Legal Principles of Multilevel Marketing

Multilevel Marketing Primer – The MLM Startup Guide


I. Multilevel Marketing/Pyramids
II. Buying Clubs
III. Business Opportunity Statutes
IV. Referral Sales
V. Securities
VI. Lotteries
VII. Recent Litigation
VIII. Conclusion
Footnotes


I. Multilevel Marketing/Pyramids

Federal and state multilevel marketing and anti-pyramid statutes are components
of a comprehensive consumer protection umbrella. These laws are designed to protect
individuals from being defrauded through illegitimate programs which lure participants
with the promise of easy money by compensating them from the investments of
additional participants rather than from legitimate product sales. These programs have
been called "Ponzi schemes," "airplane plans," "pyramids," "chain letters," and many
other names. Although known in the United States only during the twentieth century,
such programs have cost their participants hundreds of millions of dollars. Federal and
state regulatory agencies have sought to proscribe such illegal activity in multiple ways,
including the use of anti-pyramid, mail fraud, business opportunity, franchise, lottery,
and securities laws. (Each of these areas will be discussed below.)

Whether a program is a legitimate multilevel marketing plan or an illegal pyramid
depends principally on: (1) the method by which the products or services are sold; and
(2) the manner in which participants are compensated. Essentially, if a marketing plan
compensates participants for sales by their ""enrollees," "recruits," and/or their downline
enrollees and recruits, that plan is multilevel. If a program compensates participants,
directly or indirectly, merely for the introduction or enrollment of other participants into
the program, it is a pyramid.

A. Legislative Intent and Judicial Interpretation

As a practical matter, it is impossible for legislators to anticipate the infinite
creativity of individuals who devise, implement, and promote legal and illegal
marketing programs. Accordingly, anti-pyramid and multilevel statutes, like most
consumer protection legislation, are drafted and interpreted very broadly so that they
might encompass all of the possible permutations of an illegitimate scheme, and thus
have a jurisdictional basis for regulating and eliminating them.

The analysis used by regulators to evaluate multilevel marketing programs is
essentially two-fold. The first of the two foci ("focuses" if you are from Idaho) involve
a review of the theoretical or conceptual design of the compensation plan. More
precisely stated, 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." If it does the former, it
constitutes the most classic example of a pyramid. If it does the latter, it will pass
through the first prong of the analysis. Suffice it to say that the vast majority of new
MLM companies do not run afoul of this first hurdle. Historically, they, as well as many
existing companies, have had problems with the second component of the analysis.

The second aspect of the analysis involves the "operational analysis" of the
compensation plan. Notwithstanding the conceptual or theoretical design of the plan,
what in fact do distributors spend their time doing. More precisely stated, in actual
operation, what type of activity does the compensation plan incent — the recruitment
of additional distributors or sales. As discussed below, despite the sale of products or
services by distributors, the compensation plan can nevertheless constitute a pyramid.

The operational analysis involves factual and subjective determinations. Over
the decades, courts have developed a litany of factors by which they evaluate
compensation programs. The definitive (and amorphous) test is, "what is the emphasis
of the program?" If the emphasis of an MLM program is on recruiting (rather than
product or service sales), it will be a pyramid. While none of us has a crystal ball by
which we can divine the future operation of an MLM program, having reviewed
countless plans, we have developed substantial prognosticating skills.

B. Is Your Program Multilevel?

Multilevel marketing companies must guard against being classified as a pyramid
on both the state and federal levels. The majority of states statutorily regulate
multilevel, or more precisely anti-pyramid, activity. Federal regulation, on the other
hand, is primarily a function of administrative and judicial decisions arising from a
series of private party and Federal Trade Commission litigation.

1. State Statutory Approaches

As regards pyramids and multilevel marketing plans, state statutes have taken
two distinct approaches. A sophisticated minority(1) of state laws specifically define and
regulate multilevel marketing plans. Georgia’s statute provides a typical definition of
a multilevel marketing company:

"Multilevel distribution company" means any person, firm, corporation, or
other business entity which sells, distributes, or supplies for a valuable
consideration goods or services through independent agents, contractors,
or distributors at different levels wherein such participants may recruit
other participants and wherein commissions, cross-commissions,
bonuses, refunds, discounts, dividends, or other considerations in the
program are or may be paid as a result of the sale of such goods or
services or the recruitment, actions, or performances of additional
participants.(2)

The definitions of a multilevel company or multilevel marketing plan in the other
states that specifically define multilevel marketing are identical or very similar to
Georgia’s.

Broken into individual components, the elements that must be met to establish
a multilevel company or multilevel marketing plan include:

Elements of a Multilevel Compensation Plan Does Your Program Meet These Elements?
(1) A person, firm, corporation or other business entity  
(2) which

(a) sells;

(b) distributes; or

(c) supplies(3)

 
(3) for consideration  
(4) goods or services  
(5) through independent agents, contractors, or distributors  
(6) at different levels  
(7) participants may recruit other participants  
(8) compensation to participants is paid as a result of

(a) the sale of such goods or services; or

(b) the recruitment, actions or performance of other
participants

 

C. Is Your Program a Pyramid?

The vast majority of states utilize an indirect approach by defining a “pyramid”,
“chain distributor scheme” or “endless-chain scheme” and proscribing such programs.
Regardless of the name used by the statutes, their intent is to prohibit plans or
programs that reward participants, either directly or indirectly, on the basis of
recruitment or enrollment of other participants rather than compensating them for sales
of products or services to end consumers. For example, North Carolina defines a
“pyramid” as:

[a]ny program utilizing a pyramid or chain process by which a participant
gives a valuable consideration for the opportunity to receive
compensation or things of value in return for inducing other persons to
become participants in the program.

N. C. St. 14-291.2(b)

New York’s definition of a “chain distributor scheme” is more precise, but nonetheless
representative of anti-pyramid statutes.

[A] “chain distributor scheme” is a sales device whereby a person, upon
condition that he make an investment, is granted a license or right to
solicit or recruit for profit or economic gain one or more additional
persons who are also granted such license or right upon condition of
making an investment and may further perpetuate the chain of persons
who are granted such license or right upon such condition. A limitation
as to the number of persons who may participate, or the presence of
additional conditions affecting eligibility for such license or right to recruit
or solicit or the receipt of profits therefrom, does not change the identity
of the scheme as a chain distributor scheme. As used herein,
“investment” means any acquisition, for a consideration other than
personal services, of property, tangible or intangible, and includes without
limitation, franchises, business opportunities and services, and any other
means, medium, form or channel for the transferring of funds, whether or
not related to the production or distribution of goods or services. It does
not include sales demonstration equipment and materials furnished at
cost for use in making sales and not for resale.

N.Y. Gen. Bus 359-fff.

The laws of Texas contain a similar definition for “endless chain” schemes.

“Endless chain” means any scheme for the disposal or distribution of
property whereby a participant pays a valuable consideration for the
chance to receive compensation for introducing one or more additional
persons into participation in the scheme or for the chance to receive
compensation when a person introduced by the participant introduces a
new participant.

V.T.C.A., Penal Code 32.48.

Anti-pyramid statutes provide that pyramids, endless chain schemes, or chain
referral schemes are illegal. Thus, so long as a multilevel compensation plan does not
fit within the parameters of the prohibited activities, it is permissible (at least as regards
anti-pyramid laws).

Elements of a Pyramid Does Your Program Meet These Elements?
(1) A scheme, plan or program;  
(2) For which a participant renders consideration to join;  
(3) For the right or chance to receive compensation or
other things of value;
 
(4) Which is contingent upon the introduction of
additional participants into the scheme, plan or program.
 

If any of the elements listed above are absent, the program does not violate state
antipyramid legislation.

1. Federal Administrative and Judicial Decisions

There is no federal anti-pyramid statute in the United States.(4) Nevertheless,
decisions of the Federal Trade Commission and the Federal Courts, more so than
legislation from any individual state, have largely supplied the legal framework upon
which multilevel marketing companies have developed their programs. The most often
cited definition of a “pyramid” scheme is found in the Federal Trade Commission’s
decision in In the Matter of Koscot Interplanetary, Inc.(5) Therein, the F.T.C. held that
“entrepreneurial chains” are characterized by “the payment by participants of money
to the company in return for which they [the participants] 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.”

Elements of a Pyramid – Federal Decisions Does Your Program Meet These Elements?
(1) Payment of money to the company;  
(2) The participant receives the right to sell a product
(or service);
 
(3) The participant receives compensation for
recruiting others into the program;
 
(4) The compensation is unrelated to the sale of
products (or services) to the ultimate user.
 

D. Important Issues

The above discussion and tables are representative of the pyramiding issues
facing the multilevel marketing industry. Companies should be careful when developing
their marketing plans to stay within the parameters of these laws. However, designing
a program that strictly adheres to the literal terms of the law will not guarantee the
program will overcome all legal challenges. There are variables among the states in
the definition of a “pyramid scheme” which may result in a program being entirely legal
in one state yet illegal in a neighboring state. In addition, judicial interpretation of a
statute or a prior decision may result in a decision that is seemingly inconsistent with
its literal terms. Finally, the law always looks to substance over form. If a program uses
all of the right buzz words in its marketing literature, but fails to enforce its policies
which guard against pyramiding dangers, the program faces the same risks as a
program which does not incorporate appropriate safeguards into its plan.

Although the inconsistencies among the states and federal law pose difficulties
when designing a marketing plan, there are factors which both federal and state forums
consider when conducting a pyramid analysis. Although these criteria are typically not
specified by statute, they are taken into account because they provide evidence that the
dangers posed by a pyramid scheme are mitigated.

1. Substantiatable Sales of Products to End Users

As discussed above, a program that compensates its participants for the mere
act of recruiting or enrolling others into the program is a pyramid. Unscrupulous
promoters have attempted to circumvent the traditional definition of a pyramid through
a practice called “inventory loading.” Although participants in an inventory loading
scenario are technically compensated for the sales of products, the sale is in actuality
a subterfuge.

In an inventory loading scenario, new recruits are required or pressured to
purchase large quantities of products (often unconscionably overpriced and
nonrefundable). This, in turn, produces a large “commission” for upline participants.
The emphasis in such a program is not on the sale of products, but rather on recruiting
of new participants with the goal of “loading” them with as much inventory as possible.
In addition, there is usually a substantial improbability that the average distributor
would either use or be able to resell the quantity of goods that are involved in an
inventory loading setting. Because of these factors, courts have consistently held that
notwithstanding the “sale of products,” such transactions are tantamount to a
“headhunting” or “recruiting” bonus and thus constitute a pyramid. Accordingly, it is
important that sales to Distributors be reasonable in amount and price and documented
to reflect this.

2. Sales to “Ultimate Users”

Many multilevel marketing companies want to develop compensation programs
under which distributors receive commissions based on the purchase and consumption
of products by downline distributors rather than retail sales to third persons. This is a
logical approach since one of the greatest deterrents to enrolling in a multilevel
program stems from the general public reluctance to engage in sales. Indeed, the
entire industry has been built almost entirely upon the personal consumption of
products by distributors. Under a literal interpretation of the Koscot definition of a
pyramid, personal consumption satisfies the second element of the test because
distributors can be classified as “ultimate users” if they personally consume the
products they purchase.

Despite the literal language of the Koscot test, courts have interpreted and
state Attorneys General are increasingly interpreting the term “ultimate users” to
mean persons who are not participants in the program, that is to say persons who
are not distributors.
The most recent federal decision on this issue was rendered by
the Ninth Circuit Court of Appeals on March 4, 1996. In Webster v. Omnitrition
International, Inc.
(6) the court found that personal consumption by a distributor’s
downline does not satisfy the Koscot requirement that sales be to the “ultimate user.”
Therefore, when designing a multilevel marketing plan, the approach presenting the
least risk is to institute and enforce a rule that at least 70% of a distributor’s purchases
result in true retail sales to persons who do not participate in the compensation
program.

3. Inventory Repurchase Requirements

The more sophisticated multilevel jurisdictions of Georgia, Louisiana,
Massachusetts, Maryland, Puerto Rico, and Wyoming require multilevel companies to
repurchase inventory that is returned by their distributors.(7) Additionally, these states
mandate that written notice of the policy must be given to distributors in the distributor
agreement. The rationale underlying buy-back requirements is that they tend to
prevent or substantially reduce the risks and concomitant evils of inventory loading.

Under some statutes, the requirements are only triggered when a distributor
terminates his relationship with the company. In other jurisdictions, like Maryland and
Puerto Rico, the company must repurchase returned inventory simply if the distributor
was unable to sell it within three months from its receipt. These statutes require
multilevel companies to repurchase resalable products from their distributors for not
less than 90% of their original purchase price. Any commissions or bonuses that have
been paid to the product-returning distributor which are attributable to the product
being returned
(as opposed to commissions paid due to downline sales) may be
deducted from the repurchase price. Some statutes, like Georgia’s, also mandate that
a multilevel company repurchase goods that are no longer marketed if they are
returned to the company within one year from the date the company discontinued
marketing the goods.(8)

We emphatically recommend that all MLM companies include a 90% (or higher)
repurchase policy. Such a buy-back policy is probably the single best way to avert the
“cookie-cutter” class-action lawsuits that have plagued direct selling companies during
the last four years. (These lawsuits will be discussed below in Section VII, B.)
Additionally, a repurchase policy should provide that commissions previously paid to
upline Distributors will be “recaptured” or deducted from their respective future
commission payments to further reduce the incentive for inventory loading.

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II. Buying Clubs

“Buying clubs” are regulated by a significant majority of states. While they are
not illegal, they require compliance with several burdensome regulatory criteria which
are much better avoided. In general, the term means any business organization that
holds itself out as offering discounted prices to members by virtue of its “buying clout.”
A buying club need not possess any specific set of business or operational
characteristics. Whether a business organization is a buying club is simply a function
of the claims it makes. More precisely, the mere acts of an organization: (1) claiming
to offer discounted merchandise; (2) as a consequence of its size or other similar
attribute; and (3) allowing only “members” to purchase such merchandise, result in that
organization being a “buying club.” In Minnesota, a buying club is defined as

[A]ny corporation, partnership, unincorporated association or other
business enterprise organized for profit with the primary purpose of
providing benefits to members(9) from the cooperative purchase of services
or merchandise.(10)

Other states define buying clubs identically or similarly.(11)

Elements of a Buying Club Does Your Program
Meet These
Elements?
(1) Is the organization a corporation?

Partnership?
Unincorporated association?
Other business enterprise?
 
(2) Is the enterprise organized “for profit”?  
(3) Does the enterprise have “members”?  
(4) Is the primary purpose of the enterprise to provide
benefits to members (i.e., discounted goods or services)?
 
(5) Do these benefits result from, or are they promoted as
stemming from, the cooperative purchases of goods or
services?
 

The absence of any one of these elements allows an organization to avoid buying
club classification.

If a business enterprise is a “buying club,” several onerous impediments to
doing business exist. Buying club status triggers several requirements, including: (1)
registration with the state (usually the Attorney General);(12) (2) the payment of a
registration fee;(13) (3) the posting of a bond; (4) a right of cancellation;(14) and (5) notice
of the right of cancellation on the membership agreement.(15) Additionally, other states
make even more burdensome demands. For example, Florida requires that if a buying
club (or any of its agents — arguably distributors) represents orally or in writing that use
of its services will result in savings to its members, the buying club must disclose in
writing in the contract that:

[a]ll savings claims made by the buying club are based on price
comparisons with retailers doing business in the trade area in which the
claims are made if the same or comparable items are offered for sale in
the trade area and with prices at which the merchandise is actually sold
or offered for sale.(16)

Some states limit the maximum duration of members’ contracts, although most
allow for their extension after an introductory period of usually six months. Other
states require additional written disclosures, such as the fact that goods can only be
bought through catalogs with no opportunity to inspect samples, if such is the case.
Certain statutes mandate that the membership agreement must be approved by the
state prior to use, while others impose record keeping requirements which include the
right of inspection of corporate books and records by the state.

The legal requirements spanning the country are myriad, inconsistent, and
arduous. If a buying club fails to meet each requirement, it is subject to enforcement
action by the state, which may take the form of injunctive action to prevent the
organization from conducting business (or simply shutting it down), and possibly civil
penalties.(17) In Minnesota, each civil penalty may be as high as $25,000. For all of these
reasons, companies are strongly urged to avoid buying club status. This can be
accomplished quite easily, mainly by eliminating references to “buying clubs” and
discounts due to membership in your company.

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III. Business Opportunity Statutes

Most states have enacted “business opportunity” statutes. To the vast majority
of the population, the term “business opportunity” is an amorphous phrase that relates
to any commercial opportunity or business venture. To regulators, however, it has a
precise statutory meaning and is yet another component of most states’ consumer
protection programs.

Like buying clubs, “business opportunities” are not illegal, however, they
mandate compliance with a host of onerous regulatory requirements. The intent
behind such legislation is to provide consumers certain protection from large
investments for income producing opportunities. Historically, such “opportunities”
have ranged from ostrich farms to vending machines businesses. The protection
includes disclosure of information about the opportunity and its promoters, contract
rescission rights, bonding, and state registration. As a practical matter, business
opportunity statutes encompass most business activities for which the promoter
asserts that a certain amount of income may be earned.
A “business opportunity”
is essentially defined as a sale or lease of any products, equipment, supplies or services
for which the seller represents that: (1) the purchaser may or will derive income which
exceeds the price paid for the opportunity; or (2) it will provide a sales or marketing
program to enable the purchaser to derive income which exceeds the price paid for the
opportunity.

Elements of a Business Opportunity Does Your Program
Meet These Elements?
(1) Is there a sale or lease or offer to sell or lease any goods
or services?
 
(2) To a purchaser?  
(3) That are to be used by the purchaser in beginning or
operating a business?
 
(4) Involves an initial payment by the purchaser of more
than two hundred dollars?
 
(5) Involves a solicitation of purchasers in which the seller
represents that:

(a) the purchaser will provide a sales or marketing plan
pursuant to which the purchaser may or will earn an
amount in excess of the initial payment as a result of
the investment;

(b) a market exists for any goods to be made or
services to be rendered by the purchaser;

(c) the seller may buy from the purchaser any goods to
be made or services to rendered by the purchaser;

(d) the seller or a person referred by the seller to the
purchaser may or will sell, lease, or distribute the
goods made or services rendered by the purchaser; or

(e) the seller may or will pay to the purchaser the
difference between the initial payment and the
purchaser’s earnings from the investment?

 

As with buying clubs, the impact of business opportunity statutes is manifold and
burdensome. Generally, business opportunities must be registered with the state
(usually the Attorney General). Significant personal disclosures about the promoters,
the promoters’ backgrounds, and the promoters’ personal finances are mandatory. In
addition, substantial factual and financial disclosures, much like a stock prospectus,
must be provided to potential purchasers regarding the opportunity. The rationale
behind such disclosures is to afford prospective purchasers the ability to make a fully
informed decision regarding the opportunity. Purchasers enjoy expansive rights to
rescind their contracts. Further, bonding is typically required in each state in which the
opportunity is offered. Some states require that business opportunities establish an
escrow account into which all or a significant portion of the purchase price must be
placed until the goods are received by the purchaser.

Fortunately, the intent behind such legislation is to protect consumers from large
swindles. To that end, and because the risks substantially decline below a minimum
investment level, statutes defining business opportunities contain minimum initial
investment threshold exemptions. However, to make matters difficult, the minimum
threshold differs among states and the Federal Trade Commission’s Franchise and
Business Opportunity Rule.(18) Under the F.T.C. rule, as well as the majority of the states,
the minimum threshold is $500.00. The threshold in some states however, such as
Maryland, is as low as $200.00.(19)

It is important to note that business opportunity statutes are concerned only with
the initial investments that are required to become a distributor. Under various
statutory schemes, these costs often extend beyond those initially needed to “acquire
the opportunity.” Again, the states and F.T.C. differ on what constitutes an “initial
investment.” The F.T.C. and majority rule is that any required purchases within the first
six months of joining a program comprise part of the initial investment. Other states
specify that the “initial investment” extends for the duration of the term of the contract
governing the parties’ relationship. Still others fail to define the term altogether. Other
states vary the exemption slightly by mandating that the required sale be not only
below the threshold, but also “at cost.” For example, under Indiana’s business
opportunity statute, a business opportunity excludes only “not-for-profit sale of sales
demonstration equipment, materials, or samples for a total price of five hundred dollars
($500) or less.”(20)

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IV. Referral Sales

A “referral sale” is typically defined as the provision or 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, if earning the prize, discount, rebate, or other compensation is contingent
upon a sale to one of the “referred” customers.(21) To the surprise of most people,
particularly sales persons, referral sales are illegal throughout the United States.

Elements of a Referral Sale Does Your Program Meet These Elements?
(1) Does the seller offer or promise to a prospective buyer a

(a) price reduction;
(b) rebate;
(c) commission;
(d) credit;
(e) any other consideration?
 
(2) Is the promise or offer an inducement for a sale or
lease?
 
(3) Must the purchaser provide the seller names of other
potential customers?
 
(4) The offer or promise is contingent upon the seller’s
ability to make a sale to one of the potential customers?
 

As discussed above, referral sales are illegal in all states. Accordingly,
Companies are strongly encouraged not to make any references to “referral sales” or
“referral marketing, or to offer incentives contingent upon the company’s successful
sale to, or enrollment of, a person referred by participants.

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V. Securities

Although most people would not think of a pyramid as a “security,” the Federal
Securities and Exchange Commission (SEC) has used its statutory mechanisms to
prosecute pyramids. In some cases, the SEC has been able to show that a pyramid was
an “investment contract,” and thus, a security.(22) Once it overcame this hurdle, it was
relatively easy to show that the promoters were unlicensed securities brokers engaged
in selling unregistered securities.

The Securities Act of 1933, the Securities and Exchange Act of 1934, and most
state securities acts (Blue Sky laws) include the term “investment contract” within the
definition of a security. None of these statutes, however, defines the term. Thus, the
United States Supreme Court, in Securities & Exchange Commission v. W. J. Howey
Company
,(23) set forth the following three-prong test to determine if an instrument
constitutes an investment contract:

An investment contract for purposes of the Securities Act means a
contract, transaction or scheme whereby a person invests his money in
a common enterprise and is led to expect profits solely from the efforts of
the promoter or a third party, …
Elements of a Security Does Your Program Meet These
Elements?
(1) Has there been an “investment of money?”  
(2) Does a “common enterprise” exist?

(a) horizontal commonality
(b) vertical commonality.
 
(3) Are persons led to expect profits from the efforts of the
promoter or a third party?
 

A. An Investment of Money

The fact that an application fee must be paid lends itself to an argument that “an
investment” is required to become a Distributor. Indeed, if the fee is excessive, it will
be classified as “an investment.” However, if the application fee is low and only covers
the company’s cost of producing sales and training literature and materials necessary
for a person to become a distributor, a company may avoid having its application fee
categorized as an investment. For this reason, and to avoid the purview of many
business opportunity and anti-pyramiding statutes, to the extent companies require
distributors to purchase starter kits, they should sell them to new distributors at the
company’s cost.

It is also helpful in avoiding classification as an investment for companies to
refund application fees to Distributors who elect to terminate their relationship with the
company.(24) With such a policy in place, payment of the fee presents minimal risk of
loss to a Distributor, and therefore mitigates the potential that it will be deemed an
investment. Consequently, multilevel marketing companies should ensure that their
Policies and Procedures provide that application fees will be refunded if a Distributor
terminates his agreement with the Company within a finite time (e.g., 30 days, 6
months, or 1 year). Companies are further urged to sell their enrollment kits at cost to
keep the initial charge as low as possible.(25)

B. Commonality

The second prong of the Howey test requires that a “common enterprise” exist
between a promoter and an investor. A “common enterprise” is defined as:

[an enterprise] in which the ‘fortunes of the investor are interwoven with
and dependent upon the efforts and success of those seeking the
investment or of third parties.(26)

A common enterprise requires a showing of either “horizontal commonality” or
“vertical commonality.”(27) Horizontal commonality requires a pooling of investors’ funds
into a common fund, and pro-rata distribution of profits from that fund.(28) In order for
horizontal commonality to exist: (1) the participants pool their assets; (2) they give up
any claim to profits or losses attributable to their particular investments; (3) in return
for a pro rata share of the profits of the enterprise; and (4) they make their collective
fortunes dependent on the success of a single common enterprise.(29) Typically, there
is no horizontal commonality between the Company and its Distributors because there
is no pooling of assets between them. Secondly, Distributors usually do not give up
claims to profits attributable to their individual efforts in return for a pro rata share of
the profits of a single enterprise. Each Distributor’s commission is earned when sales
are generated within his sales organization, and is paid regardless whether the
Company has positive or negative earnings for the month. Moreover, the Company’s
corporate earnings are not distributed to Distributors. Because the profits earned by
Distributors and the Company are derived and distributed from completely different
sources, horizontal commonality seldom exists. Nevertheless, companies should be
extremely careful not to offer bonuses or commissions which are related in any way to
company revenues or profits.

Vertical commonality, on the other hand, requires that the “investor and the
promoter be involved in some common venture without mandating that other investors
also be involved in that venture.”(30) In order to find the existence of vertical
commonality sufficient to establish a common enterprise between a promoter and
investor, a direct relation must exist between the success or failure of the promoter and
the individual investor. Vertical commonality usually does not exist in a multilevel
marketing program as the success of a Member’s business is independent of the
success or failure of the Company.

C. Expectation of Profits Solely From the Efforts of Others

The third prong of the Howey test requires that the investor “is led to expect
profits solely from the efforts of the promoter or a third party…” Interpretation of the
word “solely” has generated considerable debate among the courts. This debate has
ultimately lead to a more expansive application of the test than the literal definition
would allow. In Securities and Exchange Commission v. Glenn W. Turner Enterprises,
Inc.
, 474 F.2d 476 (9th Cir. 1973), the Ninth Circuit Court of Appeals refined the third
prong of the test by holding:

[w]e adopt a more realistic test, whether the efforts made by those other
than the investor are the undeniably significant ones, those essentially
managerial efforts which affect the failure or success of the enterprise.(31)

A properly developed multilevel marketing program should not meet this third
prong of the Howey test for two reasons. First, the essential managerial efforts which
affect the failure or success of a direct sales business are the generation of sales and
enrollments, and these functions should be performed exclusively by Distributors – not
by Company employees
. This is a critical issue. Companies, as well as many
distributors, have frequently advised distributors simply to get people to attend
company sponsored meetings. Once the recruits get to the meeting, company
employees will do all of the work by presenting the sales plan, signing up the recruits,
and making the sales. In such situations, the company is engaged in the essential
managerial efforts which make the program operate, and the risk that a court will find
the third prong of the Howey test satisfied is substantial.

Secondly, a properly developed and presented program should avoid violating
the third prong of the Howey test by emphasizing to new Distributors that their success
is dependent on their own efforts and abilities. Distributors should not be advised to
rely on the managerial efforts of their upline or anyone else to build their businesses.
It is for this reason important that companies take action to ensure their sales force
does not promote the program with the all too common representation: “Just get in
and I will put people in for you.”

A particular word of caution is also urged upon companies in relation to the third
prong of the Howey test. It is this element on which the courts have focused in
determining whether a multilevel program constitutes an investment contract security.
Although the test calls for a three-part analysis, some courts have glossed over the first
two elements (or avoided addressing them altogether) when handling MLM cases. For
this reason, companies should take extreme care to avoid any indication that
distributors may rely on the efforts of the company, their distributors, or any other third
party for their success.

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VI. Lotteries

The majority of states have laws that proscribe the operation of a lottery. Lottery
laws were not designed to regulate pyramids, but rather to prevent illegal gambling.
Although lottery laws have been used to prosecute pyramids, more appropriate
vehicles, namely anti-pyramid and multilevel laws, are now used. Consequently, the
application of lottery laws to pyramids and multilevel companies rarely occurs in
regulatory proceedings.(32)

A lottery consists of a disposition of property, on contingency determined by
chance, to a person who has paid valuable consideration for the chance of winning the
prize. California Penal Code 319 defines a “lottery” as:

[A]ny scheme for the disposal or distribution of property by chance,
among persons who have paid or promised to pay any valuable consideration for the chance of obtaining such property or a portion of it, or
for any share or any interest in such property, upon any agreement,
understanding, or expectation that it is to be distributed or disposed of by
lot or chance, whether called a lottery, raffle, or gift enterprise, or by
whatever name the same may be known.

Each of three elements must be present to constitute a “lottery,” namely, a prize,
distribution of the prize by chance, and consideration for the opportunity to win the
prize.

As applied to pyramids, if the element of chance, rather than skill, determines the
receipt of “the prize,” such plans have been held to be lotteries. The most notable case
illustrative of this is U.S. Postal Service v. Unimax, Inc.(33) In Unimax, the Administrative
Law Judge determined that a participant’s compensation was beyond his control, and
thus, determined by chance. Rather than allowing its distributors to place their
downline distributors where they desired in their organization, Unimax assigned
distributors to positions in the downline organization. This resulted in a matrix of
unrelated distributors who were spread throughout the country and were thus, less
controllable.(34) The judge determined that the compensation received by Unimax
distributors was based “principally on the exertions of others over whom they have no
control and no substantial connection . . . (and that) success of such marketers is
determined by chance.”

Under a legitimate multilevel marketing program, a Distributor’s compensation
(the prize) is earned (won) not by chance, but rather by his skill and efforts in building
and maintaining a downline organization. In a lottery analysis, a Member’s efforts in
building his organization would constitute “consideration,” however, this is of no
consequence because the element of “chance” remains absent. Thus, a proper
multilevel program is not a lottery.

Two other similar programs, contests and sweepstakes, are perfectly legal. Each
combines only two of the three “lottery elements.” For example, a contest combines
the elements of prize and consideration, however, the element of chance is absent. In
a contest, the prize is awarded to on the basis of skill rather than luck (e.g., the person
who sells the most cars, or reaches a certain goal faster than his competitors). A
sweepstakes combines the elements of prize and chance, but lacks the element of
consideration. A sweepstakes awards its prize solely on the basis of luck, however, a
participant need not provide “consideration” (anything of value, frequently money or
effort). The most common examples of sweepstakes are magazine sweepstakes.
Although they welcome your purchase, none is necessary to participate.

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VII. Recent Litigation

In recent years, several direct selling companies have been systematically
targeted by plaintiffs’ securities and class action law firms. The first class action was
filed in 1991 by a plaintiffs’ firm from San Francisco against NuSkin International, Inc.
of Provo, Utah. The complaint alleged three counts of securities laws violations, three
counts of the federal racketeering act (RICO), and three counts of common law fraud.
NuSkin settled the case in less than 10 months. The exact amount that the settlement
cost NuSkin is confidential and hence, unavailable to the public. The success of the San
Francisco firm enticed it to file an identical class action complaint later in 1991 against
a second direct selling company, Nikken, Inc. Nikken is a U.S. subsidiary of a Japanese
direct selling organization. Nikken settled its case even faster than did NuSkin. Neither
NuSkin nor Nikken had, at the time of the lawsuits, a 90% inventory repurchase policy.
Interestingly, the remedy fashioned by the parties simply involved allowing distributors
to return resalable products for 90% of their purchase price, less any commissions or
bonuses that had been paid to them. It is widely suspected throughout the direct
selling industry that these settlements cost their respective companies many millions
of dollars.

The San Francisco firm and another plaintiffs’ securities firm out of Boston,
Massachusetts quickly filed multiple “cookie-cutter” complaints against several
medium-size and larger U.S. direct selling companies. Although each company has
handled its defense differently, those that have been careful to structure a legitimate
multilevel marketing plan that include the protections enumerated in this analysis, have
been able to successfully defeat the pyramiding, securities, RICO, and fraud claims.
The significance of these cases underscores the paramount importance of ensuring that
a direct selling company’s marketing/compensation plan is well within the bounds of
federal and state legal constraints.

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VIII. Conclusion

It is equally important that direct sellers also include reasonable mechanisms in
their programs to prevent the risks of pyramiding, securities violations, lotteries,
business opportunities, and other legal maladies. This requires: (1) distributor
agreements; (2) policies and procedures; and (3) the enforcement of policies and
procedures intended to ensure the legitimacy of the program. Indeed, in the
Omnitrition decision discussed above, one of the reasons the Ninth Circuit Court of
Appeals rejected the defendant’s arguments that its plan was not a pyramid was based
on the finding that the company failed to provide sufficient evidence that it actually
enforced its policies. Although the company had policies in place identical to those
implemented by Amway, the court stated that the mere existence of policies, without
evidence of enforcement, renders the policies nugatory. Multilevel companies are
therefore well advised that “staying legal” requires much more than developing a
program that meets state and federal requirements. Rather, it is an ongoing process
that calls for vigilance and action to ensure that distributors stay within the rules.

In summary, the emphasis of any multilevel program must be on product sales
rather than the enrollment of new distributors. To exist in the 90s and beyond,
companies and distributors must make a paradigm shift from business based primarily
upon recruitment of downline distributors and internal consumption. Distributors
should be taught that their primary function is to gather customers. Their second
priority is to build a downline and to teach it about the first priority. To assist you in
developing a multilevel marketing program, we have developed the non-exhaustive list
of suggestions below.

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Footnotes

1. These states include Georgia, Louisiana, Maryland, Massachusetts, Puerto Rico, and Wyoming.

2. Georgia Code 10-1-410.

3. Statutes do not define the terms “supply” or “distribute.”

4. Unlike the United States, Canada has passed federal anti-pyramid legislation. See Section 55
of the Competition Act.

5. 86 F.T.C. 1106, 1180 (1975).

6. 79 F.3d 776 (1996)

7. For example, Section 10-1-415(d) of the Georgia Code provides:

(1) If the participant has purchased products or paid for administrative services while
the contract of participation was in effect, the seller shall repurchase all unencumbered products,
sales aids, literature, and promotional items which are in a reasonably resalable or reusable
condition and which were acquired by the participant from the seller; such repurchase shall be
at a price not less than 90 percent of the original net cost to the participant
of the goods being
returned . . .

(Emphasis added.) The 90% buy back requirement is also a condition of membership in the Direct
Selling Association (“DSA”).

8. There is some protection afforded to multilevel companies. In certain circumstances, goods
which are no longer marketed by a multilevel company not need be repurchased if they were sold to
participants as nonreturnable, discontinued, or seasonal items and the nonreturnable, discontinued, or
seasonal nature of the goods was clearly disclosed to the participant seeking to return the goods prior
to the purchase of the goods by the participant.

9. “Member” means a status by which any natural person is entitled to any of the benefits of a club.
Minn. Stat., Chapter 325G.23., Subd. 7.

10. Minn. Stat., Chapter 325G.23., Subd. 6.

11. The definitions of a buying club in Kentucky, New Hampshire, South Dakota, Tennessee, to
name but a few, are identical to Minnesota’s. In Florida, a “buying service,” “buying club,” or “club”
means “any corporation, nonprofit corporation, partnership, unincorporated association, cooperative
association, or other business enterprise which is organized with the primary purpose of providing
benefits to members from the cooperative purchase of service or merchandise and which desires to
effect such purpose through direct solicitation or other business activity.” Florida Statutes Annotated
559.3902. North Carolina defines a “discount buying club” is “any person, firm or corporation, which
in exchange for any valuable consideration offers to sell or to arrange the sale of goods or services to
its customers at prices represented to be lower than are generally available.” General Statutes of North
Carolina, 66-131.

12. Every buying, health, or social referral club doing business in this state shall register with the
attorney general and provide all information requested on forms the attorney general provides. The
person shall furnish the full name and address of each business location where the club’s memberships
are sold as well as any other registration information the attorney general considers appropriate. Minn.
Stat., Chapter 325G.27., Subd 1(a).

13. The initial registration fee in Minnesota is $250. For each year thereafter, the fee is $150. Minn.
Stat., Chapter 325G.27., Subd 1(b). Registration fees should be paid in each state in which your
company is doing business.

14. Minn. Stat., Chapter 325G.24. states:

Any person who has elected to become a member of a club may cancel such
membership by giving written notice of cancellation any time before midnight of the
third business day following the date on which membership was attained. Notice of
cancellation may be given personally or by mail. If given by mail, the notice is effective
upon deposit in a mailbox, properly addressed and postage prepaid. Notice of
cancellation need not take a particular form and is sufficient if it indicates, by any form
of written expression, the intention of the member not to be bound by the contract.
Cancellation shall be without liability on the part of the member and the member shall
be entitled to a refund, within ten days after notice of cancellation is given, of the entire
consideration paid for the contract. Rights of cancellation may not be waived or
otherwise surrendered.

15. Minn. Stat., Chapter 325G.25. provides

A copy of every contract shall be delivered to the member at the time the contract is
signed. Every contract must be in writing, must be signed by the member, must
designate the date on which the member signed the contract and must state, clearly and
conspicuously in bold face type of a minimum size of fourteen points, the following:

“MEMBERS’ RIGHT TO CANCEL”

“If you wish to cancel this contract, you may cancel by delivering or mailing a
written notice to the club. The notice must say that you do not wish to be bound by the
contract and must be delivered or mailed before midnight of the third business day after
you sign this contract. The notice must be delivered or mailed to: (Insert name and
mailing address of club). If you cancel, the club will return, within ten days of the date
on which you give notice of cancellation, any payments you have made.”

If the contract does not contain this notice, it may be canceled by the member at any time by
giving notice of cancellation by any means.

16. Florida Statutes Annotated, 559.3904.

17. Minn. Stat., Chapter 325G.28. requires the Attorney General to investigate and prosecute
violations of the buying club statutes.

Subdivision 1. The attorney general shall investigate violations of sections
325G.23 to 325G.28, and when from information in his possession he has reasonable
ground to believe that any person has violated or is about to violate any provision of
sections 325G.23 to 325G.28, or that any club is insolvent, he shall be entitled on behalf
of the state

(a) to sue for and have injunctive relief in any court of competent
jurisdiction against any such violation or threatened violation without abridging
the penalties provided by law;

(b) to sue for and recover for the state, from any person who is found to
have violated any provision of sections 325G.23 to 325G.28, a civil penalty, in an
amount to be determined by the court, not in excess of $25,000; and in case the
club has failed to maintain the bond required by sections 325G.23 to 325G.28,
or is insolvent or in imminent danger of insolvency, to sue for and have an order
appointing a receiver to wind up its affairs. All civil penalties recovered under
this subdivision shall be deposited in the general fund of the state treasury.

18. See 16 C.F.R. 436.

19. MD Bus. Reg. 14-103.

20. Indiana Revised Statute 24-5-8-1.

21. Minnesota Statute, Section 325F.69., Subd. 2. provides:

Referral and chain referral selling prohibited. (1) With respect to any sale or lease the
seller or lessor may not give or offer a rebate or discount or otherwise pay or offer to
pay value to the buyer or lessee as an inducement for a sale or lease in consideration
of the buyer’s or lessee’s giving to the seller or lessor the names of prospective
purchasers or lessees, or otherwise aiding the seller or lessor in making a sale or lease
to another person, if the earning of the rebate, discount or other value is contingent
upon the occurrence of an event subsequent to the time the buyer or lessee agrees to
buy or lease.

22. See SEC v. Glenn W. Turner Enterprises, Inc., 348 F. Supp. 766 (D. Ore. 1972), aff’d 474 F.2d
476 (9th Cir. 1973), cert. denied 414 U.S. 821 (1973).

23. 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946).

24. In a comprehensive securities and pyramiding analysis, the Federal Trade Commission
analyzed the Amway marketing plan in In the Matter of Amway Corporation, Inc., 93 F.T.C. 618 (1979).
The FTC carefully considered Amway’s requirement that an individual purchase a $15.60 sales literature
kit to become a distributor in order to determine if the purchase constituted an investment sufficient to
warrant a finding that the Amway plan constituted an illegal pyramid and an unregistered security. The
FTC’s initial decision held there was no investment involved in the purchase of the sales kit:

[t]he Amway system does not involve an “investment” in inventory by a new distributor.
(Finding 61) A kit of sales literature costing only $15.60 is the only requisite. (Finding
34) And that amount will be returned if the distributor decides to leave Amway.
(Finding 37)

93 F.T.C. at 700.

25. It is important that sales kits be sold “at cost” for purposes of avoiding pyramid classification
as well as securities investment classification. If profits are made on the sale of starter kits, it can be
deemed an initiation or headhunting fee under a pyramid analysis.

26. Brodt v. Bache & Co., Inc., 595 F.2d 459, 460 (9th Cir. 1978), quoting SEC. v. Glenn W. Turner
Enterprises, Inc.
, 474 F.2d 476, 482 n. 7 (9th Cir. 1973).

27. Hocking v. Dubois, 885 F.2d 1449, 1455 (9th Cir. 1989).

28. Brodt, 595 F.2d at 460.

29. Hocking v. Dubois, supra, 885 F.2d at 1459.

30. Brodt, 595 F.2d at 461.

31. 474 F.2d at 482.

32. Although violation of anti-lottery laws is not a primary focus in most regulatory actions, it is
commonly included as a cause of action in civil actions brought by private party plaintiffs against
multilevel companies. Multilevel companies are therefore advised to be cognizant of lottery issues,
particularly when developing promotional programs and sales contests for their distributors.

33. P.S. Docket No. 28/77, June 10, 1988.

34. Also of significance was the lack of any training or supervisory requirement upon upline
distributors.

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