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Investors need to know whether they're investing in a pyramid scheme or a legitimate business. The rules aren't clear, but they should be.

I retired from the Wisconsin Department of Justice in 1997, after having litigated consumer cases over a 30-year period. I am not particularly interested in the stock market; most of my retirement savings are in bonds and money markets. I am not writing a book or otherwise seeking financial gain - I currently volunteer with a New York public interest firm, New York Legal Assistance Group, in an area unrelated to this article.

The recent incident involving David Einhorn and Herbalife (NYSE:HLF) drew my attention to the stock market and the subject of pyramid schemes. It seemed that the significant drop in Herbalife's stock price reflected a market uncertainty about the inherent stability and legality of this company. I understand Herbalife's annual revenue is in the $4 billion range.

Even though retired, the subject of pyramid schemes has been of continuing interest to me. When active, I prosecuted a number of pyramid cases in Wisconsin and witnessed firsthand the damage they do to those who had hoped to succeed as individual entrepreneurs only to fail after quitting jobs, using savings, and losing friends (whom they tried to recruit) and spouses. In one deceptive practices case, against Amway, in 1983, we documented, from actual tax returns, that the average net income of the top tier 1% 'direct' distributors (of 20,000 Amway Wisconsin distributors) was minus $900. According to others that have studied the issue, failure rates in these endeavors approach 99%.

Perhaps because of this background, I continue to have a concern for the victims of these schemes that now number in the millions. In this respect, I have, on several occasions, petitioned the Federal Trade Commission to become more active and responsive in this area, including a 2009 communication with the current Director of the FTC's Bureau of Consumer Protection and have filed formal comments in connection with its recently promulgated Business Opportunity Rule. The Commission ultimately exempted pyramid style offerings from coverage under this rule.

I went to Seeking Alpha to review the online discussion of the topic of pyramid schemes as they may impact the stock market and the value of a stock such as Herbalife. What interests me in this respect is the uncertainty in these discussions as to just what a pyramid scheme is and what are the distinguishing factors between such a scheme and purportedly legal "Multi-Level Marketing." It appears that a major area of dispute on legality is the existence of "retail sales." At issue as well is the question whether a pyramid style offering is inherently deceptive due to its structure, one which depends on the exponential recruitment of prospects and which cannot, because of market saturation, truthfully offer a valid opportunity to those who enter late in the process. Wisconsin's law against pyramids has no retail sale element, and has been upheld by the Wisconsin Supreme Court.

Quoted below are excerpts from decisions on this topic from the Federal Trade Commission's landmark pyramid cases, Holiday Magic (1974 - 84 FTC 748, 1037) and Koscot (1975 - 86 FTC 1106, 1180, 1186) both written by FTC Commissioner Paul Rand Dixon.

In Holiday Magic, Commissioner Dixon held at p. 1037:

A plan which holds out the opportunity of making money, by means of recruiting others, with that right to recruit being passed on as an inducement for those others to join, and being passable by them ad infinitum, contains an intolerable potential to deceive, quite apart from whatever particular representations may be made in promoting the plan. A plan involving such unlimited recruitment which extracts a valuable consideration from individuals in return for the opportunity to participate in it, threatens severe injury since at some point the likelihood must arise that participants will be unable to recoup their investment of money and time in the manner held out as reasonable. The Holiday Magic marketing plan meets these criteria entirely. To say that it is 'inherently' deceptive is to say no more than that it contains this intolerable potential to deceive, and on those grounds as well the plan requires condemnation.

Indeed, a tragic aspect of this case is that the challenged marketing plan was not obliterated in its infancy, before the seed of deception ripened into the poisonous fruit of fraud and oppression. The Commission will consider carefully in the future whether marketing plans of the sort involved here are a suitable target for its newly-gained authority to obtain injunctive relief.

In Koscot, p. 1180 Dixon Stated:

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. Cf. Twentieth Century Co. v. Quilling, 130 Wis. 318, 110 N.W. 173, 176 (1907). 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.

Part of the final order in the Koscot case, p.1186, setting forth illegal conduct, reads as follows:

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.

The Holiday Magic and Koscot cases continue as touchstones for recent cases on the subject. The Koscot ruling was formally adopted in the 1996 Omnitrition case (Webster v. Omnitrition, 79 F.3d 776, 782). Omnitrition and Koscot were cited as authority in the 2012 Burnlounge case brought by the Federal Trade Commission, FTC v. BURNLOUNGE INC. Case No. CV 07-3654-GW(FMOx) UNITED STATES DISTRICT COURT CENTRAL DISTRICT OF CALIFORNIA WESTERN DIVISION

At p. 20 of its July 2011 decision the Burnlounge court stated:

Typically, pyramid schemes depend on perpetual recruitment of new participants in an exponential fashion, such that the scheme "may make money for those at the top of the chain or pyramid, but 'must end up disappointing those at the bottom who can find no recruits. '"Webster v. Omnitrition Int'l, 79 F.3d 776, 781 (9th Cir. 1996) (quoting In re Koscot Interplanetary, Inc., 86 F.T.C. 1106, 1181 (1975)) ("Koscot"). Pyramid schemes are inherently fraudulent "because they must eventually collapse." Id. At 781.

At p. 5 of its March 2012 Amended Final Judgment, the Burnlounge Court ruled:

"Prohibited Marketing Scheme" means an illegal pyramid sales scheme (see e.g., Webster v. Omnitrition Int'l, 79 F.3d 776, 781 (9thCir. 1996), Ponzi scheme, chain marketing scheme, or other marketing plan or program in which participants pay money or valuable consideration in return for which they obtain the right to receive rewards for recruiting other participants into the program, and those rewards are unrelated to the sale of products or services to ultimate users. For purposes of this definition, "sale of products or services to ultimate users" does not include sales to other participants or recruits or to the participants' own accounts."

None of this is conclusive in respect to Herbalife, although its marketing plan could be evaluated in light of these legal standards. And though few Wall Street analysts may have been aware of these standards, enough were apparently concerned about potential corporate legal jeopardy to pull their money when David Einhorn questioned how much of Herbalife's sales revenue was from customers who were not also distributors. I have not studied the Belgian ruling that Herbalife is a pyramid; however, since Brussels is the capital of the European Union, and much of Herbalife's marketing activities are outside the United States, this ruling may be a precursor to changing attitudes about this type of marketing activity in Europe and other capitals around the world, including China.

All this legal ambiguity and investor confusion, I believe, is due to the fact that the Federal Trade Commission has left the definition of a pyramid vague, a defect which has enabled companies to market under this ambiguity and claim legal status. This confusion was enhanced by a 2004 Federal Trade Commission letter from then Acting Director of Marketing Practices, James A. Kohm. He states:

Much has been made of the personal, or internal, consumption issue in recent years. In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme. The critical question for the FTC is whether the revenues that primarily support the commissions paid to all participants are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture.

This comment appears to be in direct conflict with the statement of the Court in the FTC's own 2012 Burnlounge case, holding explicitly that the "sale of products or services to ultimate users does not include sales to other participants or recruits or to the participants' own accounts."

The confusion created by this discrepancy has permitted many pyramids to claim they are 'legal' and support that claim by stating that even though they cannot document actual retail sales in any reliable fashion, they can show sales to distributors and to their recruits and assume that the products were eventually sold at retail or were personally used by these participants and therefore are "retail."

Of course this discussion, centered on "retail" sales, completely ignores the fundamental premise of the Holiday Magic and Koscot cases, ratified by recent decisions, that these plans are 'inherently deceptive." due to their exponential characteristics. This patina of legality has also unfortunately resulted in the victims of these plans believing that any failure was their fault and not because of the inherent flaws in the pyramid structure. Consequently, they do not complain to regulatory authorities, such as the FTC.

Part of this problem stems from the unfortunate 1979 FTC Amway decision at p. 646, where the hearing examiner found, based on Amway testimony, that the company actually accomplished a 70% retail sales rate and concluded that it was not a pyramid. While I thoroughly disagree with this decision, and its value as a legal precedent, it has resulted in uncertainty sufficient to enable many companies to operate under its provisions, both in the US and abroad, claiming they are "just like Amway." In February 2000 I made a formal request to the FTC for a compliance analysis and enforcement review concerning the underlying factual and legal basis for the conclusions reached in the Amway case, and the actual frequency of its retail sales. This request was rejected notwithstanding the dismal income statistics documented in our 1983 Wisconsin case against Amway.

An FTC Chairman during the Bush years (2000-2004) worked with a law firm that represented Amway prior to his Commission appointment. His then acting executive assistant is currently heading the division within the FTC that purports to regulate this area. This may explain some of the FTC's posture in this respect. I am unsure, however, why the FTC, under the current administration, has been unwilling to deal with this matter in a more definitive and positive manner, particularly in light of its stated concern for the middle class and the importance of small business entrepreneurial efforts - efforts having a chance of success that exceed the 1% rate currently attributed to these companies.

From the standpoint of those associated with the stock market in one way or another, it would seem provident that they use their considerable resources and expertise to independently examine the underlying aspects of pyramid style companies and determine whether their structure is "inherently deceptive" or flawed, and whether they deserve the status implicit in the integrity of stocks listed on the major exchanges and the endorsement of many stock analysts.

Source: An Investor's Guide To Identifying Pyramid Schemes