of the products they purchased each month to non-distributors.
Because of the Amway decision, MLM’s, affiliates and other sellers of business opportunities now routinely implement the Amway Safeguards to ensure they are not engaged in an illegal pyramid scheme. As long as the Amway Safeguards are utilized, MLM’s and affiliates have generally been able to avoid prosecution by the FTC. This is true even where earnings of participants come primarily from the payments of new recruits.
However, this is not a guaranteed safety net to avoid being classified as a pyramid scheme. Practices that do not deter “inventory loading” and promote retail sales to the degree necessary to insulate the company from operating as a pyramid will not avoid liability even with the Amway Safeguards in place. (Webster v. Omnitrition International, Inc. (1996)). The Webster case was a groundbreaking case that set new standards in the MLM industry. It set forth two basic lessons: 1) MLM’s and businesses must place a primary emphasis on retail sales rather than recruiting; 2) enforcement of policies which deter inventory loading and encourage retail sales are of paramount importance. Without enforcement, even the most perfectly drafted policy against it is useless (you must proactively monitor sales reps to ensure that retail sales requirements are satisfied and that all programs emphasize retail sales over recruitment.
State Anti-Pyramid Laws
Some states specifically define and regulate multilevel marketing plans. They generally include plans where participants are compensated for retail sales or for new recruits. Most states define certain types of MLM plans, such as a pyramid scheme, “chain distributor scheme” or “endless-chain scheme” and restrict such practices. All state laws are meant to restrict the same thing: MLM plans or programs that compensate or reward participants, either directly or indirectly, for recruiting or enrolling other participants rather than compensating them for sales of products or services to end consumers. In other words, MLM plans must base compensation on retail sales to legitimate third party customers.
Most state laws generally provide that a business which employs the Amway Safeguards does not amount to an illegal pyramid scheme. However, following the Amway exceptions may not be enough to violate state law in some instances. There are definitely some guidelines you should follow, as established by the courts, as I discuss below.
Guidelines To Avoiding Pyramid Marketing Schemes
The following guidelines are not expressly stated in state anti-pyramid laws. However, these common principles are typically considered by both federal and state courts in determining the existence of an illegal pyramid scheme.
1. Avoid Inventory Loading
“Inventory loading” Is essentially a practice that attempts to get around the legal definition of a pyramid scheme. This practice involves new participants being required to purchase large quantities of products, which are usually non-refundable and sometimes overpriced. This produces a commission for “upline” participants. The emphasis in such a program is not on the sale of products, but rather on recruiting of new participants with the goal of “loading” them with as much inventory as possible. It is usually not very likely that the average participant would either use or be able to resell the inventory that he or she is required to purchase. Because of this, courts across the country have determined that this practice is essence recruiting and is a pyramid scheme. This has been true even where participants are compensated for sales. Because of this, it is important that sales requirements to participants are not unreasonable (volume and price) sot that it won’t be considered to be inventory loading.
2. Require 70% of Retail Sales to non-participants in MLM program
Many MLM programs base commissions off of the sale of products to “downline” participants rather than genuine retail sales to third persons. The courts have determined that personal consumption by downline participants does not satisfy the requirement that sales be to the “ultimate user.” The safest approach has been to require that at least 70% of all purchases result in true retail sales to third party customers.
3. Repurchase Inventory at 90% of the original Price
Georgia, Louisiana, Massachusetts, Maryland, Puerto Rico, and Wyoming require an MLM business provider to repurchase inventory that is returned by the members. Some states require repurchase when a participant terminates his relationship with the MLM provider. In other states (i.e. Maryland and Puerto Rico) the company must repurchase returned inventory if any participant is unable to sell it within three months from obtaining the inventory. Some states (6) require MLM providers to repurchase resalable products from their distributors for not less than 90% of their original purchase price. Georgia law also requires that a MLM provider repurchase goods that are no longer marketed if they are returned to the company within one year from the point in time the marketing has stopped for the goods.
4. Have an extended buy-back period
You should allow a refund so long as the merchandise remains currently marketed by the company and is returned in resalable condition. As stated, Maryland and Puerto Rico require as little as three months or 90 days for buy-back policy for inventory repurchase. You probably shouldn’t take back all inventory regardless of when it was purchased or with a no questions asked policy. But, four states (Louisiana, Wyoming, Massachusetts and Georgia) require companies to take back products as long as the goods are “resalable.”
5. Prove Enforcement of buy-back policies
Keep detailed records of the returned merchandise they have taken back and the refunds that have been issued. A monthly refund report should be maintained by every company so that if its program is challenged, the company can provide the court with compelling evidence that distributors do not have to take unwanted inventory if they elect to cancel their participation.