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I previously wrote on Seeking Alpha about pyramid schemes and the difficulty investors have in determining whether they are buying into an illegal pyramid scheme or a valid retail marketing enterprise. This has recently returned to the foreground with William Ackman's short of Herbalife (HLF) on behalf of Pershing Square. As with the earlier Einhorn inquiry into this company, the HLF stock has dropped significantly, although it has partially rebounded.

My understanding of the definition of a pyramid scheme is that it:

  1. Has a sponsoring company that offers and administers the operation of the plan.
  2. Requires payment, normally in the form of a periodic wholesale product purchase, as a prerequisite to participating in the pyramidal aspects of the plan as a qualified distributor (this does not involve the purchase of sales kits or other introductory elements that are offered prior to the opportunity to participate in the recruitment aspects of the plan)
  3. Promises a participating distributor that he can recruit other persons, who meet the purchase requirements in #2, and thereby be compensated through a commission paid on the qualifying wholesale product purchases of these new recruits.
  4. Provides each participating distributor not only the right to profitably recruit others but also offers these new recruits the right to further recruit others with the same promise of recruiting profits and, critically, the ability to offer all their subsequent recruits the same profits and right to recruit, without limitation as to the number of times this process can be repeated, thus creating an exponentially increasing number of recruit-participants. This enables an endless chain of recruiting possibilities, each of which generates wholesale purchases from the sponsoring company.

While a proposal such as this, given the incentives, is unlikely to generate many retail sales, it would be my opinion that the presence of retail sales does not somehow eliminate the inherent elements of a prohibited pyramid scheme. The "retail" sale aspect of this issue is discussed in this article, along with court decisions, which also deal with this particular element.

I am not at all an expert in the market and the related technical analyses involved in the evaluation of a particular stock. Before retirement, I was a consumer fraud litigator with the Wisconsin Department of Justice and tried a number of pyramid cases under a state law that has no "retail sale" element or defense. Although my primary concern is for the victims of these schemes, this article is directed to those who have invested in these pyramid offerings, or are thinking of doing so.

I believe that investors in pyramid style corporations are entitled to information sufficient to permit them to know if they are investing in a listed stock that may be involved in illegal activity related to its manner of doing business. Legal enforcement action, or the potential for this action, can significantly devalue the stock for reasons not related to normal fluctuations caused by market factors. The governmental entities responsible for providing this critical information are the Federal Trade Commission and the Securities and Exchange Commission and, possibly, the new Consumer Finance Protection Bureau. My focus has been on the FTC, since it has been actively involved in this area and is an agency with which I have had extensive contacts, dating back to 1968.

Unfortunately, it is my belief that the Commission's definitions and description of pyramid schemes fall far short of the necessary legal sufficiency required for an intelligent decision on the part of an investor or investment adviser. By doing so, these governmental agencies have unnecessarily placed the investor at risk.

The Retail Sale Requirement

One needs only look to the web, after the Ackman challenge, to sample the various and diverse opinions on the subject of legality. From the FTC's standpoint, it appears that the critical issue, aside from the endless chain pyramid mechanism, is whether the company's sales are "primarily" in the retail category - an element which, if applicable, apparently legalizes conduct that would otherwise constitute an illegal pyramid.

A January 14, 2004, Informal FTC Staff Advisory Opinion letter from the FTC to the Direct Selling Association states:

The critical question for the FTC is whether the revenues that primarily support the commissions paid to all participants are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture.

Unfortunately, just what "primarily" and "not simply incidental to the purchase of the right to participate in a money-making venture" means is indistinct and incapable of being viewed as a legal standard. The fundamental problem with this enforcement approach, aside from the ambiguity of the quoted terms, is that these elements cannot be effectively determined by readily obtained objective information - a critical factor in all investment decisions and, as well, in any legal standard that can be cogently stated to a court of law. Further, as discussed below, this Advisory appears to be inconsistent with prior case law and, in fact, cases brought by the Commission after the advisory letter was written. While it is entirely possible, even given the FTC's current definition, to document and prove the existence of a pyramid scheme, these extensive efforts should not be necessary. The Commission's formal standards should be clearer and compliance capable of objective determination.

None of the pyramid style companies that I am aware of collect or report any direct and verifiable information about retail sales, since their records reflect only wholesale purchases from listed distributors. Given this, it is difficult to understand how an enforcement agency such as the FTC could obtain the data necessary for it to conclude, from an enforcement oversight standpoint and in accord with its standards, that a company using pyramid recruiting methods is not a pyramid scheme. Further, whatever the standards, it should be the obligation of a company using the pyramid mechanism, not the Commission, to fully document legalizing retail transactions, as to all its wholesale distributors, as a prerequisite of rebutting the presumption that it is an illegal pyramid scheme. The Commission should not have to prove a negative.

There have been corporate efforts to document these "retail" transactions via company funded studies or reports filed by independent distributors. It is questionable whether these reports, aside from their anecdotal character, fully document that all distributor purchases reflect "retail" transactions sufficient to meet legal standards. A partial reply, or estimate, would in no way disprove that other unreported, non-retail, transactions have taken place. In addition, the companies' claim that distributors may be making "retail" purchases for their own use -- an activity not explicitly excluded by the FTC Advisory standard. Aside from the practical difficulty of objectively verifying the accuracy and reliability of these studies, claims, or reports, particularly across a distributor base numbering in the hundreds of thousands -- here and abroad, one also has to consider the motivations of the company and the distributors when evaluating their veracity - since if they fail to meet the retail standard, the company risks legal sanction and the distributor risks loss of purchasing status.

I contend that the FTC has come nowhere near the degree of specificity that should be required of a Federal agency charged with the responsibility of informing the public about standards that define illegal conduct. Furthermore, and to add to the confusion, recent court decisions, reflecting earlier cases, have stated, contrary to the Informal FTC Staff Advisory opinion, that the legalizing "retail" sales requirement does not include "rewards unrelated to the sale of products or services to ultimate users." - FTC v. BURNLOUNGE INC. Case No. CV 07-3654-GW(FMOx) UNITED STATES DISTRICT COURT CENTRAL DISTRICT OF CALIFORNIA WESTERN DIVISION (1012). The "rewards" referenced in this context are the commission payments made by the company when a distributor makes a wholesale purchase.

For these commission payments to be "related" to the sale of products to ultimate users, the sales would have to be consummated prior to the wholesale purchase, either in the form of a completed order or some contractual obligation to purchase. Otherwise, the commission, or "reward" would not be related to a retail sale but rather based on the unverifiable hope that an eventual retail sale would be made from items purchased at wholesale. Studies, or reports that retail sales have taken place, does not meet the standard that all wholesale orders be related to the sale of products to ultimate users. This is hardly a factual setting that will likely provide the consistent and reliable documentary evidence necessary to establish legal conduct in this critical context.

This distinction, concerning sales "related" to retail customers was made clear in the landmark case on pyramid schemes Koscot (1975 - 86 FTC 1106, 1180, 1186) , a case which remains the primary reference for current court decisions such as the BurnLounge case. On the issue of retail sales, Koscot stated prohibited conduct:

Such schemes are characterized by the payment by participants of money to the company in return for which they 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 general such recruitment is facilitated by promising all participants the same 'lucrative' rights to recruit.

Koscot, at p. 1186 explicitly described the prohibited conduct and exactly what it meant in its reference to "rewards which are unrelated to sale of the product to ultimate users":

Offering, operating, or participating in, any marketing or sales plan or program wherein a participant is given or promised compensation (1) for inducing another person to become a participant in the plan or program, or (2) when a person induced by the participant induces another person to become a participant in the plan or program; Provided, That the term 'compensation,' as used in this paragraph only, does not mean any payment based on actually consummated sales of goods or services to persons who are not participants in the plan or program and who do not purchase such goods or services in order to resell them.

The legal requirement for the existence of an "actually consummated sale" to non-participants is far from the ambiguous standards under which the FTC operates. The reason for this strict standard was explained by the Koscot court:

...even with retail sales, a scheme that promises that 'all comers' can profit must end up disappointing those at the bottom who can find no recruits. A plan that offers everyone the chance to succeed cannot be literally true because the geometric progression of recruits inherent in a pyramid will eventually and inevitably preclude some participants from succeeding.

This formal concern about pyramid plans was previously stated in the Holiday Magic case, 74 FTC, 748, at 1047 "To say that it is 'inherently' deceptive is to say no more than that it contains this intolerable potential to deceive, and on those grounds as well the plan requires condemnation."

The current, and confusing, FTC Advisory retail standard must be considered in context with the explicitly stated concern of prior FTC courts about the "intolerable potential to deceive" inherent in a pyramid scheme. The FTC should not be permitted to adopt a loose interpretation as to what is a consummated retail sale in this critical and legally significant context, particularly since it appears to conflict with its own court decisions. It is not fair to the victims that participate in a pyramid scheme, and it is not fair to those who are entitled to this information prior to investing.

My interpretation of the reference to retail sales is that they would validate what otherwise would be pyramid scheme only if the commissions paid to a purchasing distributor reflected an existing "consummated" retail purchase or a contract for such a purchase. This is a very narrow exemption for a company using a pyramid type marketing system. Such a transaction would, in essence, be an "override" commission, the type paid to general agents based on the actual sales made by sub-agents working under them. To rule otherwise would, for the reasons stated, essentially make the "retail sale" requirement functionally meaningless and practically unenforceable. It would open, and has opened, these marketing plans to the very abuses, which have been explicitly stated to be of considerable concern to the Courts and the FTC commissioners in their earlier administrative decisions.

The FTC Advisory standard has also conveniently ignored a number of state laws that either do not have any 'retail' exemption or restrict it to the 'override' type of commission "based upon sales made to persons who are not participants."

In California, California Penal Code sec. 327 states:

Every person who contrives, prepares, sets up, proposes, or operates any endless chain is guilty of a public offense, and is punishable by imprisonment in the county jail not exceeding one year or in state prison for 16 months, two, or three years.

As used in this section, an "endless chain" means any scheme for the disposal or distribution of property whereby a participant pays a valuable consideration for the chance to receive compensation for introducing one or more additional persons into participation in the scheme or for the chance to receive compensation when a person introduced by the participant introduces a new participant. Compensation, as used in this section, does not mean or include payment based upon sales made to persons who are not participants in the scheme and who are not purchasing in order to participate in the scheme.

In New York, N.Y. GBS. LAW § 359-fff : NY Code - Section 359-FFF: Chain distributor schemes prohibited states:

1. It shall be illegal and prohibited for any person, partnership, corporation, trust or association, or any agent or employee thereof, to promote, offer or grant participation in a chain distributor scheme.

2. As used herein a "chain distributor scheme" is a sales device whereby a person, upon condition that he make an investment, is granted a license or right to solicit or recruit for profit or economic gain one or more additional persons who are also granted such license or right upon condition of making an investment and may further perpetuate the chain of persons who are granted such license or right upon such condition. . . .

As used herein, "investment" means any acquisition, for a consideration other than personal services, of property, tangible or intangible, and includes without limitation, franchises, business opportunities and services, and any other means, medium, form or channel for the transferring of funds, whether or not related to the production or distribution of goods or services. It does not include sales demonstration equipment and materials furnished at cost for use in making sales and not for resale.

In this context, investors should also be aware of the potential for enforcement action by state officials. In 2009, California Attorney General Edmund Brown concluded an enforcement action against pyramid YTB International, an action that also included participation by the Illinois Attorney General. I am informed that after the conclusion of the case the company's stock dropped considerably, related stories are available and the current YTBLA stock price can be found on the web. Other states have laws similar to California and New York and may also become active, perhaps depending on the outcome of the current controversy.

Recent private actions, such as one against the Amway Corporation should also be considered.

The Question Of Market Saturation

The question is raised that if saturation of distributors is an inevitable result of a pyramid scheme, how come many companies in this general category have lasted so long, many over 30 years.

The primary answer lies in the FTC's Amway decision rendered in 1979, just over 30 years ago. This ruling held that since uncontradicted testimony in the case claimed that Amway, in fact, had 70% of its sales at retail, that each distributor had to document sales to at least 10 different customers, and that the company had a functioning buy back program, the administrative judge found that these factors legalized what would otherwise have been a pyramid scheme. Once this decision was rendered, and affirmed by the full Commission, the earlier cases, such as Koscot and Holiday Magic, while not overruled, were put in the background and all pyramids essentially took cover under the Amway case and claimed that their plans were "just like Amway." While the Commission did bring some pyramid cases after this ruling, those not sued operated under the protective blanket of the Amway ruling and with the implication that they must be legal since they were not sued. Among other things, this ruling made billionaires of the Amway owners and funded a highly effective lobby, which has fostered the interests of these plans before the Commission, the Administration and Congress.

I petitioned the FTC, in 2000, to review its Amway ruling and commence an investigation to determine whether all the testimonial claims regarding retail sales were true and accurate, as to all relevant transactions, over the intervening 21 years and whether the claimed retail sales in fact prevented the abuses inherent in a pyramid plan. The petition was denied. This is particularly troubling in light of the explicit concerns stated in the Koscot, Holiday Magic, and other cases about the inherent potential to deceive and in light of information indicating distributor retention rates near 1%.

The practical result of this unfortunate Amway legal ruling was that distributors who failed were told, and preconditioned to believe, that the failure was their fault for not working hard enough. It was not the company's fault since it was legal and not a pyramid scheme. The resulting phenomenon was that hundreds of thousands of victims failed, dropped out as distributors, and did not complain to enforcement authorities - since they believed they had been involved in a "legal" enterprise. Also, after having contacted many neighbors and friends as prospective recruits, they did not want to publicize their failure. Data, from others, has indicated that the distributor failure rate of these companies has consistently remained around 99%.

This phenomenon resulted in two critical developments. First, the absence of complaints left the Commission with no vocal objection to its new Amway based policies and no political demand to change the status quo. The second, and most important from the standpoint of saturation, was that full saturation was avoided because the failed distributors quietly dropped from the distributive tree and opened spaces, even in their own marketing area, for new recruits who could then repeat the process. Critically, for the reasons stated, the failed distributors did not convey their experiences to the new crop of unwitting recruits - thus permitting a recurring recruiting process without full saturation.

Eventually, even in the absence of criticism, areas began to saturate or the word got out that one might not be able to make even the modest amounts discussed - much less the Cadillacs and large houses of the top distributors. To solve this, many of these companies, operating with the implicit blessing of the U.S. government, moved many of their marketing operations abroad or began recruiting in discrete ethnic markets within the U.S. It is believed that about 80% of this new business is now done overseas, where participants may have less sophistication in these matters than their U.S. counterparts. This avoids full saturation to some extent, at least for the time being. It also makes the verification of overseas retail sales in those companies virtually impossible.

Conclusion

It seems that the market has generally ignored the adverse impact pyramid type schemes have had on the distributor-victims, considering that this type of marketing represents annual revenue of about $28 billion. Reliable reports indicate that about 99% of participants fail and many suffer debilitating financial and personal losses. This is a particularly troublesome fact in these difficult economic times, since these failures add to an already depleted middle class, not to speak of the diversion of entrepreneurial effort by these victims from other ventures, which may well have assisted an economic recovery. It is also troublesome that the Obama Administration has permitted this less than explicit legal standard and favorable treatment to continue, to the detriment of victims and investors, without greater oversight in respect to the Federal Trade Commission. The absence of victim complaints, not victims, has made it easier to ignore this critical area. Perhaps the responsibility for these cases should be transferred to the Consumer Financial Protection Bureau.

That stated, it is not the particular responsibility of market participants to inquire in depth about the social consequences of investing in a company. It is assumed that the appropriate regulatory authorities have obtained the necessary underlying information to assure compliance with market regulations and have promulgated clear standards, which deal with potentially illegal conduct. I feel that the Federal Trade Commission and the Administration have failed their duty in this respect. The investment community, and the public in general, deserve and should demand a substantive and legally sufficient examination of the issues raised here and a legal standard, which will protect the investing public and prospective participants in these highly questionable business offerings.

Source: Ackman's Short Of Herbalife Highlights Lack Of Adequate Information From Federal Agencies