- The pyramid scheme remains an economic blind spot and regulatory black hole.
- Confusion and bogus data have been sown about what constitutes a pyramid scheme.
- The "Endless Chain" is the powerhouse of the pyramid scheme, formerly viewed by regulators as the bright line for identifying fraud, but now celebrated on Wall Street as Marketplace Miracle.
- The FTC has been given wide latitude from recent court decisions to view the Endless Chain as the bright line to trigger investigation or industry-wide study of MLMs.
As a non-lawyer and non-investor, my contributions to the Herbalife (NYSE:HLF)/Nu Skin (NYSE:NUS)/Avon (NYSE:AVP)/Usana (NYSE:USNA)/Medifast (NYSE:MED)/ViSalus (NYSE:BTH)… discussions on Seeking Alpha have been to explain the nature of pyramid schemes, their history, and their various disguises. The pyramid scheme and its kissing cousin, the Ponzi scheme, have emerged as America's most common form of fraud, and yet they have also proven to be a psychological and economic blind spot, and a regulatory black hole.
I have provided this explanatory service to Wall Street analysts and investment managers, attorneys in class action cases, government agencies, consumer organizations, and many journalists. As a consumer education activist, I have assisted thousands of individual consumers who, when solicited to invest in various MLM "income opportunities," faced the nearly impossible challenge of sorting out sales from swindle. Often, precious family finances and marital stability are put at stake. The pyramid selling scheme does not merely want money for products month after month, but also commercial access to family and friends and possibly years of unpaid marketing servitude.
The confusion is exacerbated by financial interest and lobbying groups that benefit from a popular lack of understanding, enabling them to operate without regulation. Chief among those have muddied the waters about what is or is not a pyramid fraud is the Direct Selling Association (DSA), a K Street trade group whose members now are nearly all multi-level marketing companies. The DSA spread the astonishing data point that "direct sellers" (aka multi-level marketing participants) in America had "median average incomes" of $2,400 per year, (half of the "sellers" make that much or more and half that much or less, with approximately 15 million "direct sellers" in total). This data point, posted on the DSA website, reported in USA Today, and NY Times among many other media seemed to refute any notion of widespread consumer losses among those in "multi-level marketing."
Basic math shows that if that figure were even close to reality, direct selling would be a business far larger than Wal-Mart's. If just the upper half made the absolute minimum of $2400, their "income" would be $18 billion at the least, and, factoring incomes of all, total "sales" would need to be $100 billion or more.
In fact, the median average income of MLM participants is zero, or a substantial negative number, and that's just gross income, not net profits. At Herbalife, zero is the median average income even of the top-level Supervisors, according to Herbalife's own income disclosure.
So influential has this group been that when the FTC proposed a "business opportunity" rule in 2006 to require financial disclosures in MLM "business opportunity" solicitations - such as true average incomes - the FTC was barraged by letters, criticisms and pressures, orchestrated by the DSA. The FTC ended up imposing the new rule mostly on vending machine routes and envelope stuffing schemes. MLM, the most pervasive and largest purveyor of "business opportunity" solicitations on Main Street was exempted. One of the reasons the FTC chose not to put MLM under regulation is the claim that it might harm all this "income" being gained by millions of people.
Courts, which are thought to be unbiased arbiters, have not served to lift the veil of confusion and dis-information that surrounds the modern pyramid scheme. There is no specific law in America defining or prohibiting pyramid schemes, leaving it to judges to serve as business analysts, economists, marketing experts, or even psychiatrists who must divine the MLM participants' inner motives for signing up and buying MLM products - too much to expect from mere mortals.
The recent 9th Circuit Court of Appeals ruling on the MLM, Burnlounge, proved no exception. Like scholars of Scripture, the Koran and the Torah, financial analysts are now poring over the court's ruling. Unfortunately, analysts are likely to see only their own image in the ruling. While it strongly supported the FTC's prosecution of BurnLounge, the full wording is subject to wide interpretation on the subject of exactly how to distinguish MLM pyramid frauds, such as the 20 or more that have been shut down, from what the court called a "legitimate" MLM, without ever naming even one. Yet, Herbalife found evidence in the wording to claim its own business was exonerated of pyramid stain.
A Brilliant, Pulsating Force Field
So, setting aside hearsay, claims, Solomon-like court rulings, and expert analyses, let us pull back the curtain and directly examine the brilliant, pulsating force field that powers today's pyramid selling scheme. This is the malevolent energy that powered disgraced and prosecuted MLMs such as Equinox (a 100,000-distributors, DSA member), BurnLounge (self-proclaimed "next iTunes"; shut down by the FTC; defended in court by the DSA in an Amicus Brief), YourTravelBiz (300,000-distributors, DSA member; prosecuted as a pyramid by the California Attorney General), and Fortune High Tech Marketing (300,000-strong MLM with ex-state Attorney Generals on its "legal advisory board"; shut down by the FTC) and dozens of others that have been prosecuted by states or the FTC, all of which were adorned in the wholesome and friendly garb of "direct selling" and sometimes DSA membership.
That force field is called the "Endless Chain." This force has the power to lift huge numbers of people who are ostensibly selling ordinary fruit juice, vitamins, protein power drinks or even laundry soap to psychological states of ecstasy and joy. Indeed, it has the collateral effect of imbuing commodity products with magical properties. Miracle "snake oil" claims are a common correlate of Endless Chain manias. It can cause believers to stand on their chairs for extended ovations in adulation of MLM leaders, and to swear they "love" their MLM company, as numerous MLM participants were filmed saying at an Herbalife "extravaganza." Some will say the MLM company has shown them the true purpose of their existence and delivered them from a life of drudgery and disappointment. Many abandon old friends and close family if they do not "support" them by also joining. Clearly, the Endless Chain is a lot more than economics.
It has been shown that the Endless Chain can be powerfully harnessed to all kinds of product sales and easily surpass other forms of product marketing, even to spike sales during deep Recessions, but, alas, at great cost to the latest "salespeople" to join the plan. It empowers the "gifting" clubs, that have swept like prairie fires in every state, luring as many as a million Americans, mostly women, though 90% are pre-determined to lose in the 1-2-4-8 pyramid. Gifting Club prosecutions have put a few of the believers in jail, though the perpetrators have never shown any other criminal behavior. It can even drive awesome discount programs. Some online discounters, called "matrix systems", offer a $1,100 iMac for the amazing low price of $100, after 15 other people join the "matrix" with their own $100 payments for an iMac. Each consumer that joins waits on 15 others to come into the matrix, while urging friends and relatives to join. The matrix participant gets the iMac and the scheme pockets the $400 extra every time an iMac is "sold". Nice margin, and nice discount too, unless you're at the end of the "matrix", which 93% of all who ever join are.
But it is when the Endless Chain is attached to a livelihood proposition that may involve thousands of dollars, years of labor, entangling friends and family and displacing other economic or educational pursuits, that it becomes a serious national matter.
Endless Chain as "Business Opportunity"
When characterized as "business opportunities", "home-based businesses" and presented to the pubic as a viable or preferred means of livelihood, indeed the "income opportunity of a lifetime", Endless Chains directly affect a fundamental need of all people, that of work and survival. They affect the spirit and meaning of entrepreneurship; they consume personal talents and resources on a massive scale; they can cause serious financial losses, often to the lowest income sectors of the population; and they generate costs that can destroy families and other relationships. This is the arena where legality, regulation and public education become relevant, yet are scarce, absent, or conflicted.
Direct selling companies that employ the Endless Chain - and they are the only type of company that does - can promise "unlimited income" to all who join, regardless of age of the business, market conditions, demographics, geography or competition. This is not mere advertising puffery. It is based on the company's contractual proposition and compensation plan. Each new recruit is offered exactly the same opportunity and can make that opportunity the central selling point for enrolling others and getting them to buy the company's goods. On paper, in PowerPoints and in webinars, the wondrous potential of the Endless Chain plan is demonstrated, showing how thousands of "downliners" can be generated "exponentially" from an initial recruitment of just two other people, who continue the recruitment. The aggregate downline generates continuous and ever-increasing rewards to the earlier recruiters, forever. On paper, it seems so real, but the clincher is that the people on stage or in the video say they did it. They are living proof!
So potent is this Endless Chain force for enrolling recruits and inducing purchases, often at higher than market pricing, that media advertising becomes unnecessary as well as fixed distribution outlets. Branding is unneeded and competitors are deemed irrelevant except for other Endless Chain marketers. All Endless Chain companies prohibit their members from joining other Endless Chain companies, no matter the product sector, showing that the Endless Chain itself is the real product for sale and the common denominator of all such companies, regardless of the commodity product that is promoted.
Endless Chain Meets Wall Street
For decades, the Endless Chain force field was acknowledged only on Main Street where the glazed eye of the recruiters, the uniform dress code, the constant aphorisms about "exciting opportunity" and "winners" and "positive attitude", the unexpected appearance of the glossy MLM folders at what was thought to be a friendly social gathering were common Americana. The massive MLM rallies, like a new folk religious movement, were barely noted or were humorously viewed from patronizing heights by the media and American thought leaders. The folk heroes of this distinct grass roots movement were private individuals and families, e.g., the DeVos' of Michigan, the flamboyant Mark Hughes of Herbalife, the Dare-To-Be-Great Glenn W. Turner, the outrageously rich Mormons of Utah MLMs such as Nu Skin, and other super-star "motivation" speakers at massive, but guardedly private MLM rallies. MLM was an urban legend or as some called it, "the poor man's Ponzi."
But in recent years, the fire power of the Endless Chain sales schemes was discovered by Wall Street and business superstars like Donald Trump. US-born MLMs had grown to gargantuan sizes and spread to 100 other countries. AM radio champions like Glenn Beck advertised MLM-related "sales lead" programs for MLMers who were recruited to buy leads for calling new people to buy leads to call new people to buy leads…
On the stock exchanges there are now more than 12 publicly traded MLMs, with aggregate market capitalization of $31 billion. Public listings add profit taking opportunities in volatile stock trading, dividends, leveraged stock buy-backs, and enormous capital gains for insiders, beyond the astonishing cash that the distributor "lines of sponsorship", some spreading across 80 countries, generate for the top distributors and the owners. The Endless Chain's cash-generating capabilities gained official recognition and respect as a "marketing system" when Wall Street titans took blocks of stock or major investment houses invested client pension funds in them.
Additionally, MLM, an industry in existential need of protection from regulators, brought its newly amassed fortunes to bear in national politics. Amway's Dick DeVos tried, but failed, to capture the governorship of Michigan and was spoken of as a possible presidential contender had he won. George W. Bush is, to date, the largest beneficiary of MLM campaign money, perhaps resulting in his naming an attorney - whose firm represented Amway and who later became a MLM lobbyist - to chair the FTC. Mitt Romney took in $2 million in secret donations from Nu Skin executives. He also named the head of the MLM, Melaleuca, who had made a one-million-dollar campaign donation, as a national campaign co-chairman. Had Romney won, MLM might have gained its first Cabinet-level post in Washington.
That is now. But, until 1979, the official view of the Endless Chain "marketing system" was very different. As MLMs first appeared in the market in the late 1960s and early 70s, there was clarity and consensus among regulators and law enforcement that the Endless Chain was inherently deceptive and could only cause large-scale losses due to the pernicious internal money transfer that doomed that "last ones in". The "Endless Chain" was seen as a commercial virus, a form of trickery that basic math revealed to be an illusion. Each person recruiting 5 others would saturate the earth's population in just 13 recruiting cycles. Since large numbers of "downliners" were needed to feed "income" to the upline, the scheme permanently placed the vast majority in losing positions, guaranteeing a massive loss rate, forever. Any promise that such a system offered a broad-based income opportunity was understood as cruelly false. Indeed, the records showed the same 99% loss rates in full swing back then just as they are revealed in data now.
The common sense view expressed then, and captured in the powerful language of the FTC's seminal Koscot and Holiday Magic cases or in the elegantly simple language of California's 1968-passed Endless Chain statute, held that general income opportunity in legitimate direct selling was based upon each salesperson successfully selling products to customers who were not part of the pay incentives or affected by the pay plan's "infinity" illusion, shown to have enormous capacity to deceive. The simple rule applied by regulators for distinguishing legitimate direct selling: More customers, per salesperson, more income. If managers received overrides, they had to come from sales to real customers not from the bloating the ranks of new salespeople and their purchases.
On the other hand, the general income opportunity in pyramid selling schemes required, in various ways, recruiting of "sales" people who recruited other salespeople and whose personal purchases and ongoing recruiting were the keys to individual success. Indeed, unless recruiting occurred, the income opportunity did not exist and those who were "successful" were inevitably the successful recruiters, euphemistically called "leaders", "supervisors", diamonds, or "directors." In fact, they were the only sustainable successes in a pyramid. Virtually all others suffered net losses. Thus, the rule of the pyramid fraud: More salespeople, more income.
The Endless Chain pay plan's formula transfers the money from the bottom and middle levels of the ever-expanding sales chain to the top though a labyrinth of titles, levels, pay rates, bonuses and "royalties." The top 1-4% wind up with 50-80% of the entire payout, euphemistically called "commissions." The bottom 95-99%, facing sales-force saturation, churn yearly at 60-90%, euphemistically called "quitters and losers." Earlier court decisions called the Endless Chain "inherently" deceptive and so the FTC applied its Section 5 provision banning "unfair and deceptive" trade practices.
Few regulators, legal scholars or academics have challenged the common sense overview of Endless Chains that regulators adopted in the 60s and 70s as declared in the earliest prosecutions and court rulings when MLMs first appeared. This overview dispatched the first large MLMs, Koscot Interplanetary and Holiday Magic. It is only when one enters the details of a strictly legal definition of a "pyramid scheme" where mass confusion can be sown, such that what still looks just like an Endless Chain can be called perfectly legal, by virtue of not meeting vague or ambiguous definitions of this rogue entity called a "pyramid". In America no law explicitly defines the pyramid or bans it. It stalks the marketplace, always in disguise. Its weapon is the Endless Chain.
The door for legal sophistry about what is or is not a pyramid was opened by the famous Amway decision of 1979 in which a single Administrative Law Judge of the FTC concluded that Amway was not a pyramid scheme, as the FTC charged, though it was unabashedly an Endless Chain. Amway convinced the judge that it did not use the pay plan's illusory and inflammatory "infinity" factor, known from other MLM prosecutions to cause mass delusions of unlimited wealth and financial salvation and to influence millions of people to buy goods they did not need and to pay more than market pricing.
Amway's classic and universal recruiting authorization, executives argued, was only to efficiently address the normally high turnover rate in direct selling. All distributors could sign up new salespeople and could gain future rewards on purchases, in return for having reduced Amway's own costs for recruiting. But, the recruiting and recruits' purchases were not the keystones of the pay plan, Amway claimed. Person-to-person retailing was. The reward payments, Amway swore under oath, were primarily derived from subsequent end-user retail sales.
Amway never argued that its own sales people were its main customers, but, to the contrary, that they primarily bought products in order to resell them. When Amway awarded payments to recruiters on the purchases of recruits, the court was convinced, these rewards were only made in advance, or in anticipation of the recruits later reselling the goods. Ultimately the money came from external customers, as has always been true in "direct selling."
Customer preferences and needs and the general market for Amway goods, not the deluded or manipulated income hopes of the salespeople, inflamed by "unlimited income," drove sales, the court was told. Amway's only evidence of the retail-based pay system was a set of rules that required reselling of 70% of purchased goods and the maintenance of at least 10 customers. The apparently legal Endless Chain was thus born and a new "MLM" industry was baptized.
That was 1979. Today, Amway and all other MLMs argue that external retail sales are no longer essential to legality. The sales people have been transformed into the customers. The endless chain has been openly elevated to the status of prime marketing tool, not just an expedient device for replacing retailers at a lower cost to the company.
In a Feb. 29, 2012 video interview (Minutes: 16:20 - 17:00) of Amway executives, Doug Devos and Steve Van Andel by Wall Street Journal reporter, Dennis Berman, the new MLM narrative in which the distributors are the retail customers was made plain:
WSJ Dennis Berman: What percentage of the end products are sold to the general public and not to the Amway salespeople directly?
Amway Doug Devos: That's always a challenge to kind of find exactly what that number is. But its a large percentage. Probably... our research probably about at least half or more would go to an end-user and ultimately all of its goes to an end-user. Even if somebody happens to be a distributor, they are their own best customer. So I would say on a strictly speaking standpoint, a hundred percent, because everyone, at the end of the day, is a customer and they see value in the product or else they wouldn't buy it.
Amway has changed its defense from "We are not a pyramid because our salespeople are actually retailers," to "We are not a pyramid because our salespeople are customers.
Anatomy of the Endless Chain
We have moved from peering at the fully exposed, pulsating Endless Chain to now examining its innate nature. Is an Endless Chain still a deceptive and unfair trade practice when the money it transfers from newest participants to earlier ones passes through buy-sell product transactions? Does the buying of products change the factor of saturation (unsustainability), or change the locked-in proportion of "losers" (fairness)? Does the product purchase make the Endless Chain no longer deceptive when the recruiters promise "unlimited income" after you make purchases?
Why is an Endless Chain in which people buy products in order to join and get access to recruiting-based rewards different from people paying to stuff envelopes that are then sent to others who are solicited to stuff envelopes? Is a chain letter no longer a chain letter if each person buys something rather than just puts money in an envelope and places his or her name on the chain letter and then sends it to 10 friends asking them to repeat the process?
The Miracle of the Sales and Commissions
By outward appearance, the series of actions in the MLM would normally be defined as a pyramid money transfer. But these actions are claimed to transmute into perfect legality, due to the sacramental-like act of buying products. One can almost hear bells ring when this occurs.
Initial fees and purchase payments secure a chance to gain income if future participants can be enrolled to do the same, with the reward payments sourced directly from the later participants' funds. The process must continue forever since the last participants can recoup investments only if more join subsequently. To those uneducated in the MLM catechism or to unbelieving eyes, this would look, for all the world, like a pyramid scheme that dooms the "last ones in", who will always constitute the great majority as the geometric math dictates.
If the process had not included product purchase transactions but rather involved cash "gifts" or "membership fees" to join, recoverable by securing "fees" or gifts from new recruits, the process would indeed remain as it appears, a pyramid fraud. If mere cash had changed hands without a requisite product purchase, regulators would fly upon perpetrators with SWAT teams.
But in MLM, the holy waters of "product purchasing" are said to reorganize the molecules of the system to become only a series of independent, freely chosen purchase decisions. It has been called the "Miracle of the Sales and Commissions." From a finite base of money, mostly gained from the participants themselves, an "infinite" amount of reward is promised to all. The ritual that makes it legal and possible is everyone buys and recruits others who also buy and recruit.
The purchase events, according to MLM texts, define those transactions as driven only by the desire for the product. The payments and the rewards that accrue to the recruiters are said to be unconnected to the act of recruiting or the recruitment-based reward system or the recruiting-based structure. The rewards are said to be the consequence only of product purchases by others who are said to be ordinary "end-users." What looks like "pay-to- play" is transformed into conventional consumer "sales." What looks like "reward-for-recruiting" is called "commissions" on those sales. What looks like an endless recruiting chain of pyramid participants, linked by recruiting-based rewards, is called a "customer base" composed of ordinary consumers who have a such a deep love of the products they "sell to themselves" and "self-consume." As is universally declared by MLM promoters, "If products are sold, it can't be a pyramid!"
Lacking a specific national law against pyramid marketing schemes, the FTC must still rely upon Section 5 of the FTC Act and the numerous federal court decisions that have supported that law when applied to pyramid selling schemes, including Holiday Magic, Koscot, Gold Unlimited, Omnitrition, and now BurnLounge. Will the FTC adhere to its earlier assessment that Endless Chains are "inherently deceptive"? Is the existence of the endless chain the "bright line" that identifies the pyramid or at least serves as cause for study or investigation? The latest court ruling seemed to give wide latitude to the FTC to determine if an MLM pay plan primarily is recruiting-based. It also indicated that the mere laundering of recruitment-based rewards through product purchase transactions is no defense, if the plan is existentially recruitment-based.
MLMs have survived these last 30 years in a conducive environment based upon three key elements - a quiescent FTC, a confused, unorganized and largely silent base of victims, and no major force challenging MLM's legal and economic claims and defenses. All of these elements have changed now.
MLMs have, however, gained enormous political influence. They have also recently acquired the backing of the likes of Carl Icahn and Donald Trump and billions in Wall Street funds from financial managers who have seen the wonders of the Endless Chain and decided it is a marketplace miracle, almost too good to be true.