Direct Selling And Multilevel Marketing In The U.S.: A Note To Investors And Regulators

Includes: HLF, NUS
by: William Keep

By 2000 the transformation of the U.S. direct selling industry into the multilevel marketing (MLM) industry was more or less complete. The change corresponded with the relative decline of the industry as a retail force. Why? And what does it say about the degree to which any MLM operates a pyramid scheme?

Door-to-door sales in the U.S. took hold early in the 20th century. Companies selling brushes, vacuums, cosmetics, apparel, electrical appliances, furniture - even automobiles - successfully adopted direct selling. Sales increased throughout the 1920s and hung on during the difficult 1930s. Commissions, sometimes as much as 40-50 percent, offered viable part- and full-time career options, mostly to men. The erratically performing Fuller Brush Company, founded in 1906, reached sales of $15M by 1923 and then dropped to $10.3M in 1929 in the face of increased competition. That same year Avon generated $2.5M in revenue. New companies quickly entered.

Product demonstrations, shopping convenience, new product introductions, exclusive sales territories, corporate sales training programs, and a notable pride in success at selling directly to the consumer became industry staples. Selling became "scientific" and COD (collect on delivery) payment drove growth. College students were recruited for summer selling as early as 1913. Though a minority of the sales force, women also did well. Madam C. J. Walker, the first women and first African-American in the U.S. to become a millionaire, adopted direct selling to sell hair treatment and cosmetics to African-American women, a group largely ignored by traditional retailers and manufacturers. Earnings came from commissions paid on sales made TO CONSUMERS WHO WERE NOT PART OF THE SALES FORCE.

There were complaints - the FTC recorded 17 of them in 1920 - mostly for misrepresentations or for salesmen pocketing initial payments. But the loudest complaints came from store retailers.

How concerned were they?

In Tampa they produced full-page ads warning against "the Stranger Who Raps on Your Door." Chambers of Commerce found themselves in the uncomfortable position of established retail members now condemning new, direct selling members. At the urging of store retailers some communities adopted "Green River ordinances" that prevented direct sellers from making a home visit unless first invited to do so - a maneuver upheld by the U.S. Supreme Court. Imagine, store retailers so afraid of direct selling that they worked to create legal defenses.

Post WWII, estimates of direct selling sales varied greatly from (a surely overstated) $7B in 1949, approximately 2% of total retail sales that year, to an estimated $3B-$5B in 1970. Verifiable data has not been the industry's strong suit. By the late 1940s Nutrilite, a relatively new company, had demonstrated rapid growth using a multilevel marketing business model. In shifting the recruiting, training, and supervising of new sales people onto the sales force itself fixed costs became variable costs. In addition, instead of a branch manager being responsible for the size and effectiveness of the sales force, now potentially everyone recruited could then recruit additional sales people. So began the eventual conversion of traditional direct selling to multilevel marketing.

However, the 1970s also brought pyramid scheme accusations against MLMs - Holiday Magic, Koscot, and Dare to be Great. Described as "the number one consumer fraud in the [NYC] metropolitan area" in 1973, product-based pyramid schemes involved: fuel additives, clothes, a wide range of household products, vitamins, buying clubs, cosmetics and hosiery, fire and burglar alarms, and motivational courses. Direct selling had a new wrinkle, one that created victims rather than customers.

Despite the 1979 Amway decision, documentation of MLM sales to non-participant consumers continues to be a problem. Verifiable compensation now comes primarily from recruitment-based purchases and repurchases without regard to sales outside of the marketing program. In the spirit of "entrepreneurship," all-against-all competition replaced exclusive selling territories, preventing representatives from knowing their own probability of success or the reasons for the success of others. Unproven business sales tools sold at a profit by upline distributors to recruits, who were unable to assess their value, displaced company-financed training programs. The MLM industry moved progressively away from the direct selling tradition; i.e., from income derived primarily on commission-based selling to households. Any true threat to store retailers vanished.

The lack of emphasis on sales to customers outside the marketing program is clearly evident. Since 1974 the importance of direct selling as part of the U.S. economy declined significantly. From 1974 to 2012 the U.S. direct selling industry grew at an annual rate of 1.45% while U.S. GDP grew twice as fast, at an annual rate of 2.84%. During that period the GDP grew approximately three-fold while the direct selling industry increased by approximately 1.7 times. As the number of people engaged in direct selling tripled from 1991 to 2011, their direct sales as a percent of total retail sales at first increased and then declined (chart). By 2011, nearly fifteen million sales people generated approximately the same percentage of total U.S. retail sales as five million sales people did twenty years earlier.


Could the success of MLMs be derived primarily from recruits who join, make one or more purchases without sales to non-participants, and then quickly become inactive?

(Click to enlarge)

Unlike traditional direct selling, an MLM can survive - even thrive - on an ever-churning base of internal consumption. We see the de-emphasis on retail selling as companies fail to track sales to customers outside of the marketing program [e.g., Herbalife (NYSE:HLF)]. MLMs regularly seek to define distributor purchases as sales to "ultimate users," then describing pyramid schemes as MLMs that lack sales to "Customers," further adding their version of "Customers" as people in the marketing program (e.g., Vemma). The upshot of these self-serving characterizations is simple: as long as the MLM is selling a marketable product, it cannot a pyramid scheme.

Those close to the industry recognize its reliance on internal consumption. A long-time legal advisor to MLMs notes that any definition of "ultimate users" that excludes internal consumption would "cast a cloud over many direct selling companies." In reference to a regulatory standard that may require 50% of an MLM's sales and related rewards to be derived from sales to "non-participants," one pro-MLM commenter wrote: "few, if any, of its [MLM industry] 1,200 companies could meet such a standard." Does the FTC believe this to be possibly true?

Direct selling, the mechanism through which millions of American households acquired a wide range of products, now appears to primarily depend upon selling to itself. But unlike buying clubs, MLMs do not retain nearly the same percentage of customers. How then is compensation to participants NOT reliant on recruitment? Defining distributors as "ultimate users" is not only inconsistent with Omnitrition, BurnLounge, FHTM, and the recent SEC Investor Alert, it ignores the issue of ongoing recruitment - as if re-labeling soon-to-be inactive distributors as "ultimate users" would change the recruitment-based nature of the business.

What does that mean for the MLM industry? Companies that do not monitor sales to non-participants signal those sales to lack importance and that the company assumes no obligation for helping to achieve sales outside the network. And re-labeling distributors who failed to establish downlines as "consumers" neatly fits the strategy of characterizing them as "ultimate users" - all reinforcing the message that sales to non-participants are not a priority.

The commitment to a customer base certainly seems questionable for MLMs that care little about who buys their products or why, and have an 80-85 percent annual distributor turnover rate. Resembling neither the enrollment of a commission-based sales force of traditional direct selling nor its external customer base, such a business model relies instead on an endless chain of profitable new recruits who make product purchases with a "business opportunity" attached. Sales to recruits and to any non-participants appear ephemeral - with most new recruits quickly disappearing after they make a small number of purchases. Have they lost interest in the product or did they, just possibly, find the representation of a business opportunity misleading?

Company statements that "most successful leaders made only modest amounts of commission income," and data showing that only a miniscule percent of distributors receive life-supporting, let alone life-changing compensation, are entirely inconsistent with the rags-to-riches "financial freedom" success stories featured on many MLM company websites. New distributors hear stories of exceptional success, yet they lack the information needed to assess any of the following: their own probability of success, the actual reasons for the success of others, the relative value of business tools they are encouraged to purchase, and any data regarding the expense of building and operating a business of this type.

Some hedge fund investors view MLMs as highly attractive investments. MLMs continue to grow internationally and regularly report gross profits in the range of 80 percent. One investor, taking the moral high road, told me that he would not invest in Herbalife if he thought it to be a pyramid scheme. His pronouncement came not long after he had asked about the length of a typical FTC pyramid scheme investigation. Managing risk means knowing when to get out. Investors are not trained to identify pyramid schemes; they are trained to pursue returns. For the sake of brevity I will skip the many examples of investors profiting from illegal business practices. In the absence of pending regulatory action they have little incentive to dis-invest. Making moral judgments is generally not part of their portfolio management.

And what about the regulators? The FTC has an impressive success record against pyramid schemes posing as legitimate MLMs with approximately 20 settlements, 2 wins (one still in appeal), one pending settlement, and no loses. With an estimated 1,000+ MLMs currently operating in the U.S., what is the probability that any one of them is a pyramid scheme? Are we talking about just a few dozen pyramid schemes? A few hundred? How many thousands of victims are losing how many millions of dollars? Is this happening with publicly held MLMs?

In response to my letter to Chairwoman Ramirez the FTC wrote, "Cases such as these [FHTM and BurnLounge] can provide guidance to the public to help identify illegal pyramid schemes." If these cases represent the standard for pyramid scheme prosecutions, then any MLM that cannot document verified sales to non-participants and treats internal consumption as "ultimate users," would be ripe for investigation. When a company offers no verifiable evidence that compensation to participants derives primarily from sales to customers outside the marketing program, will the FTC act? If so, when? If not, why not?

Or, should consumers and investors look at the history of federal regulators not bringing cases against large, well-established MLMs? Does the lack of prosecution provide tacit approval of an MLM's continued operation, even legality? MLM defenders certainly make such statements. When it comes to pyramid schemes, exactly how should consumers, would-be entrepreneurs, and investors read the FTC and SEC actions and inactions?

The current direct selling industry no longer wears the mantle of traditional direct selling and, arguably, the Direct Selling Association represents companies that de-emphasize direct selling and operate on a very different business model. Kudos to industry members who rely primarily on revenue generated from sales to customers not part of the marketing program. If only we could identify who you are. The legions of MLM prospects who hear stories about life-changing wealth and purchase products and support materials at extraordinary margins, lack the information needed to accurately assess the "opportunity" or the factors that led to the success of others.

Can we please get some clarity from the FTC and SEC about the legality of specific actions and common practices associated with this industry?

Disclosure: I 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. This article has not been pre-read by or discussed with anyone at ANY hedge fund. Neither I nor my business school nor my college have received any compensation or financial gifts from any parties associated with the Herbalife controversy. I choose not to post anonymously and encourage you to do the same.