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Multilevel Marketing and Avoiding Pyramid Schemes

posted in Corporate formation, Corporate Governance, Due Diligence, Employment Law, SEC, Uncategorized by

Multilevel Marketing (MLM) programs, also known as Network Marketing or Direct Selling programs are great ways for businesses to build a brand and introduce new products to the market at a fraction of the cost associated with traditional methods.  Pyramid schemes, on the other hand, have been declared inherently fraudulent.  In an ideal world, legitimate MLM businesses would have nothing to fear, however concerns over illegal pyramid schemes masquerading as legitimate MLM programs have caused the industry to incur significant regulatory burdens.  This newsletter provides an overview of the laws legitimate MLM programs must comply with and how they can differentiate themselves from illegitimate pyramid schemes.

To protect themselves from being classified as pyramid schemes, MLM businesses should be aware of what legally constitutes a pyramid scheme. The Fair Trade Commission (FTC) has established a two part test for what qualifies as a pyramid scheme. Under this test a pyramid scheme is characterized by the payment of money by participants to the company in return for which they receive (i) the right to sell a product; and (ii) 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.

Courts applying this test have made clear thatthe second prong is of particular importance.  As such, legitimate MLM businesses should make every effort to tie bonuses to the sale of products to ultimate users; especially, when the bonuses also have the effect of incentivizing recruitment.  Moreover, courts have also made clear that determining if an MLM business is a pyramid depends upon how the MLM operates in practice.  To that end the FTC and Securities and Exchange Commission have provided some guidance on features that are red flags a program may be an illegal pyramid scheme.

The following are all features more commonly associate with pyramid schemes than legitimate MLM programs:

  •  Lack of a genuine product or service. MLM programs involve selling a genuine product or service to people who are not in the program. Exercise caution if there is no underlying product or service being sold to others, or if what is being sold is speculative or appears inappropriately priced.
  • Promises of high returns in a short time period. Be leery of pitches for exponential returns and “get rich quick” claims. High returns and fast cash in an MLM program may suggest that commissions are being paid out of money from new recruits rather than revenue generated by product sales.
  • Easy money or passive income. Be wary if you are offered compensation in exchange for little work such as making payments, recruiting others, and placing advertisements.
  • Lack of demonstrated revenue from retail sales. Ask to see documents, such as financial statements audited by a certified public accountant (CPA), showing that the MLM company generates revenue from selling its products or services to people outside the program.
  • Buy-in required. The goal of an MLM program is to sell products. Be careful if you are required to pay a buy-in to participate in the program, even if the buy-in is a nominal one-time or recurring fee (e.g., $10 or $10/month).
  • A complex commission structure. Be concerned unless commissions are based on products or services that you or your recruits sell to people outside the program. If you do not understand how you will be compensated, be cautious.
  • Emphasis on recruiting as opposed to sales. If a program primarily focuses on recruiting others to join the program for a fee, it is likely a pyramid scheme. Be skeptical if you will receive more compensation for recruiting others than for product sales.

To address these issues, MLM businesses should implement and enforce strong terms of use, and policies and procedures which address these issues.

CONCLUSION

The laws MLM businesses must comply with are complicated and comprehensive; as are the policies businesses must implement to protect themselves from being classified as a pyramid scheme. Businesses wishing to launch a new MLM program or revise an existing program to protect their operations should begin taking steps now. In any event, the different rules, provisions, and continuously changing landscape make MLM and anti-pyramid scheme laws a topic that needs to be continuously monitored and researched further.

If you are interested in learning more about anti-pyramid scheme statutes or MLM rules and regulations and how they may affect you, then please contact Larry Horwitz at lhorwitz@horwitzarmstrong.com.

19 Sep, 15

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