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Multilevel Marketing Primer–The MLM Startup

September 30, 2019

Legal Principles of Multilevel Marketing

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Entrepreneurs contemplating launching a multilevel marketing program (and management of existing companies too!) need to be aware that there are several consumer protection laws that could be violated if their multilevel program is not properly structured or operated. The founders of virtually every multilevel startup company that we have worked with over the past 30 plus years have been aware of the existence of anti-pyramid laws and that there is some potential for an improperly designed or executed multilevel program to violate those laws. The vast majority of them, however, have been surprised to learn that there are other consumer protection laws that ill-conceived or poorly designed multilevel programs may unwittingly violate.

The purpose of this article is to introduce you to not only anti-pyramid laws, but also to those other, lesser known, laws that both new and existing multilevel companies need to be aware of. Below, we will introduce you to anti-pyramid, buying club, business opportunity, securities, referral sales, and lottery laws and how companies can avoid their potentially devastating impacts. If after reading this article you have questions, we are happy to have a conversation with you.

I. Multilevel Marketing/Pyramids

Federal and state multilevel marketing and anti-pyramid laws and 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. Such programs have cost their participants hundreds of millions (if not billions) of dollars.

Whether a program isa 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 recruitment or enrollment of other participants (i.e., distributors) into the program, itis a pyramid.

A. Legislative Intent and Judicial Interpretation

Asa 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 aspect of the analysis involves 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 merely for the introduction of additional participants (aka distributors) into the program? Or, does the compensation plan, as written, appear to compensate participants 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 incentivize? Does it incentivize the recruitment of additional distributors? Or does the plan incentivize sales by participants? 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 the sales of products or services to consumers), 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 (“F.T.C.”) litigation and enforcement actions.

State Statutory Approaches

While virtually every state has an anti-pyramid statute, a minority of states specifically define and regulate multilevel marketing plans. Georgia is an example of such a state. Georgia’s statute regulating multilevel marketing programs 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.

Ga. Code § 10-1-410.

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

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

Elements of a Multilevel Compensation Plan

  1. A person, firm, corporation or other entity;
  2. Which a) sells; b) distributes; or c) supplies;
  3. For consideration;
  4. Goods or services;
  5. Through independent agents, contractors, or distributors;
  6. At different levels;
  7. Participants may recruit other participants; and
  8. Compensation 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?

State Statutory Approaches

The vast majority of states utilize an indirect approach to the regulation of multilevel marketing programs 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. Georgia, in addition to defining what a multilevel marketing plan is, also has a statute defining a “pyramid promotional scheme” as:

any plan or operation in which a participant gives consideration for the right to receive compensation that is derived primarily from the recruitment of other persons as participants into the plan or operation rather than from the sale of goods, services, or intangible property to participants or by participants to others.

Ga. Code §16-12-38(a)(8).

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 solicitor 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.

Texas statutes contain a similar definition for “pyramid promotional scheme.”

“Pyramid promotional scheme” means a plan or operation by which a person gives consideration for the opportunity to receive compensation that is derived primarily from a person's introduction of other persons to participate in the plan or operation rather than from the sale of a product by a person introduced into the plan or operation.

Tex. Bus. & Com. Code § 17.461.

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 Scheme - State Statutes

  1. A scheme, plan, or program;
  2. For which a participant gives consideration to join;
  3. For the right or chance to receive compensation or other things of value; and
  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 anti pyramid legislation.

Federal Law

There is no federal anti-pyramid statute or regulation in the United States. Nevertheless, decisions of the F.T.C. 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 case In the Matter of Koscot Interplanetary, Inc.,86 F.T.C. 1106 (1975). Therein, the F.T.C. held that pyramids 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 Scheme - Federal Law

  1. Payment of monety 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; and
  4. The compensation is unrelated to the sale of products or services to "ultimate users".

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 safe guards into its plan.

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

Substantiatable Sales of Products (or Services) 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.

Keep in mind that there are two types of inventory loading. The more commonly recognized type of inventory loading occurs where new recruits are required or pressured to purchase large quantities of products (that are 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.

The other type of inventory loading involves distributors personally purchasing the minimum required amount of products (or subscribing to services) each month in order to maintain their eligibility to earn multilevel compensation under the compensation plan. Whether such purchases are required by the terms of the compensation plan or are tacitly expected, this is a form of inventory loading. Distributors are, in essence, buying or investing their way to qualification.

In addition, there often is 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 fact that there is a sale of products in an inventory loading scenario, 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.

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 reluctance of most people to engage in sales. Historically, the entire MLM industry has been built almost entirely upon the personal consumption of products by distributors. Under a literal interpretation of the definition of a pyramid in Koscot, personal consumption satisfies the second element of the test because distributors can be classified as “ultimate users” if they personally consume or use the products or services that they purchase. Indeed, MLM companies have traditionally considered members of their sales force to also be customers and thus taken the position that so long as distributors were purchasing the products, they were “ultimate users” so their programs could not be pyramid schemes.

The F.T.C., on the other hand, has steadfastly taken the position that the term “ultimate users” means persons who are not participants in the MLM program, that is to say persons who are not distributors. Until relatively recently, there was caselaw support for the F.T.C.’s position. In the case Webster v. Omnitrition International, Inc., 79 F.3d 776 (9th Cir. 1996) the court found that personal consumption by a distributor’s downline does not satisfy the Koscot requirement that sales be to the “ultimate user.”

In 2014, these competing views of whether an MLM company’s distributors can be deemed “ultimate users” under Koscot were addressed in the case Federal Trade Commission v. Burnlounge, Inc., 753 F.3d 878 (9th Cir. 2014). As it turns out, the court in Burnlounge decided that neither view was right and neither view was wrong. In something of a victory for the multilevel marketing world, the court stated that an MLM company’s own salesforce members can be ultimate users if their motives for purchasing the company’s products or services are primarily driven by consumer demand for the product or service and not by any financial incentives contained within the company’s marketing plan.

The takeaway is that an MLM company’s distributors will not be “ultimate users” if their motives to purchase the company’s products or services are primarily driven by financial incentives that are built into the compensation plan. Thus, if a compensation plan is designed so that distributors are either required in fact or required in practice (i.e., tacitly expected) to purchase the company’s products or services (“inventory loading”), and to recruit other distributors to repeat the process, then distributors are not bona fide “ultimate users” and the sales to distributors are actually “participation fees” that are incidental to earning under the compensation plan. As such, distributors are being paid to recruit other participants (this is also known as “headhunting”) and the program is a pyramid scheme unless the distributors subsequently re-sell the products that they purchase to retail customers.

From a compensation plan design perspective, this leads to two critical factors:

  1. A plan should remove, or dramatically reduce, financial incentives for distributors to buy the company’s products/services; and
  2. A plan should contain strong financial incentives for distributors to SELL the company’s products/services to CUSTOMERS. Indeed, a plan can hard-wire retail sales requirements into the program that forces distributors to generate sales to customers.

Moreover, when designing a multilevel marketing plan, the approach presenting the least risk is to institute and enforce a rule that at least 70% of sales attributable to a distributor result in true retail sales to persons who do not participate in the compensation program.

Inventory Repurchase Requirements

As noted above, some states have statutes that regulate multilevel marketing. Those statutes require multilevel companies to contractually agree to repurchase inventory and sales aids that is returned by their distributors. For example, Georgia law provides:

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 . . .

Ga. Code §10-1-415(d)(1) (emphasis added).

Note also that the 90% buy back requirement is also a condition of membership in the U.S. Direct Selling Association (“DSA”). 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. Note that there is some protection afforded to multilevel companies. In certain circumstances, goods which are no longer marketed by a multilevel company do not need be repurchased if when they were sold to participants, they were clearly identified at the time of sale as being nonreturnable, discontinued, or seasonal items.

We emphatically recommend that all MLM companies include a 90% (or higher) repurchase policy in their agreements with their distributors. If included in the agreement, the repurchase policy should also 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 number 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 its members.

While the statutory definition of a buying club varies among the states that have buying club laws, there are two basic models that these statutes fall into. In some states, whether or not a program is a buying club depends on whether or not the benefits that flow to members are a result of the buying clout of the organization. For example, Minnesota defines a buying club as “any corporation, partnership, unincorporated association or other business enterprise organized for profit with the primary purpose of providing benefits to members from the cooperative purchase of services or merchandise.” Minn. Stat. § 325G.23 Subd. 6 (emphasis added).

Arizona, on the other hand, defines a buying club as a “person, corporation, unincorporated association or other organization that, for a consideration, provides or purports to provide its clients or the clients or members of any other discount buying organization with the ability to purchase goods or services at discount prices.” Ariz. Stat. § 44-1797(3).

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 claiming to offer discounted merchandise to its members may result in that organization being a buying club.

Elements of a Buying Club

  1. A for profit business enterprise;
  2. That has members;
  3. Primary purpose of the business enterprise is to provide benefits tomembers (i.e., discounted goods or services); and
  4. The business enterprise advertises/promotes such benefits.

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 complications to doing business exist as buying club status triggers several requirements, including: (1) registration with the state (usually the Attorney General); (2) the payment of a registration fee; (3) the posting of a bond; (4) a right of cancellation; and (5) notice of the right of cancellation on the membership agreement. Additionally, some states make even more burdensome demands. For example, Florida requires that if a buying club or any of its agents (including, 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:

all 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.

Fl. Stat. § 559.3904(5).

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. 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

Just over half of the states have enacted “business opportunity” (aka “seller-assisted marketing plan”) 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 many 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 with 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 money may be made.

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

  1. Sale or lease or offer to sell or lease any goods or services;
  2. To a purchaser (i.e., a distributor);
  3. That are to be used by the purchaser (i.e., distributor) in starting or operating a business;
  4. Involves an initial payment by the purchaser of more than $200; and
  5. Involves a solicitation of purchasers (i.e., distributors) in which the seller (i.e., the MLM company) represents that: a) the seller will provide a sales or marketing plan to the purchaser (distributor); or b) a market exists for any goods to be made or services to be rendered by the purchaser; or c) the seller may buy from the purchaser any goods to be made or services to rendered by the purchaser; or 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.

Virtually every multilevel program meets elements 1, 2, 3, and 5. Element 5 is met as every multilevel program provides its distributors with a marketing plan. If a multilevel program requires its distributors to pay $200 or more to join, the multilevel marketing company must comply with the business opportunity requirements of each state that has a business opportunity law.

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 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. In some states, purchasers enjoy expansive rights to rescind their contracts. In some states, there may be a waiting period of as long as 10 days from the date that the opportunity is presented before a prospect may sign up. Further, bonding is required in some of the business opportunity regulating states.

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. If the initial investment falls below the applicable threshold, the promoter need not comply with the burdensome business opportunity law requirements. However, to make matters difficult, the threshold differs among states. In the majority of the states that have a business opportunity law, the threshold is $500.00. The threshold in some states however, is as low as $200.00.

Itis 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.” Among the states with business opportunity laws, there is some difference as to what constitutes an “initial investment.” In about half of the business opportunity regulating states, all required purchases or payments within the first six months of joining a program comprise the “initial” investment or payment. Other states specify that the “initial” investment or payment extends for the first year of the 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.”

Therefore, in order to avoid having to comply with the onerous business opportunity law requirements of all states, we strongly recommend that all purchases and payments required from a new distributor not exceed $200 over the first year of the distributor agreement and that such amounts be “at cost” amounts for sales aids and tools and product samples. This would include payments for mandatory starter kits, mandatory replicated website and back-office subscriptions, mandatory technology fees, mandatory enrollment fees, etc.

Note that there is a Federal Business Opportunity Rule administered by the F.T.C. - 16 CFR 437. However, the rule making record makes clear that the Federal Business Opportunity Rule is not intended to apply to multilevel marketing businesses. That could change in the future. The F.T.C. has indicated an intention to amend the federal rule to include multilevel marketing in its coverage.

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IV. Referral Sales

A “referral sale” is typically defined as a sales technique in which a seller offers to give a discount, prize, rebate, or other compensation to a prospective customer as an inducement for a sale to the prospective customer and the receipt of the benefit requires the prospective customer to give the names of other prospective customers to the seller, if earning the prize, discount, rebate, or other compensation is contingent upon a sale to one or more of the “referred” customers. That’s quite a mouthful. Maybe an example would help: A salesperson tells a customer “hey customer, if you give me the names of other potential customers and at least one of those customers buys from me, I will give you a$100 rebate if you buy the widget that I am trying to sell to you today.” To the surprise of most people, particularly salespersons, referral sales are illegal throughout the United States.

For example, the Texas Deceptive Trade Practices Act classifies referral sales (referred to in the act as “chain referral sales”) as a false, misleading, or deceptive act or practice:

(a) False, misleading, or deceptive acts or practices in the conduct of any trade or commerce are hereby declared unlawful and are subject to action by the consumer protection division . . .

(b) . . . the term "false, misleading, or deceptive acts or practices" includes, but is not limited to, the following acts:

. . .

(19) using or employing a chain referral sales plan in connection with the sale or offer to sell of goods, merchandise, or anything of value, which uses the sales technique, plan, arrangement, or agreement in which the buyer or prospective buyer is offered the opportunity to purchase merchandise or goods and in connection with the purchase receives the seller's promise or representation that the buyer shall have the right to receive compensation or consideration in any form for furnishing to the seller the names of other prospective buyers if receipt of the compensation or consideration is contingent upon the occurrence of an event subsequent to the time the buyer purchases the merchandise or goods;

Tex. Bus. & Com. Code § 17.46.

Elements of a Referral Sale

  1. Seller offers or promises one of the following to a prospective customer: a) a price reduction; b) a rebate; c) a commission; d) credit; or e) other consideration;
  2. As an inducement for a sale or lease;
  3. The prospective customer must provide the names of other potential customers to the seller; and
  4. The prospective customer’s receipt of the promised consideration is contingent upon the seller’s ability to make a sale to one of the customers referred by the prospective customer.

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.

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. 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. Unfortunately, none of these statutes define the term. However, the United States Supreme Court, in Securities & Exchange Commission v. W. J. Howey Company, 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed.1244 (1946), set forth the following three-prong test for 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, . . .

328 U.S. at 298 –299.

Elements of a Security

  1. An investment of money;
  2. Common enterprise; and
  3. Persons are led to expect profits from the efforts of the promoter or a third party.

Each of these elements bear a little more discussion.

A. An Investment of Money

The fact that a new distributor must purchase a starter kit, pay an enrollment fee, or subscribe to a replicated website and/or back-office tool lends itself to an argument that “an investment” is required to become a distributor. Indeed, if the payment is excessive, it will be classified as “an investment.” However, if the payment is low and only covers the company’s cost of producing sales and training literature, tools, and materials necessary for a person to become a distributor, a company may avoid having the payment 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 or pay enrollment fees, 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 these payments to distributors who elect to terminate their relationship with the company. In a comprehensive securities and pyramiding analysis, the F.T.C. analyzed the Amway marketing plan in In the Matter of Amway Corporation, Inc., 93 F.T.C. 618 (1979). The F.T.C. carefully considered Amway’s requirement that an individual purchase a 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 F.T.C.’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)

With such a refund policy in place, the purchase or payment of the fee to join as a distributor 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 such purchases and fees will be refunded if a distributor terminates his agreement with the company within a finite time (e.g., 1 year). Companies are further urged to sell their enrollment kits at cost to keep the initial charge as low as possible. (It is important that sales kits and enrollment fees 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 or on the collection of enrollment fees, such payments can be deemed an initiation or headhunting fee under a pyramid analysis.)

B. Common Enterprise/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.’” 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).

A common enterprise requires a showing of either “horizontal commonality” or“ vertical commonality.” Hocking v. Dubois, 885 F.2d 1449, 1455 (9th Cir. 1989).

Horizontal commonality requires a pooling of investors’ funds into a common fund, and pro-rata distribution of profits from that fund. Brodt, 595 F.2d at 460. 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. Hocking v. Dubois, 885 F.2d at1459.

Typically, there is no horizontal commonality between an MLM 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 of 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 anyway 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.” Brodt, 595 F.2d at 461. 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 distributor’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 led 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 amore 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.

474 F.2d at482.

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 the MLM company’s employees. This is acritical 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. For this reason, it is 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 prohibit the promotion or 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. That said, allegations of violation of anti-lottery laws are 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.

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. For example, California 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.

Cal. Penal Code § 319.

Each of three elements must be present to constitute a “lottery,” namely, (1) a prize, (2) distribution of the prize by chance, and (3) consideration paid or given 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., P.S. Docket No. 28/77, June 10, 1988. In Unimax, the Administrative Law Judge (“ALJ”) 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. The ALJ 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.” Also of significance was the lack of any training or supervisory requirement upon upline distributors.

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 inbuilding and maintaining a downline organization. In a lottery analysis, a distributor’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 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 properly designed sweepstakes awards its prize solely on the basis of luck, however, a participant need not provide “consideration” (anything of value, frequently money or effort). While most sweepstakes promoters welcome your purchase, none is necessary to participate.

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VII. 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 current regulatory and legal environment, 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 sell products and acquire customers. Their second priority is to build a team and to train the team about the first priority.

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