The FTC Should Take A Definitive Stance On Pyramid Type Offerings Rather Than A Case-By-Case Approach

Jul.21.14 | About: Herbalife Ltd. (HLF)

Below is my letter to the chairwoman of the Federal Trade Commission on the subject of pyramid schemes. It is a criticism of the manner in which the Commission has dealt with this issue since 1979, when the Amway decision was rendered. To some extent, this may provide comfort to those supporting Herbalife (NYSE:HLF) and its marketing plan since the delays and legal ambiguities I criticize in the letter also exist in this specific situation.

The often cited Koscot case actually discussed what I have asked the FTC to consider – a regulatory statement which can guide prospective recruits, and investors, with specific legal standards which do not require, in every instance, the re-invention of the wheel after 30 years of extensive litigation.

Koscot said:

“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. . . . To require too large an evidentiary burden to condemn these schemes can only ensure that future generations of self-made commercial messiahs will dare to be great and dare anyone to stop them.”

My sense is that is exactly what is going on. By not addressing head-on the legal flaws in pyramid schemes, and the documented and significant economic injury they have caused, pyramid type “MLM” offerings have, with FTC acquiescence, enjoyed a presumption of legality which can only be challenged by specific litigation – often years, if not decades, after business has been commenced. This is a process which guarantees the economic and personal losses of victims damaged in the interim. The Herbalife matter is a perfect example of this enforcement shortfall, and even if it is eventually concluded – favorable to Herbalife or not – prospective recruits and investors will face, in the future, the same questions, delay, and uncertainty as before.

As stated in the letter, I had hoped the Obama Administration would reverse this benign approach and urge the Commission to take a more definitive stand on the matter. This has not happened. On a personal level, I’m getting too old to pursue this matter much longer – a fact which may be welcomed by many readers. I am just concerned about the millions of victims of these schemes, persons who cannot afford the losses inherent in the pyramid mechanism and who do not appear to have the political clout to counter the powerful business interests on the other side of the issue.

Here is the letter, it was delivered Monday, July 21, 2014:

Bruce A. Craig, Esq.

924 West End Ave. #1

New York, NY 10025

Edith Ramirez, Chairwoman

Federal Trade Commission

600 Pennsylvania Avenue, NW

Washington, DC 20580

Re: Pyramid Schemes – Enforcement Policy

Dear Ms. Ramirez:

I served as an Assistant Attorney General in the Wisconsin Department of Justice for approximately 30 years (1967-1997). My primary duties involved the enforcement of consumer laws and litigation against violators. This included a number of cases against pyramid schemes, the last one concluded in 1997. I also drafted Wisconsin’s regulation concerning these schemes, which was upheld by our Supreme Court. Over the years, I have worked with Commission staff in a number of instances and respect their efforts to protect the public. I remain concerned about the victims of these schemes for the reasons stated below.

A recent petition and White Paper, addressed to the Commission, have stated the nature of the problems concerning pyramid schemes and the attendant economic and personal damage they have caused. They document significant (99%) consumer losses and failure rates in an industry with annual revenues in the $30 billion range.

My focus, as one having some familiarity with enforcement policy, is on the current posture of the FTC in respect its public and legal position on the subject of pyramid schemes.

The most recent FTC public declaration in this respect was made on May 13, 2014, by Aditi Jhaveri, an FTC Consumer Education Specialist.

“What’s the difference between a multilevel marketing program and a pyramid scheme? Pyramid schemes are illegal.

If the money you earn is based on your sales to the public, the company may be a legitimate multilevel marketing plan. Here are some signs that the company is operating a pyramid scheme:http://www.consumer.ftc.gov/sites/default/files/blog/pyramid-scheme_180x168.jpg

Your income is based mainly on the number of people you recruit, and the money those new recruits pay to join the company — not on the sales of products to consumers

You’re required to buy lots of inventory

You’re forced to buy other things you don’t want or need just to stay in good standing with the company

One other key difference: You’re likely to lose money if you sign up for a pyramid scheme.

. . .

If you’re planning to buy into a multilevel marketing plan, get the details.

Ask these questions to learn if it’s a pyramid scheme. Make sure your income is based on sales to the public, not on what you have to buy yourself or the number of people you recruit.”

Be skeptical of rags-to-riches stories or portrayals of lavish lifestyles made possible by participating in the program. These stories may not represent the experiences of most members.

Exercise doubt. Even if a company sells products or services you’re familiar with — or boasts celebrity members — it may not be legitimate.”

With all due respect to Ms. Jhaveri, this provides little, if any, information to a prospective consumer. The most sophisticated pyramid style offerings have had over 30 years to develop effective, but cosmetic, responses to prospects who raise questions about the generally phrased issues listed in her article. In consequence, these well phrased responses would likely tend to alleviate consumer concerns created by the article and encourage participation. This would be particularly true in respect to unsophisticated victims who have little skill in independently documenting or evaluating responses to the critical questions raised, not to speak of the legal elements of the matter.

Unfortunately, Ms. Jhaveri’s blog reflects the general posture of the Commission and its Bureau of Consumer Protection to the effect that there are no objective and verifiable criteria through which the public – including victims, investors, and the press – can make any meaningful preliminary determination of whether a pyramid style offering is legal or not. This leaves enforcement determination to an after-the-fact analysis of the business practices and victim injuries caused by a particular company - that is, after the company has been in business for a period of time and economic and personal damage has already occurred. It also leaves the distinct impression that those pyramid style companies not subject to pending FTC inquiry or litigation are presumptively legal.

The Commission’s position on this point is stated in a staff report issued by the Division of Marketing practices and then Bureau of Consumer Protection Director David Vladeck. The report, at pp. 20-21, discusses the Commission’s decision to functionally exempt MLM companies from coverage under its December 2011 Business Opportunity Rule stating that:

“We agree with the Commission’s decision articulated in the RNPR to narrow the scope of

the IPBOR, to avoid broadly sweeping all MLMs into the ambit of the Rule. The Commission reasoned that the IPBOR would have imposed greater burdens on the MLM industry than on

other types of business opportunity offerings without providing sufficient countervailing benefits

to consumers.58 At the same time, the Commission acknowledged that some MLMs engage in

unfair or deceptive acts and practices, including the operation of pyramid schemes and the making of false and unsubstantiated earnings claims. However, the Commission concluded, and we agree, that neither the earnings disclosure provided by the proposed Rule, nor alternatives proposed by commenters, would enable potential recruits to differentiate between a legitimate MLM and a pyramid scheme, or to inform consumers adequately about likely earnings. fn59 Consequently, the Commission concluded that because Section 5 continues to provide an effective tool to challenge unfair and deceptive acts or practices in the MLM industry, the burden of applying the Rule to MLMs generally appeared to outweigh any potential benefits.

We agree with the Commission’s conclusions. While we take very seriously the commenters’ concerns about pyramid schemes posing as legitimate MLMs, we are not persuaded that subjecting all MLMs to the Rule would allow consumers to differentiate between unlawful pyramid schemes and legitimate companies using an MLM business model. fn 60”

as stated at p. 21, footnote 60:

“. . . identifying a pyramid scheme (or, at least, one that attempts to disguise itself as a legitimate business opportunity) entails a complex economic analysis including an in-depth examination of the compensation structure and the actual manner in which compensation flows within an organization. See Vander Nat & Keep, supra note 15, at 149. There is no bright line disclosure that would help consumers identify a fraudulent pyramid from a legitimate MLM.” (emphasis mine).

The report further concludes, at p.21, by stating that pyramid matters are “particularly well-suited to Section 5 enforcement, which proceeds on a case-by-case basis.”

Perhaps I am missing something, but for an enforcement agency to declare, after 30 years of extensive litigation, that it has no idea how to effectively and objectively identify an illegal pyramid scheme and circumscribe its conduct through regulatory efforts and meaningful public information borders on the incomprehensible. This is particularly true in respect to an agency specifically created to protect the public, including its most vulnerable segments, from the significant economic and personal losses caused by sophisticated frauds such as pyramid schemes. Public injury cannot be remedied via an after-the-fact approach. Victims often leave productive employment, use personal savings, max-out credit cards, create personal problems with friends and family and extinguish any entrepreneurial motivation towards other valid enterprises. Also, there is little chance that any meaningful economic recovery from perpetrators can be accomplished.

The direct result of this flawed policy is the public impression, as evidenced by Ms Jhaveri’s blog and the above recited staff report, that there exists a preponderance of legal “MLM” offerings and a few illegal pyramid schemes. This is notwithstanding documented evidence from corporate disclosures (pp. 3-6, 10-12) of significant losses experienced by participants in many of the longest standing “MLM” offerings presently doing business and a paucity of evidence that these "legal" plans have structural elements any different than those companies sued.

This ad hoc and ambiguous enforcement stance has persisted since at least 1979 and, rather than deterring future conduct, has resulted in the exponential growth of pyramid style companies while, at the same time, giving the general public the impression that an ongoing and effective enforcement effort is in place. The current dispute concerning the Herbalife Company is an excellent example of the regulatory paralysis involved.

World-wide annual sales of these mostly US based or sponsored companies now exceeds $150 billion, overseas acceptance is clearly enhanced by ambiguous FTC regulatory postures and listing on US stock exchanges. Due to the presumptive legality of these companies, victims are pre-conditioned to believe failure was theirs and not due to the flaws inherent in a pyramid offering. Victims are also frequently low income or of ethnic background and cannot effectively coalesce to pursue relief. This has resulted in a paucity of complaints in relation to the millions of victims affected by these schemes.

Although Commission case law, prior to 1979, unequivocally condemned pyramid style offerings, the rulings and language in these cases is virtually ignored in public Commission statements and policy. The lead case in this category, Koscot, made it clear that these plans are "inherently deceptive":

“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.

As is apparent, the presence of this second element, recruitment with rewards unrelated to product sales, is nothing more than an elaborate chain letter device in which individuals who pay a valuable consideration with the expectation of recouping it to some degree via recruitment are bound to be disappointed. . . . Indeed, even where rewards are based upon sales to consumers, a scheme which represents indiscriminately to all comers that they can recoup their investments by virtue of the product sales of their recruits must end up disappointing those at the bottom who can find no recruits capable of making retail sales.” (emphasis supplied)

Koscot is continually cited as controlling in current briefs filed by the Commission, most recently in BurnLounge, but it is fundamentally ignored in public discourse or as the basis for meaningful regulation. Koscot further holds that the only "sales" which could legalize such an offering are those actually "consummated" at the time any commission is paid, an exception intended to exclude override commissions paid in traditional two or three level sales enterprises.

The latest example of the impact on consumers of the Commission’s case-by-case, after-the-fact, enforcement policy is found in its FHTM litigation. The case was concluded in May 2014, reciting over 300,000 victims. According to the BBB, FHTM was founded in January 2001, and thereafter operated in plain sight for over 12 years. The money recouped from the defendants will cover only a small fraction of consumer losses. The inescapable conclusion which must be drawn from this litigation is that this approach is flawed not only in respect to the consumer damage incurred in the interim and the continued absence of a cognizable legal standard, but also in the implication that other companies, with virtually identical marketing plans, are, in the absence of any standard, viewed as "legal" – at least until they are sued, if ever. Supporting FTC expert affidavits, reciting the factual history of offending companies imply that such extensive after the fact inquiry of public damage is critical to enforcement activity – and that the Commission bears the burden of proof of subjective factual matters such as "retail sales". Such a burden, given the elusive character of most of these factual issues, guarantees limited enforcement and the perpetuation of the existing, and flawed, Commission enforcement policy.

One major intervening factor is the Commission’s Amway decision. From an enforcement standpoint, the Amway case was significantly flawed due to the absence of any documentary proof, other than company testimony, that its "rules" actually protected, and continue to protect, participants from the personal and economic damage predicted in Koscot. I wrote Commissioner Robert Pitofsky of this concern in February of 2000 and asked that an enforcement review be conducted to determine whether the underlying basis of his ruling, of such overwhelming economic impact and victim injury, could be verified by objective data available to the Commission via investigative demand. This was not done, the explanation provided me, in July 2000, by James Kolm, then an FTC attorney in the BCP Marketing Practices Division, recited pyramid cases brought by the Commission and stated that:

“The FTC continues to explore avenues for halting pyramid schemes that fleece millions of dollars from consumers, including the clarification of legal standards in this area.”

The failure of the Commission to verify the effectiveness of the exculpatory rules cited in Amway, and clarify the “legal standards in this area,” has created a multi-billion dollar industry capable of exercising the political power which has fundamentally insulated it from meaningful regulatory oversight. Timothy Muris, from a firm which represented Amway, was appointed FTC Chairman by President Bush in 2001. His then chief of staff, Lois Greisman, is currently the head of the Marketing Practices Division of the BCP, as she was at the time of the MLM exclusion from the BOR rule.

I fully recognize that you inherited this situation, but it is my sincere belief that immediate, and substantive, enforcement and regulatory efforts must be implemented to prevent continued abuses and massive victim losses in the area of pyramid schemes. Matters which have been fully documented in the press and through the Commission’s own litigation. The most recent episode concerns Vemma, which allegedly has targeted and exploited college students, according to USA Today in a July 13, 2014 article. This is a continuation of other minority or vulnerable groups being exploited and evidence of an ‘anything goes’ attitude on the part of those promoting these schemes – operating without apparent concern for meaningful enforcement exposure or response. The prospect of college students dropping out to pursue a purported $50,000/yr income opportunity is one which should be addressed immediately.

An effective remedy, given the significant economic and personal impact involved, is critically needed in the near future. I was troubled by a March 2014 public statement of BCP Director Jessica Rich to the Consumer Federation. It lists the Commission’s top five priorities and does not include even a reference to pyramid schemes as a relevant enforcement topic, notwithstanding her representation that “the Commission is first and foremost a law enforcement agency.” After over 30 years of ineffective enforcement, substantial public injury, and the absence of a legal standard, I had sincerely hoped that the Obama administration would dictate a Commission policy concerning pyramid schemes which would finally result in meaningful enforcement standards and litigation pursuant to those standards which would prevent victim damage before it occurs. I do not feel that this has happened. Perhaps these particular victims are politically invisible to those in charge.

While the Herbalife matter has been of current public interest, and one which should be resolved via effective enforcement, it also exemplifies the much larger problem presented by the absence of a legal standard and the comparable aggressive marketing practices of other similar companies. This can only be done through the prioritization of this matter, effective analysis, timely enforcement efforts on a broad basis, and the development of a meaningful regulatory framework which relies on something other than after-the-fact analysis and litigation.

I write only on my own behalf and have no economic interest, direct or indirect, in this matter.

Respectfully submitted,

Bruce A. Craig, Esq.