A Legislator’s Guide To Pyramid Schemes

Herbalife Ltd. HLF

A Legislator’s Guide To Pyramid Schemes by William Keep, Seeking Alpha

Summary

Investors follow what legislators and regulators do.

Multiple briefings on the Hill will raise legislator awareness regarding pyramid schemes and the MLM industry.

Less than 600 words can describe the nature of the problem and need for increased industry oversight.

A federal pyramid rule and/or increased regulatory oversight will bring industry change, affecting private and public MLM companies.

The Federal Trade Commission (FTC) estimates that hundreds of thousands of Americans, and possibly a million+, are pyramid scheme victims each year1. Victim losses rise to hundreds of millions of dollars annually. A pyramid rule could clarify legal business practices and reduce the cost and length of enforcement.

What is a pyramid scheme? 2,3,4,5,6,7,8

  • Recruits obtain the right to sell an “opportunity,” often in conjunction with selling a product*.
  • The right to sell includes the right to earn rewards by recruiting others.
  • Fees and/or product purchases sustain eligibility and are required for the prospect of any significant rewards.
  • Rewards derived primarily from recruiting others, who typically buy products and/or pay fees for the sake of pursuing the opportunity, and not primarily from selling products to the public.
  • Pyramid schemes have company policies, marketing material, and compensation plans that reinforce recruiting new participants into the opportunity rather than selling products to the public.

Product-based pyramid scheme symptoms necessarily include: deceptive earnings claims, a compensation plan that rewards recruitment unrelated to sales to the public, a convoluted set of policies and procedures, an inability to demonstrate consumer demand independent of recruitment, and ineffective anti-pyramid scheme safeguards. Unsupported product claims (i.e., product efficacy) may or may not be an issue and product margins considerably higher than competing products in the market are commonplace.

Product-based Pyramid Schemes vs. Legal Multilevel Marketing:

Because product-based pyramid schemes intentionally emulate legal multilevel marketing, distinguishing between the two can be difficult. Through an administrative action in 1975, the FTC accused Amway, at the time the largest multilevel marketing company, of operating a pyramid scheme. Using language that distinguished sales to distributors (i.e., wholesale sales) from sales to the public (i.e., retail sales), Amway successfully defended its business model with three key anti-pyramid scheme safeguards: 1) each distributor must have 10 retail customers monthly; 2) before making a new purchase, each distributor must sell 70% of last month’s purchase at wholesale or retail, leaving 30% of each product purchase for self-consumption or inventory holdings; and 3) dissatisfied distributors could return unused products for a refund and leave the business. The FTC found Amway policies to be effective and enforced, and in 1979, declared the business model not to be a pyramid scheme9.

Confusion and Grey Areas:

Deceptive selling practices have existed in a variety of formats for literally centuries. This is particularly true when the benefits of product usage are difficult to assess (e.g., the so-called “snake oil salesman”). While potentially illegal and surely unethical, such practices do not constitute pyramid scheme behavior. Nor does a viable product make a company immune to a pyramid scheme charge. As a result, prosecutors look for evidence of rewards derived from recruitment-driven fees and/or product purchases unrelated to the sale of products to the public, and an absence of effective, enforced anti-pyramid scheme safeguards. As pyramid scheme operators know of this focus, virtually every MLM company found to be a product-based pyramid scheme has claimed (A) to retail products to the public and (B) to have in place some version of effective anti-pyramid safeguards. Neither claim could be supported.3,4,5,6,7,8

*Product is defined as a physical product or service.

1FTC Fraud Surveys, 2FTC v. Koscot; 3Webster v. Omnitrition; 4FTC v. BurnLounge; 5FTC v. YTB; 6United States v. Gold Unlimited, 7FTC v. Vemma, 8FTC v. Equinox, 9FTC v. Amway

Additional disclosure: I have received no compensation from any parties associated with the Herbalife controversy and have no known financial position associated with any firm mentioned.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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1 Comment on "A Legislator’s Guide To Pyramid Schemes"

  1. I could craft a law in less than 40 words: The majority of the MLM gross profit must come from sales to non-distributors. This includes but is not limited to tool profit, initial payments to join, renewal fees, etc. Effective anti-inventory and product return policies must also be enforced.

    The DSA claims about 17 million people in the U.S.: Frequently Asked Questions | Direct Selling Facts – quite a few more than the FTC’s estimate of 1 million. Amway alone has 300,000 in the U.S. If the FTC can’t get this simple fact correct, it doesn’t appear they have a clue how big this problem is, and that should be the first thing they get calibrated on.

    What is a pyramid scheme? 2,3,4,5,6,7,8
    Recruits obtain the right to sell an “opportunity,” often in conjunction with selling a product*. –> Pyramid schemes and legitimate MLMs have this feature, so this is confusing.
    The right to sell includes the right to earn rewards by recruiting others. –> Ditto.
    Fees and/or product purchases sustain eligibility and are required for the prospect of any significant rewards. –> Not just required, but also if highly promoted or otherwise incentivized.
    Rewards derived primarily from recruiting others, who typically buy products and/or pay fees for the sake of pursuing the opportunity, and not primarily from selling products to the public. –> Bingo, that is a key differentiation. Also, the BurnLounge judge agreed with the 1979 Amway judge, that there is a “conjoined opportunity” (buying products for the value AND to make more money) that makes the question of motivation impossible to answer, which is why customers, which buy products ONLY for the value the only way to measure legitimate free market demand.
    Pyramid schemes have company policies, marketing material, and compensation plans that reinforce recruiting new participants into the opportunity rather than selling products to the public. –> Not just policies, but product prices, which make products nearly impossible to sell to customers, so virtually all of the purchases are made by distributors having the above conjoined opportunity. Company policies include allowing tool scams, and no legislator’s guide should leave out this issue. If companies had lots of retail sales, the MLMs with tool scams would merely adjust their tool costs to take the retail profit from the distributors and return the lack of net profit situation for the vast majority of the distributors to square one.
    Product-based pyramid scheme symptoms necessarily [I would use the term typically] include: deceptive earnings claims, a compensation plan that rewards recruitment [as the FTC website states, this also includes ongoing distributor self consumption purchases] unrelated to sales to the public, a convoluted set of policies and procedures, an inability to demonstrate consumer demand independent of recruitment, and ineffective anti-pyramid scheme safeguards [such as rules against inventory loading and a generous return policy]. Unsupported product claims (i.e., product efficacy) may or may not be [are often an issue, because the overpriced products have to be differentiated from other comparable market choices] an issue and product margins considerably higher than competing products in the market are commonplace [owing to higher production costs caused by lower production quantities compared to major brands, high company profit, and high distributor
    compensation costs].

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