Business

William Keep – The Direct Selling Association On Pyramid Schemes: Truth And Truthiness

The Direct Selling Association On Pyramid Schemes: Truth And Truthiness by William Keep

Summary

  • Implications for investor risk of a pyramid scheme prosecution and legislators concerned with consumer protection.
  • Contracting “experts” with no industry expertise invites misinformation for investors, consumers, AND industry members.
  • A positive path forward relies on neither damning an entire industry nor sprinkling “industry self-regulation” pixie dust on regulators and legislators.

By Peter Vander, Ph.D. and William Keep, Ph.D.

Public statements presented as true, though without supporting logic or evidence, if repeated frequently and with enough gravitas may eventually be accepted as true. To capture this type of phenomenon, a new word has been added to our lexicon, “truthiness.” Truthiness does not necessarily indicate a false statement, though a false statement authoritatively asserted as though it were true does qualify.

Below we test our understanding of truthiness with regard to a recent report commissioned by the Direct Selling Association (DSA) and other assorted DSA public statements. Curiously, the authors of the DSA report are antitrust experts, who have neither published any scholarly works concerning multilevel marketing companies (MLMs), nor acted as pyramid scheme experts in a court of law. Perhaps it is due to this lack of expertise and experience that their report mainly appeals to truthiness.

As for truth, it is certainly true that much effort, time and many words went into criticizing a paper* that we wrote thirteen years ago. But it must be pointed out at the start that the model we developed as a scholarly work has never been used in a court of law to determine whether or not a company is operating a pyramid scheme, and it was never proposed that it could function in that way. This is so because each pyramid case presents a unique set of available data, and the analysis in each case must address how the company functions in practice. Unfortunately, the authors of the DSA report did not appreciate these relevant points. If they had, their report could have been cut in half, and perhaps more.

The DSA report grants at the start that we are recognized experts in the field of distinguishing a legitimate business enterprise from a pyramid scheme. But it omits the recognition that, in the 15 pyramid scheme cases in which Dr. Vander Nat was appointed the government’s expert – each time submitting an economic analysis to the court — no court has ever rejected his conclusion that the organization is/was a pyramid scheme. That is to say, the vast majority of arguments made in the DSA report are old news, having been considered and either rejected or ignored in numerous courts of law.

Unencumbered by this precedent, the DSA report takes a novel stand and boldly declares (literally puts in bold), “[t]he key diagnostic for a pyramid scheme is whether the transactions defining the commercial enterprise yield incremental value to society,” — a claim that is firmly rejected by eminent scholarship in law and economics (see Posner below). Here is a respectful word of advice to DSA members: although you might like what this report has to say, if ever an MLM company is in court defending itself against pyramid scheme allegations, waxing poetic about the firm’s value to society won’t help; far better to focus on retail sales.

We further highlight that the 2014 BurnLounge decision, which is used as the basis for the DSA’s critique of our work, does not invalidate our emphasis on retail sales, whether in the 2002 paper or in specific court testimony (below). By presenting a few selective portions of the BurnLounge ruling and ignoring the fully articulated basis for the ruling that BurnLounge was a pyramid scheme, the DSA report dismisses our emphasis on retail sales as “a premise that cannot be sustained.” Actually, we show the opposite. Not only can it be sustained, an emphasis on retail sales is being sustained by the appellate decision itself (2014) and in a recent federal court injunction against Vemma (2015).

A Sampling of Truthiness in the DSA Report and Public DSA Statements

As to the report’s purported “key diagnostic:”

  • This assertion (quoted earlier), conveying a concomitant need for cost/benefit analysis regarding a pyramid scheme, is a striking example of ignorance for known principles in economics and law. A pyramid scheme is inherently fraudulent (every court has said so), and is properly analyzed under the established maxim that deception/fraud carries no social benefit. As explained by Judge Posner in his Economic Analysis of Law (2nd ed. P.81), “The question of affirmative misrepresentations in consumer transactions is straightforward: the costs of making and of unmasking the misrepresentation represent a deadweight social loss,” and later continues with “Misrepresentation involves costs to both sellers and buyers that yield no social gain.”
  • The FTC follows the same principle and never offers extrinsic evidence by way of cost/benefit analysis in prosecuting deception. Ironically, based on the DSA report, the FTC must be missing the “key diagnostic for a pyramid scheme.”
  • Instead, the agency affirms (FTC Policy Statement on Deception; 1983) that extrinsic evidence in cases of deception “can consist of expert opinion, consumer testimony (particularly in cases involving oral representations), copy tests, surveys, or any other reliable evidence of consumer interpretation.”

In sympathy with the DSA report, Mr. Mariano, President of the DSA declared: “The legal analysis should be: is the product being used by real consumers?” Whether the consumer is a distributor is immaterial, he says.

  • What about the following? Courts have ruled that whether product purchasers are primarily business participants versus consumers is an important part of pyramid determination, with numerous courts finding MLM companies to be pyramid schemes with negligible sales beyond what their distributor-recruits purchase, and with documented harm to tens of thousands of victims. MLM companies continue to face pyramid scheme charges.

“Even if one were to accept the faulty premise that case law trumps economics when it comes to performing economic analysis, recent developments have made it clear that the premise underlying the V&K paper cannot be sustained.”

  • Our 2002 paper purposely uses case law to further elucidate the economics underlying a pyramid scheme, since the law, not economics, determines the legality of company behavior-similar in concept to anti-trust cases. In most pyramid cases a judge (and sometimes a jury) considers expert economic analysis presented by opposing sides. Our model is consistent with that same consideration, as it is based on prior cases that incorporate both the law and the accepted economic analysis. As noted above, all the cases encompassed by the model were either won by court decisions or settlements favorable to the government’s prosecutorial position.
  • The economic analysis presented by the government shows that by the very design of the pyramid compensation plan, the vast majority of participants are doomed to predictable economic losses -thereby addressing the core deception of the scheme. The above quote from the DSA report indicates some adversarial relationship between economic analysis and case law that is neither logical nor relevant to pyramid scheme deception and prosecution.

The Report’s Review and Mischaracterization of The Retail Sales Criterion

“Under the ‘retail sales criterion’, only third parties with no connection to the selling organization are considered legitimate ‘ultimate users’. Consequently, the V&K paper deems the consumption of product by distributors (‘internal consumption’) to be illegitimate and simply a cover for fraud.”

  • Only the first sentence reflects case law at the time of our paper; the second sentence is neither a logical extension, accurate to our language, nor does it mention that we fully recognize the 1979 Amway decision, which upon closer analysis allows for up to 30% of any month’s purchase to be used for a distributor’s own use and/or inventory holdings.
  • An assertion that our model considers distributor product consumption (or whatever the label applied) as illegitimate or a form of fraud is contrary to how we present and analyze participant compensation. In the 2002 model we expressly explore the possibility that all upline rewards may have a proper retail basis for the totality of distributor purchases. At no point in our paper do we write or imply that sales to distributors are, per se, prohibited or constitute a form of fraud. Rather, we place all company sales in the full context of purchases, including incentives in the firm’s pay plan, as courts have done (e.g., Omnitrition; 1996) and continue to do (BurnLounge; 2011 & 2014 and Vemma injunction; 2015).
  • It is accurate to say the BurnLounge appellate court in 2014 (but not the federal district court in 2011) denied the FTC’s claim-consistent with all cases up to that point-that only sales to non-distributors were to be counted under Koscot (1975) as sales to “ultimate users,” since the case was brought under the Koscot ruling, while also citing to Omnitrition (1996) for support of that same ruling. In recognizing just selected portions of the court’s decision, the DSA report neglects to recognize that both BurnLounge courts (2011 & 2014) affirmed and relied upon Omnitrition (1996). The courts expected but did not find consumer demand independent of purchases incentivized by the BurnLounge compensation plan. The lack of such sales formed a critical part in finding that BurnLounge was a pyramid scheme.
  • The DSA report also neglects to note that both the 2011 & 2014 BurnLounge decisions affirmed the admissibility of Dr. Vander Nat’s approach, including his emphasis on sales to the public, which the appellate court characterized as not being materially different from what the Omnitrition court held (1996) — thus, incidentally, rendering an affirmation that is clearly relevant to the scope of our 2002 paper.
  • Recently, on TINA.org, Dr. Vander Nat goes into a detailed analysis on the history of retail sales in court decisions. The entire history shows, expressly in the context of pyramid analysis, that emphasis on retail sales is consistent with every court decision, including the 2014 Burnlounge decision.
  • In the FTC’s ongoing litigation against Vemma, the court ruled that in all likelihood, the FTC’s pyramid allegation will win on the merits and wrote an accompanying analysis that included an evidential lack of sales to non-distributors. The court placed Vemma under a preliminary injunction that requires any payment of upline rewards to have more than a 50% basis in sales to non-distributors, i.e., people who are not enrolled in Vemma’s business opportunity (thus, general customers).

Further Truthiness in the Report and What Courts Have — and Have Not — Stated

“Consequently, and contrary to the arguments advanced by Vander Nat and Keep, even the courts have now stated clearly that determining the identity of the purchasers is not particularly probative to the question of whether a pyramid fraud is in progress.”

  • Again, the above TINA.org blog entry addresses this matter in detail. Here is certain reminder language from the BurnLounge court (2014): “But it is incorrect to conclude that all rewards paid on these sales [distributor purchases] were related to the sale of products to ultimate users… the rewards Burn-Lounge paid for package sales were not tied to the consumer demand for the merchandise in the packages; they were paid to Moguls for recruiting new participants….[and in affirming a quote related to Omnitrition and specifically to Vander Nat testimony] …obtain monetary rewards primarily through enrolling new people into the program rather than selling goods and services to the public.”
  • The quote from the DSA report further contains a peculiar qualifier, “not particularly probative.” We can all know what it means if something is “probative” to an issue; i.e., Black’s Law Dictionary (7th Ed.) probative: “tending to prove or disprove.” What may be communicated by “not particularly probative” regarding the stated issue? Applying the dictionary, it would mean “not particularly tending to prove or disprove.” Does that mean the relevance of the identity of purchasers is up for grabs? Federal courts do not think so, including the Vemma injunction of September 2015. Did the consultants’ reading of the evidence from the full historical record lead them to conclude that the identity of the purchasers is probative, or not? Their claim of “not particularly probative,” seems to seek an answer somewhere between yes and no.
  • Beyond the BurnLounge decision (2014), the Vemma case now in progress under an injunctive order (2015) demonstrates that the identity of the purchasers (business distributor v. general consumer) is and remains probative.

According to the DSA report, alone or in concert, we “tip the scales toward reaching the conclusion that the enterprise is a pyramid scheme,” offer “biased inquiries into these matters,” and use “normative judgments” to convict an MLM company of being a pyramid scheme.

  • Based on these statements, in Equinox (1999), Gold Unlimited (1999), BurnLounge (2011), FHTM (2013), BurnLounge (2014, 9th Circuit decision), etc., the courts must apparently be slavishly appeasing an FTC economist or college professor. Actually, the courts were building on a consistent body of case law. The acceptance of our thinking, and more specifically our testimony, regarding pyramid schemes rests not with us, the DSA, or a hired consultant but, rather, with federal courts. The report reflects either a naïve understanding of court processes or a disregard of the full articulation of court decisions.
  • An example of testimony accepted by the court: In BurnLounge (2011), the federal court reviewed the assertions of the defense expert and characterized them as “not remotely persuasive.” Regarding the government’s expert, the court ruled that Dr. Vander Nat’s methods were reliable and reliably applied to the facts of the case. The court then went on to cite Dr. Vander Nat’s testimony numerous times in support of holding that BurnLounge was a pyramid scheme.
  • The 9th Circuit court in its de novo review (2014) of Dr. Vander Nat’s expert opinions regarding BurnLounge, affirmed the federal court’s reliance on his testimony, adding that it was not materially different from Omnitrition, and specifically so in regard to his definition, “a pyramid scheme is an organization in which the participants obtain their monetary rewards primarily through enrolling new people into the organization rather than selling goods and services to the public.”

Numerous Theoretical Arguments in the Report in Search of a (Missing) Basis

The DSA report contains numerous theoretical arguments with little explanation or support. For further example, take the notion of consumer surplus, a major argument in the report in the critique of our approach, stating our 2002 model “ignores the consumer surplus that is generated by internal consumption.”

As a refresher, consumer surplus is, as taught to undergraduate students across the country, the value the consumer receives from paying less for a product than he/she would have been willing to pay. For example, if you were prepared to pay $9,995 for that Ralph Lauren Purple Label Suede Shearling Coat and paid only $7,995 you have consumer surplus of $2,000. The report is replete with statements regarding consumer surplus made with suitable gravitas, while the authors provide no data – or where one might obtain it – on the amount or level of consumer surplus generated in an industry, or even within a specific MLM, having many tens of thousands of distributors engaged in an all-against-all competition. What evidence demonstrates the price a customer is willing to pay above the discounted price paid by distributors? That is the critical question of consumer demand, for which (as a pertinent example here) the BurnLounge trial court concluded there was no evidence, including the sales data that BurnLounge offered.

Further, basic economics says that more sellers selling the exact same item in the same market will drive down the market price. Evidently, the authors overlooked that in practice any evaluation of consumer surplus would require knowledge of market price and a consumer demand curve. The report gives no indication or support for how that could be determined under the indicated circumstances.

And equally important is that an analysis of consumer surplus is relevant only to an enterprise that grants incremental value, and is thereby amenable to an estimate of net incremental value by weighing costs and benefits. For a pyramid scheme such analysis is obviated by the fact that the scheme, being inherently fraudulent, bestows no value to society. Therefore, re-writing a sentence highly pertinent to the DSA report, the key diagnostic for an analysis of a pyramid scheme with an MLM-type structure cannot be whether the transactions defining the commercial enterprise yield incremental value to society.

Court Consistency Through Vemma

Missing by a wide margin decades of pyramid scheme analysis accepted by the courts and declaring, “we have not examined the factual allegations in the matter of Vemma,” the authors nonetheless dive in, claiming the government expert Dr. Stacie [not “Sharon”] Bosley offers arguments “premised on the assertion that only sales to third-parties constitute legitimate business activity. BurnLounge rejects the legalistic rhetoric of the ‘retail sales criterion.'” As with their critique of our paper, the authors ignore that Dr. Bosley’s analysis treats sales to third-parties within the full context of the business activity. Further, the “retail sales criterion” that these authors review in connection with our 2002 paper was never presented to, and therefore never rejected by, the BurnLounge court. Above we show that an emphasis on retail sales has been affirmed by every federal court decision, including BurnLounge (2014).

Further ignoring BurnLounge and the factual allegations in Vemma, the DSA report objects to Dr. Bosley’s statement: “incentives are…aligned with recruitment and purchases, rather than retail sales based on market demand”. Lacking expertise in the area of pyramid schemes, the authors fail to see the obvious parallels between Dr. Bosley’s statement and one found in BurnLounge: “In practice, the rewards…were not tied to the consumer demand for the merchandise in the packages; they were paid to Moguls for recruiting new participants.” By ignoring BurnLounge and the facts of the Vemma case, the authors may have hoped to spare themselves embarrassment of court rulings contrary to their analysis (but not successfully so). We have recently seen two rulings on Vemma that move contrary to much of what these authors say in the report: 1) the initial Vemma injunction, and 2) the court’s further rejection of Vemma’s proposed compensation plan, because its “51% rule” does not ensure that the receipt of rewards based primarily on recruiting new Affiliates have been prevented — again affirming that the identity of product purchasers matters very much to the court.

Sorting Out the Logic

The authors also claim that our paper and Dr. Bosley’s arguments confuse the logical inverse with the contrapositive, which sounds serious. As young people say, let’s break it down. If “M” represents all situations were a vast majority of participants are mathematically guaranteed to lose money (e.g., a state lottery, roulette, etc.) and “P” represents pyramids schemes, where participant compensation derives primarily from recruitment and the vast majority of participants are mathematically guaranteed to lose money, then “P” becomes a special case (i.e., a subset) of “M”. Because a contrapositive must agree with the original relationship, any situation “not M” is necessarily also “not P”. For example, a legal direct selling business would not result in the vast majority of participants mathematically guaranteed to lose money, hence it is “not M” and therefore also “not P.” What makes pyramid schemes (P) a unique subset of all situations where the vast majority of participants lose money (M) is the fraud necessary to grow the pyramid scheme. (Once this subset relation is recognized (P is a proper subset of M), the report authors’ alleged confusion by Dr. Bosley between the contrapositive and the inverse can safely be dismissed.)

Attempted Reassurance Offered to DSA Constituents

Finally, in attempting to reassure his constituents, DSA President Mariano writes: “DSA enforces one of the most rigorous self-regulatory codes of ethics in business today, ensuring that direct selling companies not only follow the law, but in many cases exceed its requirements” and “The Direct Selling Association (DSA) has worked collaboratively and productively with regulators and legislators over many decades to not only perfect the definition of a pyramid scheme, but also to give law enforcement the tools they need to prosecute the offenders.”

This comes at a time when the SEC reports “seeing ‘a proliferation’ of pyramid schemes” and, “an increase in pyramid schemes under the guise of ‘multi-level marketing’ and ‘network marketing’ opportunities;” an award-winning member of the DSA is under a court monitor facing an FTC pyramid scheme charge; Herbalife (NYSE:HLF) continues to be under investigation by the FTC and SEC, and Nu Skin (NYSE:NUS) temporarily halted operations and paid penalties in China. Despite all of this the DSA claims to mysteriously play the role of legal enforcer. (See here and here why we need greater industry regulation by the FTC and SEC).

Conclusion

In view of the analysis expressed in this article, we think the thrust of the DSA report and statements made by the DSA largely seek to validate, without sufficiently reasoned analysis or factual support, a desired conclusion, namely that the legal analysis should be: is the product being used by real consumers; whether the consumer is a distributor is immaterial. But decades of court decisions have shown otherwise.

*See Drs. Vander Nat and Keep, “Marketing Fraud: An Approach for Differentiating Multilevel Marketing from Pyramid Schemes,” Journal of Public Policy & Marketing, vol. 21, no. 1, pp. 139-151 (2002). In the paper we present a collection of pyramid scheme cases completed by court decision or a settlement favorable to the government’s prosecutorial position. We also present a mathematical way to think about these (prior to ’02) cases as mutually consistent pyramid prosecutions.

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.

Herbalife Ltd. HLF Pyramid Schemes