Enrico Schaefer - March 30, 2020 - Business Law
FTC guidelines provide guidance as to what constitutes an illegal MLM (pyramid) scheme, versus a legitimate and lawful MLM business. If a distributor, affiliate, reseller, participant is paying and these two tests are satisfied, chances are you have a high risk MLM business model:
(1) the right to sell a product, and
(2) the right to receive compensation or consideration in return for recruiting other participants into the program unrelated to the sale of the product to third party unrelated purchasers/users.
At the most basic level, the law requires that an MLM pay compensation that is based on actual sales to real customers, rather than based on mere wholesale purchases or other payments by its participants. Ask yourself what your contract says and how your MLM is working in real life: “Who is getting paid what, for what?”
Here are some good resources on various state laws and regulations governing lawful MLM and legal multi-level-marketing. While states vary in their pyramid scheme prohibitions, there are some common themes.
As a general matter, the pyramid and endless chain statutes prohibit the payment of a consideration for the right to recruit others for economic gain where the compensation is unrelated to the sale of products or services.
Key Issues: What type of activity does the compensation plan incentivize. Does the compensation plan, as written, appear to compensate participants: (1) merely for the introduction of additional participants into the program; or (2) for the sale of goods or services to “end consumers.” Word choice is important for you MLM compensation plan. As set forth below, words will not save you if the practical applicaiotn of the MLM violates the rules.
Question: Does the compensation plan incentivized the recruitment of additional distributors (illegal) or sales (legal)?
Here are some other indicia of unlawful MLM schemes which could draw the attention of the FTC of a state attorney general:
1. Products which have “no real world” marketplace.
2. Products which are sold at inflated prices.
3. Mandatory purchases of company product.
4. Plans which result in inventory loading distributors.
5. Substantial cash investment requirements.
6. Mandatory purchases of peripheral or accessory products or services.
7. Plans in which company products are totally or substantially consumed only by distributors.
8. Plans in which distributors are left with substantial unsold inventory upon cancellation of participation.
9. Plans in which distributors purchase products in order to further the marketing plan rather than out of genuine desire and need for the product.
10. Plans which would fail without purchases by participants.
11. Plans which make no effort to emphasize retail sales to the ultimate nonparticipant consumer.
12. Plans which require no meaningful participation by distributors after becoming a distributor.
13. Plans in which fees are paid to distributors for headhunting.
14. Plans in which commissions are not based on actual retail product sales.
15. Plans in which emphasis is on recruitment rather than sale of product.
16. Plans which contain elements of a lottery rewarding participants based on chance rather than on bona fide sales efforts.
17. Earnings misrepresentations or inflated earnings representations.
Several states have so-called buy back requirements to preclude the forcing of goods onto distributors who ma, or may not, last long in the MLM. Participants must have the right to cancel “contracts of participation” for any reason and at any time precluding long term contracts. Examples of state law might require the MLM company to repurchase inventory and sales materials from the MLM participant at a price not less than 90% of the distributor’s original net cost, as well as refund fees paid by the participant. Other states have a combination of a time period- i.e. one year – for distributors to obtain a refund.
A ‘referral program’ is often defined as a program where there is an offer to provide a customer a prize, discount, rebate, or other compensation as an inducement for a sale that requires the prospective customer to give names of other prospective customers to the seller. In these circumstances, courts and lawyers will look to see if earning the prize, discount, rebate, or other compensation is contingent upon a sale to one of the “referred” customers.
Courts will look beyond the words of your compensation plan for MLM participants. and do an “operational analysis” of the compensation plan. What in fact do distributors spend their time doing. More precisely stated, in actual operation, what type of activity does the compensation plan incentives, recruitment or sales.
As noted above, a good rule of thumb is that a multilevel marketing plan, the approach should be able to substantiate numbers that at least 70% of a distributor’s purchases result in true retail sales to persons who do not participate in the compensation program.
Class action lawyers love bringing lawsuits on behalf of distributors participating in MLM programs believed to be unlawful pyramid schemes. You should include in your terms of service, and distributor contracts a terms which precludes class action lawsuit or participation.
Be aware that the FTC can and will issue fines for violation of unfair advertising or truth in advertising laws.