MLM Industry Acts Like It's In Crisis

| About: Herbalife Ltd. (HLF)

Summary

Industries in crises try to redefine what they do.

Industries in crises aggressively try to change their environment.

FTC regulators (not FTC enforcement) blithely contributed to the MLM crisis.

Recently, the Direct Selling Association (DSA), industry lobbyists, consumer groups, and industry critics (this author included) expended time and energy to try to advance or retard, depending on their respective view, the progress of H.R. 5230, the so called "The Anti-Pyramid Scheme Bill." Designed to immunize MLM companies against a pyramid scheme charge (see this telling parody), the bill represents the industry's continuing departure from entrepreneurship and direct selling. The industry's effort illustrates just how uncomfortable it has become with the history of FTC enforcement.

A 1971 Life Magazine feature article (p. 68) on Glenn Turner highlighted his self-aggrandizing statements: "Abraham Lincoln and I think exactly alike" and "Someday I'll be bigger than Howard Hughes." Described as a "super-huckster" with "fur-covered golf tees," Turner, founder of Koscot Interplanetary and Dare To Be Great, also had the attention of "at least 20 state attorneys general." A piece in New York magazine reported that Turner addressed the Marketing Club at Harvard Business School wearing a "yellow-striped three-piece suit" and shoes "made of un-born calf's skin, hair side outside." Ultimately, Koscot was a pyramid scheme that not even F. Lee Bailey could defend.

In theory, according to the Federal Trade Commission (FTC), "All [Koscot] participants are designated as independent contractors and except for the beauty advisors who sell primarily at retail through party plans and door-to-door methods, are permitted to, and do, sell or attempt to sell at both wholesale and retail." No doubt many purchased products for their own consumption. The problem was not sham products but rather, "the 'big' money to be made through recruitment virtually ensured the failure of the retail operation" and "The Koscot marketing program was structured so as to maximize recruitment earnings even at the expense of retail earnings."

Replace "Koscot" with "BurnLounge" or "Vemma" and, despite four decades, the language is strikingly similar.

The BurnLounge court:

"We agree with the district court that BurnLounge was an illegal pyramid scheme in violation of the FTCA because BurnLounge's focus was recruitment, and because the rewards it paid in the form of cash bonuses were tied to recruitment rather than the sale of merchandise."

The Vemma court:

"The evidence before the Court leaves little doubt that the FTC will ultimately succeed on the merits in demonstrating that Vemma is operating a pyramid scheme. With regard to the first Koscot prong, Vemma's bonus structure and training materials are designed to make new Affiliates buy a $600 Affiliate Pack, which makes payment for the right to sell a Vemma product if not a written requirement, a practical one. With regard to the second Koscot prong, the evidence shows that the bonuses Affiliates earn are primarily for recruitment of other Affiliates, not the sale of products."

With H.R. 5230, the MLM industry now wants to relieve distributors of any true retail sales obligation. Tantamount to the worse kind of industry self-regulation, the bill virtually eliminates "direct selling" from the direct selling industry. Instead, MLM representatives become referral agents, not unlike a car salesman recruiting another car salesman who in turn recruits yet other car salesmen, with rewards based on cars purchased by recruits during the process. And to the delight of investors, these cars carry well above average margins. At no point does a car salesmen build his/her own retail business. The car dealership remains the sole retailer. Regardless of who in the process makes obligatory purchases, the effect remains the same - an ever-churning base of recruits purchasing products from the company to qualify for rewards primarily by recruiting others, who similarly buy product from the company to qualify for rewards by recruiting still others, and so on.

Why has the DSA and MLM industry chosen to defend a model where recruit purchases alone satisfy any retail sales requirement? At a minimum, it appears that they are trying to hold together an industry shaken by successful FTC enforcement. According to one industry member:

"DSA demands a huge annual fee per year/country and what you are supposed to get back is protection just in case you get challenged by the regulators because after all to be part of DSA you must pass all the regulations of a legal MLM company. Well where was the protection for Vemma? Vemma was a DSA member so what happened? The point is this, DSA has created a false impression that if you have a DSA membership, you are safe from regulatory interference no matter how you operate."

Bill H.R. 5230 also appears designed to exploit the obvious gap between FTC enforcement actions and FTC regulatory inaction. Unlike FTC regulators, who have the luxury of imagining all sorts of economic motivations and theoretical outcomes, FTC enforcement lawyers have to draw a line in the sand when considering a pyramid scheme case. Can they make the case based on existing case law or not? Over the past twenty years, no MLM company formally accused by the FTC of operating a pyramid scheme has survived intact, each either ended the offending operation or lost in court. There have been nearly two dozen such cases.

Recent cases put the industry on notice, with the FTC prosecuting Vemma (2015), an award-winning member of the DSA, and winning BurnLounge (2014). An ex parte action closed Fortune-Hi Tech Marketing (2013), an MLM company with two former attorneys general and a former associate general counsel of the DSA on its advisory board (here and here). Both Vemma and FHTM operated for ten years. As a result, the pyramid scheme problem in the U.S. has become an MLM industry problem.

Alternatively, FTC regulators have botched numerous opportunities to increase consumer protection. From an unclear 2004 Staff Advisory, to statistically questionable and confusing fraud surveys, to a business opportunity cost-benefit analysis that disregarded information readily available to MLM companies (here and here), FTC regulators have demonstrated the policy failure that comes from separating theory, from practice. Here, the FTC quite literally refuses to describe the difference between a legal MLM model and an illegal pyramid scheme. And, here and here, I question their ability to limit even potential deceptive marketing, a relatively clear regulatory standard.

In an effort to counter FTC enforcement successes, the industry seems confused as to what constitutes a legal MLM business model. In 2013, the president of the DSA claimed "everybody has their own definition of multi-level marketing" and in 2012 he suggested a need "to synthesize what direct selling should be defined as." Thus, an industry that began in 1886 with Avon can no longer articulate its own business model or effectively differentiate it from a known fraud. In fact, the industry no longer calls its participants "Direct Sales Representatives," a label applied as recently as 2013, now preferring the label "People Involved in Direct Selling."

One only need to check his/her social media feed to realize that pyramid schemes and companies that look like pyramid schemes have effected a large swath of American consumers. Many hundreds of millions of dollars in wealth has been lost by individuals who joined and made product purchases to pursue an illusive business opportunity. State regulators lack a history of successful prosecutions and the resources needed to address the problem. Some state legislators simply let the industry define the issues for them, a setback to consumer protection everywhere.

Business fraud undermines markets and misallocates financial resources. Managing it can be difficult. In the guise of MLM companies, pyramid schemes are the perfect fraud storm that has swirled around U.S. consumers for decades, transferring small amounts of wealth from hundreds of thousands of victims using face-to-face deceptive marketing. As a result, a small number of perpetrators reap large rewards.

A federal pyramid law consistent with well-established FTC actions is sorely needed. But H.R. 5230, wholly inconsistent with decades of successful pyramid scheme prosecutions, is not that law. Instead, the bill would allow a troubled industry incapable of self-definition, let alone self-regulation, to function as an even greater hiding place for pyramid schemes.

Disclosure: I/we 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.