Consumer Groups, Direct Selling Industry Debate Anti-Pyramid Legislation

A bill in Congress would “make it harder for the FTC to challenge illegal pyramid schemes," several consumer groups argued in a letter this month, “placing consumers seeking small business opportunities at grave risk of being taken for a ride."

The “Anti-Pyramid Promotional Scheme Act of 2016", or H.R. 5230, would relieve multilevel marketing (MLM) companies of the need to have actual customers outside of individuals who are recruited for a network, according to the consumer organizations in a June 2 letter to members of the House Energy and Commerce Committee.

“We think the FTC’s powers now are adequate and good for policing the pyramiding behavior of some companies," said Sally Greenberg, executive director of the National Consumers League, in a phone interview. “This bill has a name that suggests that it would help the FTC police … pyramiding practices, and we think it does just the opposite," she said later in the interview.

The letter to lawmakers was submitted by Consumer Action, Consumer Federation of America, Consumer Watchdog, National Consumers League and U.S. PIRG.

Responding to criticism of H.R. 5230, the leader of the Direct Selling Association (DSA) advised members of Congress that the bill “reflects a decades-long and successful effort by those interested in consumer protection, including members of DSA, to define and prohibit pyramid schemes."

“None of H.R. 5230’s central provisions—that a pyramid scheme exists when compensation is based primarily on the act of recruitment (as opposed to retail sales) and that personal use, or being able to purchase products at a discount, is a legitimate business practice in direct selling—are new or outlandish," said Joseph Mariano, president of DSA, in a June 17 letter.

Amway, Herbalife and Nu Skin—all members of the DSA and some of the largest U.S.-based MLM companies selling nutritional and skin-care products—had no comment on the legislation.

Reps. Marsha Blackburn and Marc Veasey introduced the bill. Blackburn, a Republican from Tennessee, and Veasey, a Democrat from Texas, are co-chairs of the Direct Selling Caucus. Spokespersons for the lawmakers did not respond to requests for comment.

The legislation, which FTC declined to comment on, isn’t expected to move far this year on Capitol Hill. Not only does Congress have an abbreviated session due to the forthcoming presidential election, the bill apparently isn’t high on the agenda of the House Energy and Commerce Committee, said Greenberg of the National Consumers League.

Criticism of the legislation underscores the controversy and ambiguities surrounding multi-level marketing, especially in recent years. In a phone interview, Mariano described an environment focused on companies in which there has been “misstatements and misunderstanding about how the legitimate model works, and what the state of the law is."

Perhaps most notably, Herbalife has been the subject of a years-long FTC investigation after billionaire Bill Ackman of the hedge fund Pershing Square Capital Management accused the company of running a massive pyramid scheme that is doomed to fail. Herbalife has fervently denied the pyramid scheme allegations, although the marketer of weight-loss shakes and supplements recently disclosed it was in advanced talks with the government to reach an agreement that would possibly include injunctive relief and a fine of US$200 million.

While the definition of a pyramid scheme has been well understood for a number of years based on the case law, there is no federal statute defining it, Mariano noted.

H.R. 5230, if passed, would not influence ongoing investigations, and “in fact, in our view, doesn’t change the status of the law," he said in the interview. “It merely puts in federal statute what the law already is."

Concord, Massachusetts-based lawyer Douglas Brooks expressed a starkly different view.

“The bill would make it extremely difficult if not impossible to prosecute the most pernicious forms of deceptive multi-level marketing programs and product-based pyramid schemes," said Brooks, who has represented distributors in numerous class-action lawsuits and was class counsel in a case whose 1996 appellate decision is often cited in MLM-related litigation, Webster v. Omnitrition International Inc.

Critics of the legislation introduced by Blackburn and Veasey pointed to its definition of an ultimate user as “a non-participant in the plan or operation, or a participant who purchases reasonable amounts of products, goods, services, or intangible property for personal use, and whose purchase is not made solely for purposes of qualifying for increased compensation."

“The idea of the bill is to stop the FTC, and to supersede or override the court precedent that’s been 40 years in the making," argued Robert FitzPatrick of Pyramid Scheme Alert, a consumer education and advocacy group, in a phone interview.

He said the bill is aimed at removing the requirement for an external market for products.

A participant in an MLM is “totally different from somebody buying the product like you would going into a store where you can comparison shop, where you can look for the lowest price, and easily return the good," said FitzPatrick, who noted that he has served as a consultant or expert in several court cases. “What they’re saying [in the bill] is that an ultimate user is a legally defined distributor."

A “seminal" FTC decision in 1975 made clear that rewards to distributors had to be funded from sales to individuals who did not participate in a marketing plan, noted Brooks, referencing the government’s case against Koscot Interplanetary Inc., a seller of cosmetics.

“The bill would reverse this requirement and permit rewards to be paid from sales to participants, subject only to the vague and unenforceable provision that the participants’ purchase ‘is not made solely for purposes of qualifying for increased compensation,’" Brooks asserted in an email to Natural Products INSIDER. “This language would pose an insurmountable challenge to any enforcement action by the FTC, as it would require the agency to poll vast numbers of participants to ascertain whether their purchases were motivated ‘solely’ or only partially for purposes of increasing compensation."

The direct selling industry has insisted internal consumption of products by MLM distributors is common and reflects strong demand for companies’ products. In an income disclosure statement revealing compensation paid to U.S. members in 2015, Herbalife noted (based on a 2013 survey) that 73 percent of its members joined predominantly to obtain a discounted price on its products. Mariano said his sister joined a member company of the DSA 15 years ago for that exact same reason: because she was mostly motivated to get vitamin products at a discount.

Ackman and other critics of MLMs have pointed out that relatively few distributors earn money and turnover is extremely high, but Mariano countered that most people join a company with limited expectations and anticipate only working part-time.

While there is consensus on what constitutes a pyramid scheme, Mariano referenced cases that he said unduly focus on internal consumption. The focus, he said, should be on whether individuals participating in an MLM plan are actually buying products for their personal consumption, or instead doing so as a “sham" related to recruitment.

FTC Prosecutions

Debate over H.R. 5230 comes in the wake of a few high-profile investigations and prosecutions, including a lawsuit against Vemma Nutrition Company. In September, a federal judge in Phoenix preliminarily enjoined Vemma from engaging in certain marketing practices after he found the energy drink company was likely a pyramid scheme.

In June 2014, FTC won a case at the U.S. Court of Appeals for the Ninth Circuit, which upheld a finding that a marketer of music and music-related merchandise—BurnLounge—was a pyramid scheme.

The government’s actions haven’t been unanimously praised.

H.R. 5230 is “important because it creates clear guidelines for regulators," said Kevin Thompson, an MLM lawyer whose firm Thompson Burton PLLC in Franklin, Tennessee represents upstart and mature network marketing companies. “And I think regulators are wandering off the beaten path, and they are acting very erratically and unpredictably. And it’s important to have a concrete bill that guides everybody instead of the current ‘you know it when you see it’ standard."

Thompson mentioned a 2004 advisory letter to the DSA in which FTC said the amount of internal consumption by MLM members isn’t determinative of whether a business is 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," an FTC official explained in the letter.

In the BurnLounge case, FTC’s position on internal consumption was entirely different, Thompson noted in a recent article discussing the anti-pyramid legislation on his law firm’s website. In the Ninth Circuit appeal, FTC argued “internal sales" to other independent retailers, or so-called Moguls, didn’t qualify as “sales to ultimate users."

The court rejected the government’s argument and referenced the 2004 FTC letter, which Thompson interpreted as the court’s “way of saying … ‘You wrote this. You live with it.’"

Still, the Ninth Circuit decision upheld the lower court decision that BurnLounge was operating a pyramid scheme.

“As discussed above, the rewards BurnLounge paid to Moguls were primarily in return for selling the right to participate in the money-making venture—the Mogul program," Circuit Judge Morgan Christen wrote in the Ninth Circuit’s decision after examining BurnLounge’s bonus structure and quoting the FTC letter. “The merchandise in the packages were simply incidental … The fact that some sales occurred that were unrelated to the opportunity to earn cash rewards does not negate the evidence that the opportunity to earn cash rewards was the major draw of the BurnLounge Mogul scheme."

While Mariano said the courts have been fairly consistent in applying the law, judges over the years have weighed various factors in distinguishing legitimate operations from pyramid schemes.

The average person may be especially vulnerable to a scam masquerading as a legitimate operation.

“I would say it’s impossible for a consumer looking at joining a multilevel marketing company to determine whether that MLM is a pyramid scheme or not," Brooks said in a follow-up phone interview. “It’s fiendishly difficult even for the FTC to figure it out, or [an] expert like an economist. But for a typical person who is thinking about becoming an MLM distributor, it is impossible for them to determine whether a given company is a pyramid scheme or not."

Consider a ruling last year affecting Vemma. In responding to a request to approve a revised compensation plan, a federal judge in October denied the company’s proposal to grant an affiliate the right to receive full bonuses if the affiliate’s organization generated 51 percent of sales from “customers," who were defined as participants “interested in purchasing and using" the company’s products.

U.S. District Judge John Tuchi reasoned the proposal didn’t go far enough to prevent pyramid scheme behavior because, for instance, an affiliate could still receive substantial compensation based on sales primarily to other affiliates downstream in his or her network, and Vemma didn’t have other safeguards to prevent loading of inventory.

Minimum Volume Requirements

On a webpage striving to distinguish legitimate direct selling companies from illegal pyramid schemes, DSA explained the former group bases compensation predominantly on the sale of products to the “ultimate user," and distributors generate compensation from their own sales or the sales of others that they have recruited. (The webpage didn't define the term ultimate user, although as noted above, the federal legislation does).

But critics have slammed MLM companies’ policies that require distributors to purchase a certain amount of products each month in order to qualify for commissions.

“The critics have a point in that distributors under the influence of a pay plan will spend a lot of money on products they don’t really want," Thompson said. In order to qualify for commissions, he explained, distributors must move a certain amount of points, “and moving is defined as somebody who is on autoship, somebody who buys for personal consumption, or somebody who sells via retail."

“But what happens a lot of times is people just get on autoship and they don’t sell anything, which is fine, and that’s legal, but it gets abused," the lawyer continued.

Thompson proposed modifying the legislation so that for distributors subject to monthly personal volume requirements, half of the amount purchased must be designated for certified retail sales outside the network. Such a rule could allay some of the critics’ concerns with H.R. 5230.

The “essential problem with most MLM programs is the use of … inventory purchase qualifications in their compensation plans," noted Brooks, who made the same observation earlier this year in an article for Seeking Alpha. “Prohibition of such requirements would be the simplest method for distinguishing between legitimate MLM and pyramid schemes, and would not harm any program that is truly based on bona fide retail selling."