Given the volume of comments on SA, the pyramid scheme question is a significant and contentious issue for investors in publicly traded multi-level marketing firms such as Herbalife (NYSE:HLF), Nu Skin (NYSE:NUS) and USANA (NYSE:USNA). Several SA contributors have pointed out that the Federal Trade Commission's current enforcement posture concerning MLM makes it extremely difficult to distinguish between legitimate MLM firms and pyramid schemes. For instance, Bill Keep, Dean of the School of Business at the College of New Jersey, has stated that "there is a serious problem when experienced investors, journalists, lawyers, regulators, and consumers cannot tell the difference between a pyramid scheme and a legit MLM business." See here.
In a nutshell, the reason it has become so difficult to determine whether an MLM firm is a pyramid scheme is that under the FTC's decision in the famous Amway case, a firm which would have been considered a pyramid scheme under prior FTC decisions such as Koscot, is not considered a pyramid scheme if it has distributor rules which are enforced and effective in ensuring that most of the firms' sales are to retail customers. Accordingly, an MLM firm which desires to avoid being prosecuted as a pyramid scheme has two options: Either comply with the bright line rules set forth in Koscot (no payment of commissions except on consummated retail sales to non-participants, no required payment for the right to receive commissions other than the purchase of a reasonable quantity of sales materials sold at cost) or comply with the much fuzzier and ambiguous standards applied in Amway (have and enforce distributor rules which are actually effective in ensuring that most products are retailed). Predictably, all modern MLM firms have elected to follow the Amway model rather than the Koscot model. Those seeking a more detailed discussion of this issue can read Jon Taylor's comprehensive web site or the white paper drafted by Robert Fitzpatrick, Bruce Craig and me.
The practical effect of the Amway decision is that the only way to determine whether an MLM firm is a pyramid scheme is by undertaking a burdensome and time-consuming review of the retail sales records of the MLM firm and its distributors. Pyramid scheme expert and SA contributor Robert Fitzpatrick has detailed the difficulties with the FTC's enforcement policies concerning MLM and the impact of the "Amway rules" in a number of articles, including here and here. Bruce Craig, former Wisconsin Assistant Attorney General, has noted that "the FTC or anyone else faces a virtually impossible task in determining, from hundreds of company internal records, whether participant injury has actually been, and will be, avoided." See here.
The widespread adoption of the Amway model by MLM firms means that prospective distributors and investors do not have any reasonably simple method for determining whether the company they are considering joining or investing in is a pyramid scheme. It is simply not possible for them to undertake the detailed analysis of retail sales records that the Amway model requires. Moreover, MLM firms do not release the relevant data; Herbalife has stated publicly that it will not release such data due to privacy concerns. See here. Government regulators have subpoena power and can require a targeted MLM firm to product retail sales data. However, the review and analysis of such data is complex and time-consuming, and if the MLM firm does not collect it then the regulator may be forced to attempt to collect the data from distributors, a truly monumental task.
Investors, consumers, and regulators are not the only parties who are affected by the uncertainty and ambiguities of the Amway model. A legitimate MLM firm (and I will resist the temptation of questioning whether there is such a thing) which follows the Amway model faces considerable difficulties in establishing that it is not a pyramid scheme. One might think that the executives in such a firm would want to have a bright line rule that would establish their firm's legitimacy without the need for a lengthy and cumbersome analysis of their distributors' retail sales. However, a cynical observer might conclude that they prefer to take shelter behind the ambiguity of the Amway rules.
Over two years ago, I filed a petition with the FTC on behalf of an ad hoc, an international coalition of consumer advocates requesting that the FTC investigate the MLM industry and promulgate regulations that would require disclosure of material information concerning MLM business opportunities, and clarify what constitutes a pyramid scheme. There has been no official reaction to this petition. Recently Peter VanderNat, a former FTC economist, and expert on pyramid schemes, called for a federal pyramid scheme rule that would clarify and simplify the analysis of whether an MLM is a pyramid scheme. See here. Unfortunately, the FTC rule-making process proceeds glacially. For example, the FTC's initial request for comments that led eventually to the Business Opportunity Rule was in 1995 (I was one of the commenters) but the BOR, revised to exempt MLM firms, did not become final until 2012.
Until a federal pyramid scheme standard is promulgated by the FTC or enacted by Congress, every MLM firm - and its investors - must accept the risk that its compensation plan will cause it to be deemed to be a pyramid scheme.
Or must it?
My modest proposal (hat tip to Jonathan Swift) is that any MLM firm that desires to draw a bright line to distinguish itself from unlawful pyramid schemes has the power to do so now. An MLM firm that eliminates inventory purchase qualifications for earning commissions from its distributor compensation plan is extremely unlikely to be considered a pyramid scheme. Such a move would not eliminate the risk of regulatory actions based on other deceptive practices, such as earnings claims (see my article here), but putting the pyramid scheme issue to rest would be a substantial benefit.
The same analysis should be helpful for prospective distributors and investors in MLM firms. Does the firm you are considering joining as a distributor or investing in impose inventory purchase qualifications? If the answer is "yes" you would probably be better off looking at another company.
Why focus on inventory purchase qualifications?
One of the defining elements of a pyramid scheme is the payment of money by a participant. Most MLM firms attempt to avoid this element by providing that the only "required" purchase is a "starter kit", typically comprised of product samples and promotional materials, which is sold at cost and - at least among the more sophisticated MLM firms - does not generate a commission for the new distributor's upline. MLM firms typically deny that there are any other required purchases. However, the Federal Trade Commission has noted that the payment element may be disguised as a required purchase of inventory. An FTC Staff Advisory Opinion states that "Modem pyramid schemes generally do not blatantly base commissions on the outright payment of fees, but instead try to disguise these payments to appear as if they are based on the sale of goods or services. The most common means employed to achieve this goal is to require a certain level of monthly purchases to qualify for commissions." (FTC Staff Advisory Opinion from James A. Kohm to Direct Selling Association)
Examples of such required purchases are not difficult to find. Herbalife distributors, for instance, must purchase 5,000 "volume points" (a volume point is worth approximately $1) over a period of 12 months to reach the level of "Supervisor", at which point they are eligible to receive "Royalty Overrides" based on purchases by distributors in their "downlines." However it is not enough to have achieved the level of Supervisor in order to be paid overrides; Supervisors must purchase from 500 to 2500 volume points every month to qualify for overrides. Additional bonuses are available at higher levels in the plan, but those bonuses require additional, higher levels of purchases. See Herbalife's Marketing Plan. Nu Skin and USANA have similar requirements. Nu Skin has "group sales volume" qualifications, which can be met by the distributor's own "personal sales volume." See here. USANA distributors must maintain "personal sales volume" and "group sales volume" to qualify for commissions. See here. Jon Taylor has compiled a list of over 500 MLM compensation plans which include these "pay to play" provisions.
Why do MLM compensation plans impose inventory purchase qualifications to receive commissions?
To a critical observer of the MLM industry, it is difficult to identify any legitimate purpose for inventory purchase qualifications. The real purpose of these requirements seems to be clear: they create incentives to purchase the MLM firm's products regardless of whether there is sufficient consumer demand (often called "inventory loading"), and they create incentives for distributors to recruit still more distributors whose qualifying purchases will generate commissions regardless of consumer demand. Moreover, in most MLM compensation systems, commissions that would have been paid to upline distributors who don't meet their purchase qualifications are paid to higher level distributors who do meet their qualifications. This phenomenon is called "roll-up," and it causes the bulk of the commissions generated by downline purchases to be paid to a relatively small group at the highest levels of the plan.
Inventory Purchase Qualifications Should Not Be Necessary
Distributors in an MLM firm perform two functions: (1) selling products to retail customers; and (2) recruiting, training and motivating new distributors who will themselves sell products to retail customers and recruit, train and motivate still more distributors. The compensation for retailing is the profit earned on the sale of the product. The compensation for recruiting, training and motivating new distributors are the commissions generated by the purchases of those recruits, and their recruits, and so on. In a legitimate MLM system, there is no functional reason why the payment of a commission based on a downline recruit's purchase should be tied to the upline distributor's purchase of inventory.
The only reason why a distributor should purchase a product is because he or she intends to sell it. If there is actual retail demand for the manufacturer's products, downline distributors will be motivated to purchase them. Imposing an inventory purchase qualification on upline recruiters in order to qualify for commissions should not be necessary. If the only motivation for a downline distributor to purchase a product is to sell it, and the downline distributor purchases a product, that suggests that the upline distributor is doing his job in training the downline distributor, and the upline should receive a commission. If they downline distributors are not buying, then the upline is not doing their job, and they shouldn't get paid. Imposing inventory purchase qualifications create artificial incentives for purchasing products which are not related to actual consumer demand.
How do MLM firms justify inventory purchase qualifications?
Given all of the controversies over MLM, especially over the past three years, one would think that the answer to this question would be relatively easy to find. It isn't. I have reviewed securities filings by publicly traded MLM firms, read articles and blog postings by proponents of MLM, including the Direct Selling Association, and have consulted with analysts of the MLM industry, but have found little or no attempt to explain why MLM compensation plans impose inventory purchase qualifications. Accordingly, I offer below a few potential justifications, none of which stand up to serious scrutiny.
All MLM firms have inventory purchase qualifications
Well, it may be true that all MLM firms have inventory purchase qualifications (I have yet to see one that doesn't - and check out Jon Taylor's list, referenced above), but "everybody does it" is not an explanation for why they should exist. In addition, it is worth noting that "everybody does it" is usually not a good defense. See here and here.
Traditional distributorships have quotas - why not MLM?
In a traditional exclusive distributorship, where the distributor has an exclusive territory or protected market, sales quotas are normal and expected. The key concept here is "exclusive." If you are the only distributor serving a particular territory it is not unfair for the manufacturer to require you to maintain a certain level of sales. And if you fail to perform, it is not unreasonable for the manufacturer to replace you, or appoint another dealer in the area. Even in distribution systems which are not exclusive, manufacturers usually take care not to appoint too many dealers in a given market, understanding that a healthy distribution system depends on financially viable distributors.
In contrast, MLM distributorships are not exclusive. Distributors are not entitled to protected territories. Moreover, there are no limits on the numbers of distributors who are appointed in a given territory. MLM compensation plans encourage distributors to turn customers into new distributors. Distributors who do so are recruiting potential competitors. In such a system, with no protected territories and no limits on the number of new distributors, inventory purchase quotas are unnecessary, unreasonable and unfair.
Effective distributors are "products of the product"
One oft-heard phrase among MLM promoters, speaking to prospects or new recruits, is that you have to be a "product of the product." For instance, the USANA compensation plan referenced above states as follows:
"Before you sell USANA's top-rated products, you really should use them yourself. And although this step isn't required, it's important to become a product of the product - there's no easier way to do that than by setting up an Auto Order."
Obviously, a good salesman needs to be familiar with the products he or she is selling. But that does not justify monthly inventory purchase qualifications. If frequent personal use of the MLM firm's products makes one a better salesperson, then sales people who use them will be more effective at stimulating retail demand and will order more products in order to meet that demand, and sales people who don't use them will not succeed and drop out. In addition, sales people can obtain the necessary familiarity with their products even if they don't use them personally. Not every Cadillac salesperson drives a Cadillac, and not every vacuum cleaner salesperson pushes the vacuum at home.
Upline distributors need to set a good example for their downlines
Certainly, one of the legitimate functions of an upline MLM distributor is to train and motivate their downline distributors. Teaching sales techniques and demonstrating good selling practices may well be part of that function. But purchasing inventory to meet qualifications - otherwise known as inventory loading - is not setting a good example. Proper sales training should encompass purchasing only enough inventory to ensure you have enough to meet actual demand.
MLM firms need to prevent free riders.
MLM firms may have distributors who join up and do nothing but, due to their position in the recruitment chain, may receive commissions anyway. MLM firms may want to weed out such "free riders", but inventory purchase qualifications are the wrong tool for the job. In fact, they are counter-productive. Consider an MLM distributor who is very effective at training new distributors in how to sell the products. It is in everyone's interest for that distributor to spend most of his or her time on training other distributors, and not on selling the products themselves. Given the person-to-person nature of direct selling, selling products to retail customers requires a great deal of time and energy. Forcing a distributor who is a good trainer to buy products in order to qualify for commissions will force that distributor to spend more time selling the products rather than on training (unless of course they find it economically feasible to simply let the products pile up in their basement).
There are surely better ways of solving the free rider problem. Reducing the number of levels on which a distributor can earn commissions would be one way. Monitoring the activities of distributors to determine whether they are really earning their commissions is another.
A legitimate MLM does not need to impose inventory purchase qualifications in its compensation plan. The potential for earning retail profits should be sufficient motivation for distributors to purchase products from the manufacturer. Eliminating inventory purchase qualifications would eliminate most of the risk that the MLM will be charged with being a pyramid scheme. However, I predict that my modest proposal will be ignored, because the painful truth is that inventory purchase qualifications are at the core of what makes the MLM system attractive to MLM firms and the tiny percentage of high-level MLM distributors who receive the bulk of financial rewards. If you are contemplating investing in an MLM firm, ask its executives why they have inventory purchase qualifications. The answer should be interesting.
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.