7 Common Misconceptions About Multilevel Marketing And Pyramid Schemes

by: William Keep

Summary

BurnLounge appellate court decision reinforces the danger to distributors and investors in misidentifying a "legal" multilevel marketing company that is actually a pyramid scheme.

Presuming that business fraud in the form of operating a pyramid scheme will be quickly shut down would be a mistake.

MLM compensation based on distributor purchase not directly related to sales to non-distributors raises concerns regarding rewards primarily based on recruitment (court language).

The recent appellate court decision in BurnLounge (here) heightens our appreciation for the FACT that some MLMs actually are pyramid schemes. Consumers, potential distributors, and investors who provide capital all serve as fodder for such schemes. Warnings posted by the FTC and SEC (here, here, and here) help, but conversations with investors and media show that misconceptions persist. Perhaps the following can add clarity:

1) Multilevel marketing (MLM) distributors typically earn company compensation based on their product sales.

False. Multilevel marketing companies typically compensate participants based on sponsor purchases and purchases made by distributors in their downline. With company compensation triggered by distributor purchases and NOT directly from sales to non-distributors, the MLM model is quite different from traditional direct selling (learn more about how this industry changed here). Though MLM companies point to the potential for distributors to generate income by selling products to non-distributors (e.g., friends, neighbors, etc.), and in some cases to other distributors, documentation on the amount of income earned from these product sales can be lacking. Too little product sales to non-distributors can lead to rewards based primarily from recruiting others, a practice that BurnLounge court and other courts determined to constitute a pyramid scheme.

2) MLM companies that are actually pyramid schemes have either upfront distributor fees or sell "sham" products (i.e., products that do not perform as promised).

False. Pyramid schemes come in all shapes and sizes. Some have fees (Gold Unlimited here); some do not (Equinox here). Some have sham products (WCM and WCM777 here); some have real products (Equinox and BurnLounge); some have no products at all (here). Products sold by MLM companies found to be pyramid schemes have varied from providing proprietary products available only from the company to branded products from national manufacturers. Non-competitive retail prices can be a clue. For example, in BurnLounge the court found the company's products "had some value, but concluded that the evidence did not support a finding that the products were worth what was charged for them" (page 10). In all cases, however, pyramid schemes compensate participants primarily from product purchases and/or fees related to recruiting new distributors and not primarily from product sales to non-distributor customers (in addition to the BurnLounge decision above, see Omnitrition decision here and Koscot here).

3) Federal and/or state regulators will quickly take action against any MLM company thought to be a pyramid scheme.

False. In 2013, a court closed Fortune Hi-Tech Marketing (FHTM) for operating a pyramid scheme, based on Federal Trade Commission analysis (here). FHTM had operated for ten years and two former state Attorneys General serving as advisors helped reinforce a message of legality. Other prosecutions of FTC-alleged pyramid schemes posing as proper MLMs have also occurred after operating for many years. For example, Equinox International (above), an ostensible MLM company, agreed to a settlement to close its doors (including any international operations) and pay $40M in consumer redress after operating for at least 10 years. Part of the problem is in gathering sufficient evidence about how the company and distributors actually makes money. In addition, state and federal regulators have limited budgets for stopping all consumer frauds. While the most obvious non-product pyramid schemes may be closed quickly, product-based pyramid schemes may take many years to identify.

4) Two MLM distributors working equally hard in the same company will have about the same probability of success (i.e., hard work = success in an MLM company).

False. Hard work helps in every endeavor. However, the underlying economics of the MLM structures means that two distributors working equally hard, participating in the same training, and investing equally in products and support can face very different competitive environments. One may have dozens of nearby distributors selling the exact product and business opportunity while the other may have few. As a result, two distributors working equally hard will not have the same chance for success. It is this difference that makes the path to success in an MLM company impossible for a new recruit to predict. Some upline distributors claim that purchasing leads or attending seminars will directly increase a distributor's chance of success, adding value to his or her hard work. Unfortunately, profit made by some upline distributors from selling leads and offering seminars raises questions about their motivations. It is clear that even an MLM distributor who tries and fails can generate profit for upline distributors.

5) An MLM company with these policies cannot be a pyramid scheme: 1) a 10-customer or retail sales rule, 2) a 70% rule, and 3) a product return policy.

False. In the late 1970s, Amway successfully defended itself against a pyramid scheme charge by pointing to company policies intended to ensure retail sales, prevent inventory loading, and allow product returns. In 2014, the BurnLounge court emphasized the importance of enforced policies in noting, "Though Amway created incentives for recruitment by requiring participants to purchase inventory from their recruiters, it had rules it effectively enforced that discouraged recruiters from "pushing unrealistically large amounts of inventory onto" recruits" (page 17). Though an MLM company may claim to have policies similar to Amway's in 1979, the actual language may be different. As a result, the policies designed to prevent an MLM from being a pyramid scheme can be ineffective, unenforced, and even unenforceable.

6) Claims made by current MLM distributors regarding potential earnings and product performance are bound to be true because false claims are prohibited by law.

False. Of course, making any false or misleading statements in trade or commerce, including about a product or earnings in a business opportunity, is illegal and if documented, can bring enforcement litigation. Messages between a distributor and potential recruits, however, are less easy to document and have a lower chance of being noticed. In 1951, the Food and Drug Administration obtained an injunction against Nutrilite, the first modern MLM company (here) "prohibiting 15,000 door-to-door salesmen from making 'extravagant therapeutic claims'." In 2014, the government of China fined Nu Skin, a large international public MLM company, "for illegal product sales and misleading local consumers" (here). It seems that MLM companies have difficulty trusting or guaranteeing what their distributors are saying.

7) If a multilevel marketing company is actually a pyramid scheme plenty of victims will come forward to complain.

False. Research by the Federal Trade Commission shows that among victims of the ten most common consumer frauds, pyramid scheme victims are by far the least likely to complain (here). Because failure may be incorrectly presented as failing to work hard (see above), victims of pyramid schemes may blame themselves. Or, they may be embarrassed for being snookered into the pyramid scheme fraud in the first place. Either way, pyramid scheme victims often simply go away without complaining and without sharing their story with others.

Don't be fooled by unsubstantiated claims or statements that diminish the evidence. Don't discount the motivations of others. Don't mistake hype for hope.

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.

Additional disclosure: I have received no compensation from any parties associated with the Herbalife controversy.