Channel Partners

July 1, 2004

6 Min Read
MLM or Pyramid Scheme

We’ve all heard of multilevel marketing, or MLM, having been introduced to it either at a home party, through an infomercial or via the Internet. This method of direct selling can be profitable, but there is a fine line between a legitimate MLM and an illegal “pyramid scheme.”

Both offer participants the opportunity to earn commissions, and both often require new members to make an initial investment. Among other factors, the fundamental difference between the two business methods often boils down to the amount of the initial investment required by the participant, the means by which the constituent products or services are sold and the basis by which commissions are earned in the program. While the distinctions between the two business methods may seem relatively minor, the degree of contrast may prevent you and your company from becoming the subject of a regulatory proceeding or defendants in litigation.

In this article, we will guide you through the myriad state and federal statutory requirements, as well as applicable MLM guidelines developed through case law precedent.

Standards and restrictions on MLMs have evolved on the federal and state level through developing case law and statutory requirements.

The leading Federal Trade Commission MLM decisions are In re Koscot Interplanetar Inc., 86 FTC. 1106 (1975) and In re Amway Corp., 93 FTC. 618 (1979). In both of these cases, the FTC sought to identify and distinguish the characteristics of a legitimate MLM from that of an illegal pyramid scheme. Pyramid schemes are characterized by the requirement that participants pay money in return for either the right to sell a product or service or the right to receive, in return for recruiting other participants into the program, rewards that are unrelated to the sale of applicable products or services to ultimate retail customers.

In other words, pyramid schemes predominantly compensate participants, either directly or indirectly, for the recruitment and enrollment of other participants.

Regulatory agencies often look for two red flags that in ascertaining whether an illegal pyramid scheme exists are “inventory loading.”

These red flags are 1) a company’s incentive program forces recruits to buy more products than they could ever sell, often at inflated prices; and, 2) a lack of retail sales, especially when sales occur only between people in the pyramid structure or to new recruits, not to consumers in the general public.

In contrast to an illegal pramid scheme, a legitimate MLM has a real, marketable product or service to sell, one that is sold to the general public without requiring consumers to pay an additional fee to join the MLM program. MLMs may pay commissions to a long string of distributors, but these commissions are paid for actual retail sales, not for obtaining new recruits.

As an initial determination, a two-prong analysis is helpful in determining whether a plan could be considered an illegal pyramid scheme. First, you should conduct a theoretical analysis of the compensation plan to determine whether the subject plan, as written, appears to compensate merely for recruitment, or instead, for the retail sale of goods or services to end consumers. If the program compensates participants solely for sales to retail consumers, it will pass the first prong of the test. The second prong involves an operational analysis to determine what type of activity the plan induces;

specifically, what do distributors spend their time doing? This prong of the analysis is often more difficult to decide conclusively. Several different factors may contribute to the determination, but the basic test is, “what does the plan emphasize?” If the plan emphasizes recruitment, even though distributors make retail sales, it may be found to be an illegal pyramid scheme. Incorporating the safeguards set forth in the following two paragraphs will help to ensure that your program passes the second prong of this analysis.

In addition to distinguishing a legitimate MLM program from that of an illegal pyramid scheme, the FTC’s Amway case also sets forth several “safeguards” that should be incorporated when endeavoring to fashion legitimate MLMs:

  1. There should be no entry or “headhunting” fees;

  2. There should be no large inventory purchase requirements;

  3. Each distributor should be required to sell, at wholesale or retail, at least 70 percent of its purchased inventory each month;

  4. Each sponsoring distributor should be required to make at least one retail sale to each of 10 different customers each month;

  5. Distributors should be required to buy back any unused and marketable products from their recruits upon request. Legitimate MLMs should have a 60-day, 100 percent money-back guarantee. After 60 days, the MLM should accept returned inventory (unless perishable or seasonal) with a 10 percent restocking fee. This helps to mitigate against a charge of inventory loading;

  6. Legitimate MLMs should not falsely represent, expressly or by implication, the amount of earnings or income that can be, or which is likely to be, derived from participation in the MLM.

Further, pursuant to statutory guidelines and existing case law, MLMs must disclose the following:

  • The number and percentage of current participants who have not received any commissions, bonuses or overrides;

  • The median amount of commissions, bonuses and overrides received by all participants, together with the percentage of participants that have received less and those that have received more;

  • The average amount of commissions, bonuses and overrides that have been received by all participants;

  • For each level and rank within the plan, the number and percentage of current participants that have reached that level or rank, and the average length of time it took to reach that level.

Many states also regulate MLMs and expressly prohibit pyramid schemes. The method of regulation varies, with some states enacting specific anti-pyramid statutes, while others regulate MLMs by way of lottery, consumer protection and/or antifraud statutes. States that have specific anti-pyramid statutes include: Arizona, California, Delaware, Florida, Georgia, Illinois, Indiana, Louisiana, Massachusetts, Missouri, Montana, New Mexico, North Dakota, Oklahoma, Tennessee, Texas, Utah and Wyoming. Several states have MLM registration requirements, and some go so far as to require that the MLM obtain a surety bond prior to opening their plan up to participation in the respective state.

By way of example, Wyoming simply requires the MLM to file a Notice of Intent to Conduct Business. In contrast, Texas requires MLM to file, in addition to other items, a financial statement, a complete description of the program participant compensation structure, disclosure of all persons with a 20 percent or greater ownership interest in the MLM, and copies of all program promotional materials. At a minimum, the states that require MLM filings generally require the MLM to appoint the Secretary of State as the agent for service of process.

It also is worth noting that even if your written MLM plan complies with all applicable federal and state guidelines, it is the actual ongoing conduct and performance of the MLM within its program structure that truly matters. If, despite its written policies, the program sponsor operates the business closer to that of an illegal pyramid scheme than that of a legitimate MLM, regulatory agencies are more likely to view the plan as an illegal pyramid Scheme. As the saying goes: “If it looks like a duck and it quacks like a duck, then it must be a duck.” Please note this is only a brief overview of some of the more significant issues that you will be faced with if when preparing to launch an MLM program. We recommend that you consult with experienced MLM legal counsel prior to embarking on such an undertaking.

David O. Klein is a partner in the firm of Klein, Zelman, Rothermel & Dichter LLP in New York, N.Y. He practices in the areas of promotional and telecommunications law. He can be reached at +1 212 935 6020 or by e-mail at [email protected].

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