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Is the Federal Trade Commission Stating its Current Enforcement Posture on MLMs?

A recent article by Matt Stroud of the Verge raises the question whether the FTC may be setting the stage for further enhanced enforcement efforts in respect to Multi-Level Marketing:

“But in a court filing on Friday, the US Federal Trade Commission (NYSEARCA:FTC) took a step toward clearly defining a pyramid scheme. That filing could put every multi-level marketing (NYSE:MLM) company in the United States — including Herbalife, as well as Avon, Amway, Vemma, ViSalus, Nutrie, and a host of others that contribute to the $30 billion-per-year industry— at risk of a major lawsuit from the nation’s foremost consumer protection agency.”

This court document, filed on December 20, 2013, and in the form of an affidavit by FTC pyramid expert, Peter Vander Nat concerning the Global Information Network (GIN), seems to indicate that the Commission is placing substantial reliance on the standards established in it's case against Koscot Interplanetary.

Dr. Vander Nat is the FTC's primary witness in pyramid type cases, he has testified in six pyramid cases brought by the FTC, SEC, and DOJ and has been deposed in eight pyramid scheme matters. He has been with the Commission for twenty-five years. No court has ever rejected his conclusion that a particular enterprise constituted a pyramid scheme.

Dr. Vander Nat states at p. 5: (at the top of the document page)

The Meaning of a Pyramid Scheme

5. There are two closely related descriptions of a pyramid scheme. The first is a general economic characterization in use for many years: a pyramid scheme is a perpetual recruitment chain in which the design of the scheme's compensation plans dooms the vast majority of participants to financial failure. The Koscot test - adopted by the Federal Courts - applies this meaning to ongoing recruitment in the context of multilevel marketing (MLM), focusing on an MLM firm that sells a product or service and pays recruitment rewards that are unrelated to the sale of the product/service to people outside the MLM's network.”

Dr. Vander Nat quotes extensively from the Koscot case and also concludes that 90% of the defendant GIN's members “earned nothing at all.” p.13

Other MLM listed corporations such as Nuskin (NYSE:NUS), Usana (NYSE:USNA), Mannatech (NASDAQ:MTEX), Reliv (NASDAQ:RELV) Blyth (NYSE:BTH), Primerica (NYSE:PRI), and Medifast (NYSE:MED), may also be affected by this recent development and possible enhanced enforcement efforts.

The Koscot case referenced in the Vander Nat affidavit, has some explicit language on pyramid schemes and the issue of retail sales.

Commissioner Paul Dixon stated:

“At the very least we would conclude that a company which offers its distributors substantial rewards for recruiting other distributors, and charges them substantial amounts for this right, creates overwhelming barriers to the development of a sound retail distribution network and resultant meaningful retail sales opportunities for participants. What compels the categorical condemnation of entrepreneurial chains under Section 5 is, however, the inevitably deceptive representation (conveyed by their mere existence) that any individual can recoup his or her investment by means of inducing others to invest. That these schemes so often do not allow recovery of investments by means of retail sales either merely points up that there is very little positive value to be lost by not allowing such schemes to get started in the first place. A discussion of 'inherent' illegality and capacity to deceive may seem pointless given the more than 4000 pages of transcript detailing the actual deception and injury in which the Koscot plan resulted. Nothing could be further from the truth. It is regrettably clear that responsible authorities, including this Commission, have acted far too slowly to protect consumers from the manipulations of respondents and others like them.

“We think that failure to act more promptly can be traced to the previous inability of relevant authorities to obtain summary relief against the practices involved. The necessity to prove that a marketing plan, manifestly deceptive on its face, has in fact resulted in injury to numerous consumers, is a lengthy process. Only where the law condemns the mere institution of such a plan, without the necessity to demonstrate its consequences, is meaningful relief likely to be obtained.” pp. 42-43

“By requiring that compensation for recruitment be based in all cases upon retail sales by those recruited, the order provides a readily monitored means to ensure that recruitment of distributors is based on market demand, which is the goal of any legitimate business enterprise.“ p. 44

On the issue of retail sales, the Commission's Koscot injunction reads:

“2. 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.” p.45

'Consummated' sales in this context would not include wholesale purchases made by participants seeking to qualify for the right to recruit others. They would include only retail orders already obtained by the participant, not a wholesale purchase which hopes, eventually, to become a retail transaction.

This current declaration appears to be the considered opinion of the Commission in respect to the definition of a pyramids.

A January 14, 2004 letter from the then acting director of the Division of Marketing Practices to the President of the Direct Selling Association has been quoted, and relied upon, by some MLM advocates to the effect that 'retail' sales to company distributors could be recognized as valid 'retail sales' in considerations concerning the existence of a pyramid. The Vander Nat affidavit makes no reference to this document and, by relying on the Koscot standards, appears – at a minimum – to reject any implications in the letter that would justify as 'retail' sales made to persons within the MLM company.

I think it would be fair to state that an explicit definition of a pyramid, fortified with requirements for factual criteria necessary to make a legal evaluation is, at present, non-existent. Generalities abound concerning the existence of 'retail sales', inventory loading, promises of high earnings, and products of questionable value, but there is precious little hard data coming from corporate or investigative sources as to just what is going on and who is doing what. My sense is that the current state of confusion is exactly the way many MLM promoters would like to keep it, as evidenced in the Business Opportunity Rule proceedings in which, after massive lobbying from the Direct Selling Association, the FTC exempted MLMs from making even basic disclosures of prior participant experiences.

The main difficulty in determining which offering is legal and which is not is the absence of explicit enforcement standards that would enable a potential participant, or investor, to make a clear choice between legal and illegal. There is also a noticeable absence of accurate and publicly available corporate information, particularly in the area of retail sales outside the company's network of distributors, that would assist in the process and enable enforcement authorities to do their job before significant consumer injury. The dispute involving Herbalife (NYSE:HLF), much of which has been discussed in the pages of Seeking Alpha, has highlighted both these factors.

The Direct Selling Association also warns against these schemes, emphasizes the difficulty in identifying them, and urges that the public participate in “legitimate” Multi-Level Marketing offerings. It provides guidelines that purport to explain how to differentiate between legitimate MLMs and pyramids.

However, the DSA’s guidelines provide no concrete standards by which an enforcement agency could make a clear legal conclusion. This essentially enables any MLM to claim legal status. As the FTC itself has pointed out, it is almost impossible for a consumer to tell the difference. “There is no bright line disclosure that would help consumers identify a fraudulent pyramid from a legitimate MLM.” the staff wrote.

The question that now presents itself is what specific actions the Federal Trade Commission will implement to insure that the Koscot standards are followed by those marketing through a MLM mechanism. I sincerely hope that this recent effort by Dr. Vander Nat and the FTC will signal a concerted effort to establish the 'bright line' desperately needed in this area. The ultimate goal in this respect would be the promulgation of a Commission rule which reflects the legal status of the matter as stated by Dr. Vander Nat.

The Amway Case:

Some have taken the position that the Commission's Amway case is the final word on this matter, since it found that Amway was not an illegal pyramid.

Many MLMs have adopted the 'Amway Rules' and self-declared their legal status by doing so. This semblance of legality has permitted these US based companies to expand to other countries to the extent that 80% of their revenues presently come from outside the United State, with annual sales currently at $150 billion, this is not a minor matter.

However, the Amway case differed from the others brought by the Commission in that Amway, through direct testimony and evidence, demonstrated that it had rules in place that prevented inventory loading. The rules were also cited as an effective enforcement of true retail selling to bona fide end-users, in contrast to today’s frequently made representations of “self-consumption” and selling to other distributors as “retail sales.” The court accepted the claims that Amway’s rules were enforced and were effective in preventing the consumer injury documented in the Koscot and Holiday Magic Cases. In other words, Amway proved to the Court that its rules worked.

“ And Amway has prevented inventory loading at this point with its 'buy-back rule,' which states that a sponsoring distributor shall '[p]urchase back from any of his personally sponsored distributors leaving the business, upon his request, any unused, currently marketable products. . . .' By this rule, a sponsoring distributor is inhibited from pushing unrealistically large amounts of inventory onto his sponsored distributors in order to increase his Point Value and Business Volume, and thereby increase his Bonus.
Two other Amway rules serve to prevent inventory loading and encourage the sale of Amway products to consumers. The '70 percent rule' provides that '[every] distributor must sell at wholesale and/or retail at least 70% of the total amount of products he bought during a given month in order to receive the Performance Bonus due on all products bought . . ..' This rule prevents the accumulation of inventory at any level. The '10 customer' rule states that '[i]n order to obtain the right to earn Performance Bonuses on the volume of products sold by him to his sponsored distributors during a given month, a sponsoring distributor must make not less than one sale at retail to each of ten different customers that month and produce proof of such sales to his sponsor and Direct Distributor.' This rule makes retail selling an essential part of being a distributor.”

“The ALJ found that the buy-back rule, the 70 percent rule, and the ten customer rule are enforced, and that they serve to prevent inventory loading and encourage retailing. Initial Decision, p. 26, Findings 72-75, and p. 58, Findings 145-47. Given these facts, the Amway plan is significantly different from the pyramid plans condemned in Koscot, Ger-Ro-Mar, and Holiday Magic.” p. 55

Critically, the exculpatory standard in that case was that the rules were “enforced and that they serve to prevent inventory loading and encouraging retailing.” While I have difficulty with the legal analysis in the Amway case, it nonetheless states clearly that it is the defendant's obligation to prove through direct testimony and documentary evidence that its 'rule' actually prevents the injury inherent in a pyramid scheme. I know of no other case brought against a multi-level marketing company where this type of testimony or evidence was elicited, yet it has served as a shield except in cases where the FTC developed facts, as here, documenting extensive participant losses. Given the total absence of any proof that the Amway Rules have achieved the results as stated in the Commission's decision, my recommendation would be that it's ruling be restricted to the facts in that case.

As stated in Amway, it should be the burden of the company operating a pyramid style business offering to prove that it has rules which prevent the injury inherent in a pyramid offering. To date, the horse has already left the barn by the time an FTC enforcement case is brought. As stated in the Koscot case:

“The necessity to prove that a marketing plan, manifestly deceptive on its face, has in fact resulted in injury to numerous consumers, is a lengthy process. Only where the law condemns the mere institution of such a plan, without the necessity to demonstrate its consequences, is meaningful relief likely to be obtained.” p.43

Perhaps the FTC is reaching the point where it realizes that the necessity to prove a company is operating a pyramid, as exhibited in Dr. Vander Nat's affidavit, is a task which results in justice delayed as justice denied. To date, all of the FTC affidavits, and independently developed data from experts such as Robert Fitzpatrick and Dr. Jon Taylor, conclusively indicate MLM participant losses well in excess of 90% and distributor turnover every two years.

Considering this documented consumer injury and the notable absence of publicly available evidence relating to sales to the retail public, there appears little reason to continue with the current legal approach. It may be that the FTC is coming to this conclusion as well.

As stated in the Koscot case:

“That these schemes so often do not allow recovery of investments by means of retail sales either merely points up that there is very little positive value to be lost by not allowing such schemes to get started in the first place.”

It would be my sincere hope that this twenty-five year experience on the part of the most qualified expert on the subject be consolidated into a meaningful enforcement posture and the eventual drafting of a regulation which sets forth the Koscot principles. In our country, with the largest and most advanced economic community in the world, the Federal agency charged with protecting its citizens from fraud, providing critical information to the market, and establishing an enforcement mechanism that stops these pervasive frauds should have the resources and motivation to fulfill its statutory obligations.

In any event, the public and investment community should concern themselves with the critical distinction made between legal MLMs and illegal pyramids. At present, the best course of conduct for a MLM would be to follow the Amway example and publicly document the existence, terms, and effectiveness of those rules that convinced the Commission that Amway was not a pyramid. Evidence of retail sales and the absence of inventory loading should be made as a public corporate declaration of compliance with the law, it can and should be a convincing selling point for all those wishing to assure the public and the market that they are on the legal side of the line. Claims by some MLM companies today that purchases by their own distributors, under reseller contract, at wholesale prices and subject to all reseller contractual restraints and obligations constitute “retail sales” are clearly outside the bounds of federal court rulings.

This challenge has been made more complex by the extensive lobbying efforts on the part of the industry to maintain the status-quo. However evidence of cumulative losses, in the many billions of dollars, over the past thirty years and an absence of any meaningful information coming from corporate sources presents a graphic picture of the critical need for effective enforcement policy on the part of the Federal Trade Commission and other involved Federal agencies. Evidence of current losses in the Latino community underline the fact that this illegal conduct persists and must be addressed.

Source: Is The Federal Trade Commission Stating Its Current Enforcement Posture On MLMs?