The event having the greatest impact on the course of the multilevel marketing industry in the last decade was the Ninth Circuit Court of Appeals' decision in Webster v. Omnitrition International, Inc. 2 The restrictions placed on the industry are, in some cases, groundbreaking. Other limitations are simply a restatement of well established principals that have governed the industry for the last twenty years. This article will discuss the Ninth Circuit's decision, how it impacts your business, and explore measures that can be taken to meet the standards it sets.
Omnitrition marketed nutritional supplements through a multilevel marketing program. Its distributors could purchase products at a 20% discount from suggested retail and sell them at retail. At the lowest distributor level there was no obligation to purchase or sell products. However, the lowest level distributors were not entitled to receive commissions on the sales of their downline. To receive commissions on downline sales, a distributor was required to become a "supervisor." The lowest level supervisor position ( the "bronze" level), required the distributor to purchase $2,000.00 in merchandise in one month, or $1,000.00 in two consecutive months.
In 1992 various Omnitrition distributors filed a class action lawsuit against the company, its principals, and its outside attorneys. The complaint alleged that Omnitrition operated a pyramid scheme, violated federal securities laws, the civil RICO (Racketeering Influence and Corrupt Organizations Act) statute, and state fraud laws through the creation, promotion and marketing of Omnitrition distributorships. In 1994 the trial court dismissed the case against Omnitrition. The plaintiffs appealed the trial court's decision to the United States Ninth Circuit Court of Appeals. On appeal, the Ninth Circuit found numerous factual questions existed which should be resolved by a jury and therefore reversed the trial court's dismissal and remanded the case back to the trial court.
The starting point for the Ninth Circuit's pyramid analysis of the Omnitrition marketing program was a review and adoption of the longstanding definition of a pyramid contained in the F.T.C.'s decision in Koscot Interplanetary, Inc. 3 Therein the F.T.C. defined a pyramid as:
[c]haracterized by the payment by participants of money to the company in return for which they 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.
The Koscot pyramid test does not break new ground. It has been on the books for over 20 years and has been cited in numerous pyramid cases. However, in applying the test to the Omnitrition program, the Ninth Circuit set new implementation standards which must be met by MLMs if they are to avoid operating as a pyramid.
The Ninth Circuit makes it painfully clear that commissions paid to distributors must be directly tied to retail sales. The court stated: "The key to any anti-pyramiding rule ... where the basic structure serves to reward recruitment more than retailing, is that the rule must serve to tie recruitment bonuses to actual retail sales in some way." 4 This appears a straightforward requirement, but the court threw several obstacles in the way of traditional methods of tying commissions to retail sales.
a. Products Purchased by a Distributor for Personal Consumption do not Qualify as a Retail Sale
The court stated that sales to persons who are participants in the company's compensation program do not qualify as "retail sales" for purposes of satisfying the Koscot test. This interpretation of the Koscot test 5 precludes companies from paying commissions on products sold to distributors for personal consumption. This is contrary to the foundation of many MLM programs, where personal consumption by distributors is the driving force powering sales.
The court's reason for requiring that commissions be based on sales to non-distributors rests on its belief that mandatory minimum distributor purchases foist inventory on people who may not want the products or be able to sell them. Rather, the real reason for the purchase is simply to participate in the compensation plan. The facts of the Omnitrition case presented the court with compelling evidence that enrollments rather than sales were the driving force that supported the program. A key factor upon which the court focused was evidence that under the Omnitrition program, distributors were encouraged to buy large amounts of merchandise ($2,000.00 per month) and simply "give them away" in order to participate in Omnitrition's "proven plan of success." The message in this practice is that the product is irrelevant - all that matters is getting people enrolled. Once enrolled, new distributors will make their required purchases whether they can sell the merchandise or not. These mandatory sales drive the compensation plan. In the Ninth Circuit's view, companies operating under this scenario are promoting inventory loading. Although there is a sale of a legitimate product involved, the court will regard the product as nothing more than a facade to camouflage a pyramid scheme.
b. Inventory Loading - A New Standard?
Inventory loading is the principal evil which anti-pyramid laws seek to prevent. The danger presented by inventory loading is that companies may saddle distributors with large quantities of expensive inventory which they cannot resell or return for a refund. For the last 18 years, the multilevel marketing industry has operated under the F.T.C.'s definition of "inventory loading" which was handed down In the Matter of Amway Corporation, Inc. 6 In the Amway decision, the F.T.C. defined "inventory loading" as a practice which "[requires] a person seeking to become a distributor to pay a large sum of money, ..., for the purchase of a large amount of nonreturnable inventory."
One of the key terms in the definition of "inventory loading" is the word "nonreturnable." Companies have traditionally avoided inventory loading by implementing inventory repurchase policies for distributors who elect to cancel their distributorship agreements. Inventory repurchase policies (sometimes called "buyback" policies) ensure that distributors can recover much or all of their inventory and sales aid expenditures if the business does not meet their expectations. Therefore, the financial risk associated with participating in a multilevel marketing program is minimal. However, the Omnitrition court issued a new definition of "inventory loading" which completely changes the direction companies must take to avoid inventory loading. The Ninth Circuit's new definition provides:
'Inventory loading' occurs when distributors make the minimum required purchases to receive recruitment-based bonuses without reselling the products to consumers. 7
The court provided no basis for this definition. In fact, it omits all reference to the Amway decision's definition of "inventory loading." Rather, the court placed this definition in a footnote, seemingly as an afterthought. However, the court's new definition has a dramatic impact on the MLM industry. First, it arguably removes an inventory repurchase policy as a defense to an inventory loading allegation. Secondly, it places in jeopardy those MLM programs that require distributors to produce minimum sales volumes to qualify for commissions. Unless the distributors resell the products, the company is engaged in inventory loading, even if the quantity of required purchases is small enough that it can easily be personally consumed by the distributor.
c. Commissions Must be Calculated Based on Actual Sales to Retail Customers
It is common for companies to calculate commissions to their distributors based on the volume of merchandise purchased by their downline organizations, whether at wholesale, suggested retail, or on a point basis. Companies can track these figures and calculate commissions with relative ease. The Omnitrition court determined that such a practice does not sufficiently tie commissions to retail sales. The court stated that payment of compensation based on the volume of merchandise ordered by a distributor is facially unrelated to the sale of product to ultimate users. 8
Prohibiting commissions from being calculated on purchases made by distributors creates enormous operational difficulties for companies. With the right software, tracking a distributor's purchases is a relatively simple process. On the other hand, few, if any, companies have the infrastructure allowing them to determine how much product has been sold to retail customers versus how much has been personally consumed by the distributor. Most companies simply rely on distributors' certifications that they have resold 70% of their prior order before ordering more merchandise.
d. Traditional Safeguards to Avoiding Pyramid Classification Are Not a Guaranteed Safety Net.
Most MLMs incorporate some form of the traditional "Amway safeguards" into their programs under the belief that these policies will protect them from operating as a pyramid. These safeguards are: 1) distributors must sell to ten retail customers each month; 2) distributors must resell 70% of the product they purchase every month; and 3) if a distributor elects to cancel his or her distributorship, the company will repurchase the distributor's remaining inventory at 90% of the cost paid by the distributor. Omnitrition incorporated these safeguards into its program, but the court nevertheless found that the mere existence of these safeguards did not deter inventory loading and promote retail sales to the degree necessary to insulate the company from operating as a pyramid.
1) The Ten Customer Rule
Omnitrition required its distributors to sell to ten customers per month to qualify for commissions. To ensure compliance with this rule, the company would randomly survey members of its distributor force and inquire about retail sales. The court found that this rule, even though enforced, was insufficient to tie commissions to retail sales. The basis for the court's analysis was the fact that Omnitrition required its distributors to purchase "thousands of dollars" worth of merchandise per month to qualify for upper level (supervisor level) commissions. The court held: "[T]hat some amount of product was sold by each supervisor to only ten customers each month does not insure that overrides are being paid as a result of actual retail sales." 9
One of the messages in the court's ruling is that the number of retail customers which a company requires its distributors to service each month must be proportionate to the amount of inventory required to be purchased. For example, by requiring distributors to purchase $2,000.00 of inventory per month, and selling to only ten customers, each customer would have to buy an average of $200.00 of nutritional supplements. This is an unrealistic assumption. If however, a company requires its distributors to purchase $200.00 worth of inventory per month, and sell to a minimum of five customers, for an average sale of $40.00 per customer, a far more realistic scenario exists.
A minimum customer rule that has a rational relationship to the amount of required inventory purchases, although an important step, is not in and of itself sufficient to actually deter inventory loading and to promote retail sales. The second Amway safeguard, the 70% rule, must be implemented to ensure that regardless of the number of customers, the majority of the inventory is being resold to retail customers and is not gathering dust in distributors' basements and garages.
2) The 70% Rule
Omnitrition required its distributors to "certify" that they sold 70% of the merchandise they had previously purchased before becoming eligible to receive commissions. The court held that Omnitrition failed to present evidence that it enforced the rule, nor that the rule actually served to deter inventory loading. In fact, the court emphasized two points that made it unlikely the 70% rule tied commissions to retail sales: 1) the requirement could be satisfied by sales to the distributor's downline; and 2) the requirement could be satisfied by distributors' personal consumption of the merchandise they purchased from Omnitrition. 10
The court's analysis of Omnitrition's application of the 70% rule is one of the strongest statements in the decision that sales to distributors do not qualify as a sale to the ultimate user. On this point, the court held:
[P]laintiffs have produced evidence that the 70% rule can be satisfied by a distributor's personal use of the products. If Koscot is to have any teeth, such a sale cannot satisfy the requirement that sales be to "ultimate users" of a product. 11
To further drive home the point that distributors are not the "ultimate users" (retail customers) of Omnitrition's products, the court pointed out that the company does not treat distributors the same as true retail customers. Under Omnitrition's product satisfaction guarantee, retail customers are entitled to return the products within 30 days for a refund. This same offer was not extended to distributors who purchased Omnitrition products for personal consumption. 12
3) Inventory Repurchase Rule
In attacking Omnitrition's inventory repurchase rule, the court again stated that Omnitrition presented no evidence that it actually repurchased excess inventory from distributors who elected to cancel their distributorships. Fortunately for the multilevel marketing industry, enforcement of an inventory repurchase policy does not present a major problem. Indeed, if a company has a buy-back policy, but does not honor it, there are few industry members that will sympathize with the company because such conduct gives the entire industry a bad reputation. 13
What is more disturbing about the court's analysis of the inventory repurchase rule is that it focused on two points which it asserted made Omnitrition's buy-back policy weaker than the Amway policy. First, the court focused on the fact that Omnitrition only refunded 90% of the price of the of the product returned. This is problematic because 90% is the standard refund rate for inventory repurchases in the MLM industry. This is not by coincidence, as all six jurisdictions which statutorily regulate MLMs uniformly specify that a 90% refund is acceptable. 14 Although the Ninth Circuit did not specifically hold that a 100% inventory repurchase is required, subsequent courts can certainly make this inference as the Ninth Circuit has questioned whether a 90% rate is adequate. Moreover, the court's position potentially creates an inconsistency between state and federal law which companies can only reconcile if they have a 100% inventory repurchase policy.
The second reason why the court stated that Omnitrition's inventory repurchase policy was weaker than the Amway policy, and therefore does not deter the possibility of inventory loading, is that under the Omnitrition policy, the company will only repurchase consumable products if they are less than three months old. On this point, the court observed:
Omnitrition will only repurchase consumable products (the majority of what it sells) if they are less than three months old. The latter fact is very significant. The buy-back rule is only effective if it can reduce or eliminate the possibility of inventory loading by insuring that program participants do not find themselves saddled with thousands of dollars worth of unsaleable products. Omnitrition's rule potentially would not achieve this goal for any person who participated in the program for more than three months. 15
Although Omnitrition's three month buy-back policy is on the shorter end of policies adopted by industry members, it is not totally lacking in support. Maryland specifies in its MLM statute that buy back provisions must last at least three months, and Puerto Rico requires a buy back provision be held open for 90 days. 16 The Ninth Circuit's analysis, however, brings into question how long a buy-back period must remain open, but fails to provide any meaningful guidance on what length of time it would consider adequate. The few jurisdictions that have statutes which address the issue are not uniform, and the Ninth Circuit has added an additional layer of confusion to the issue.
The Ninth Circuit's decision is already having a dramatic impact on the MLM industry. It is often cited by Attorney Generals in negotiating settlements with companies allegedly violating pyramid laws. The die is cast and it is now incumbent upon companies in the industry to design and implement their programs to operate within the strictures dictated by the court if they wish to avoid pyramid violations and the securities, RICO and state fraud violations associated with the operation of a pyramid. The following are recommendations to minimize the risks associated with operating as a pyramid.
a. Focus First on Retail Sales, then Promote Recruiting
Too often multilevel marketing companies exclusively emphasize the importance of recruiting new distributors. Others emphasize sales, but only secondarily to recruiting. What is necessary is a paradigm shift from a primary emphasis on recruiting to a primary emphasis on retail sales. It is certainly acceptable to promote recruitment of new distributors, for this is an essential element to growing a business. However, the emphasis on recruitment must be of secondary importance; distributors must be taught that the primary emphasis is on the development of retail sales. This will be difficult for many companies because it removes the inducement to purchase offered by a lucrative compensation plan and forces them to compete with retail brand products based on price, quality, convenience, and uniqueness.
1) Promote Convenience - Direct Customer Programs
A very effective means of promoting retail sales is through a direct customer program. Under these programs, distributors recruit individuals who wish to purchase merchandise directly from the company, but who do not wish to participate in the compensation plan. Customers are assigned an identification number and are placed in the recruiting distributor's downline. When the customer wishes to purchase products, he or she contacts the company, places an order, and it is directly shipped to the customer. These programs can be easily marketed to customers by promoting their convenience because the distributor need not handle the inventory, and the customer need not be bothered by repeated sales calls from the distributor. All a distributor need do is call the company and order more product when needed. In fact, if a company institutes an auto-ship program, even the hassle associated with making repeat orders disappears. However, the distributor (and his or her upline) who recruited the customer is entitled to a commission based on the purchases of the customer.
Direct customer plans represent true retail sales since the customers, no matter how much they spend, do not receive commissions. Moreover, since distributors do not handle any inventory, they avoid problems associated with inventory loading. They are also advantageous because companies can track retail sales with relative ease, and therefore determine if a sale is commissionable under the Omnitrition ruling. Moreover, satisfied customers are a warm market for potential future distributors. If an individual is familiar with a company's products through months or years of personal use, they will be more receptive to selling the product themselves.
2) Competitive Price Strategies
Products sold through multilevel marketing programs are historically priced higher than retail store brands. Most MLMs recognize that they will not be able to compete on a price basis with mass production and merchandising machines like the Proctor & Gamble and Walmarts of the world. Therefore, MLMs tend to focus on niche markets by producing and selling higher quality products than the mass merchandisers offer. In addition, although MLMs do not have the high advertising costs associated with mass marketing, there are many layers of commission which are paid on the sale of each product. These two factors tend to drive up the price of goods sold by MLMs.
Although MLM's production and commission expenses are higher than those of mass marketed goods, MLMs must not ignore the realities of supply and demand if they are going to compete for legitimate retail sales. To reasonably attract customers, competitive pricing is essential. In order to advance retail sales, companies must price their products competitively with other goods competing for the same niche. Thus, for example, if a company positions a product as a high-end hair care system, it should at a minimum be priced competitively with similar high end salon and designer products.
b. Implement and Enforce Methods Safeguards Against Inventory Loading
Although Omnitrition had the traditional Amway safeguards in place, the court was not willing to rule as a matter of law that these policies effectively deterred or prevented inventory loading. This ruling does not mean that the Amway safeguards are no longer valid anti-inventory loading policies. Rather, the court ruled against Omnitrition because it lacked sufficient evidence that the polices were enforced and effectively safeguarded against inventory loading. The clear message is that companies must implement effective anti-inventory loading policies and must enforce the policies. Without enforcement, even the most sound policy will not provide a defense. The following discussion presents policies that can be utilized to guard against inventory loading. Bear in mind, however, that because a lack of retail sales is so closely tied to inventory loading under the Omnitrition definition of inventory loading, implementing a solid retail sales program is the most critical inventory loading safeguard.
1) The Amway Safeguards
Despite that Omnitrition did not win on appeal with the Amway defense, the Amway safeguards are nevertheless a good starting point for most companies that sell tangible goods.17 A review of numerous 1996 settlements between State Attorney Generals and multilevel marketing companies reveals that a five customer rule (rather than 10 customers as in the Amway case) and a 70% resale requirement are very common components to the agreements. Additionally, an inventory repurchase policy refunding 90% of a terminating distributor's net cost for returned merchandise is not only common in settlements, it is mandated in six jurisdictions (Georgia, Louisiana, Maryland, Massachusetts, Puerto Rico and Wyoming).
The Ninth Circuit questioned whether Omnitrition's three month, 90% inventory repurchase policy adequately prevented inventory loading. Despite the court's position, 90% still represents the industry standard. Although a company may receive incrementally more protection by incorporating a 100% refund policy, the fact that various jurisdictions have enacted legislation specifying a 90% rate is strong evidence that a 90% refund rate remains satisfactory.
The duration of the buy-back period is also a critical question. Although two jurisdictions require as little as three months or 90 days (Maryland and Puerto Rico, respectively), it is highly advisable to extend the policy to one year or longer (in some states the repurchase policy may have to be extended even further). The most generous inventory repurchase policy will take back all inventory, regardless of when purchased, with no questions asked. Although this policy offers the greatest protection, it also opens the company up to abusive practices by distributors. A policy which balances consumer protection concerns with the company's interest is more practicable. An example of such a policy is to allow a refund so long as the merchandise remains currently marketed by the company and is returned in resalable condition (four states - Louisiana, Wyoming, Massachusetts and Georgia - have open ended statutes [Louisiana utilizes an administrative rule] requiring companies to take back products as long as the goods are "resalable").
Central to the effectiveness of any inventory repurchase policy is the company's ability to prove that its refund policy is enforced. This requires that companies keep detailed records of the returned merchandise they have taken back and the refunds that have been issued. A monthly refund report should be maintained by every company so that if its program is challenged, the company can provide the court with compelling evidence that distributors are not saddled with unwanted inventory if they elect to cancel their participation in the program.
Many MLMs have adopted the Amway safeguards under the misunderstanding that they are the only viable inventory loading safeguards and are therefore mandatory or that they constitute a complete defense to an inventory loading charge. In fact, the F.T.C. decision merely found that the safeguards were effective in preventing inventory loading in that case. Thus, the door is open to other creative measures which, if enforced, can assist in preventing inventory loading and should be considered.
2) Other Disincentives to Inventory Loading
Some companies limit the quantity of merchandise a distributor can purchase unless the distributor presents invoices or other evidence that he or she has pre-sold orders exceeding the limit. Other companies limit commissionable purchases to the first $100.00 or $200.00 per month in product orders, with no commissions being paid on purchases over that amount. These policies can be very useful under the traditional definition of inventory loading as stated in the Amway decision (inventory loading requires "a person seeking to become a distributor to pay a large sum of money," ..., for the purchase of a large amount of nonreturnable inventory). These policies do not, however, satisfy the Omnitrition court's new definition of inventory loading. Under the Omnitrition definition, a distributor is inventory loading if he or she makes the minimum required purchases to receive recruitment-based bonuses without reselling the products to consumers. Thus, under this definition, a distributor must sell the product which they purchase to avoid inventory loading.
Despite the Omnitrition court's definition of inventory loading, disincentives to excess inventory purchases such as maximum purchases and limiting commissions to the first $100.00 or $200.00 are a recommended practice as they put the company in a good position to avoid inventory loading under the traditional definition. Furthermore, the Omnitrition court's definition of inventory loading lacks legal foundation. Rather, the court's definition is a statement representing the individual views of the author of the opinion, and should not binding in subsequent cases (in legalese, such a statement of opinion is known as "dicta"). Certainly regulatory bodies will seize upon the language and use it to their advantage at every opportunity, but industry members must be aggressive in fighting this definition, otherwise it could become an accepted definition.
3) Allow Distributor's Personal Production Quotas to be Satisfied by Retail Sales.
As discussed, many programs require their distributors to purchase a minimum amount of product each month. In theory, distributors must retail the majority of the products (typically 70%) before qualifying for a commission. In reality, distributors often meet their quotas by personally consuming most or all of the products they purchase. To reduce the personal consumption of distributors and to promote the development of retail sales, companies should allow the distributors to satisfy their monthly minimum volumes through purchases made by their personally enrolled direct customers. This option will move the company one step closer to satisfying the retail sales requirements set forth by the Ninth Circuit.
4) Low Minimum Qualifications
If a company requires minimum monthly purchases of its distributors, the minimums should be kept low. There is no bright line test as to what constitutes a "high" or a "low" purchase requirement, but a strong dose of common sense should be used. Set minimum quotas low enough so that the products can realistically be sold at retail before the distributor must purchase the next month's inventory. Without question, Omnitrition's $2,000.00 per month quota caught the court's attention, and would certainly catch the attention of any regulatory body investigating a company.
The multilevel marketing industry is currently operating in an atmosphere of extreme regulatory scrutiny. The Omnitrition decision makes doing business even more challenging. However, by paying attention to the lessons contained in the decision, companies can chart a course that will allow them to operate legitimately and profitably.
At the very least, there are two lessons the multilevel marketing industry must take from the Omnitrition decision. First, companies must place their primary emphasis on retail sales rather than recruiting. It is certainly possible for companies to grow and prosper with programs that are driven by sales to retail customers. These programs will not emerge without some resistance, but the innovative companies that are able to make this paradigm shift will be the ones that emerge as the future success stories.
The second message, which must echo loud and long, is that enforcement of policies which deter inventory loading and encourage retail sales are of paramount importance. Without enforcement, even the most perfectly drafted policy is useless. It is therefore critical that companies proactively monitor their sales forces to ensure that retail sales requirements are satisfied and that their programs are properly presented to emphasize retail sales ahead of recruitment.
1. Spencer Reese is a partner in the law firm of Reese, Poyfair, Richards, PLLC. His practice concentrates on all aspects of multilevel marketing, sales, advertising, consumer affairs law, and FDA practice. Mr. Reese has been involved in the multilevel marketing industry for ten years, acting as a distributor for several companies including Melaleuca. During Mr. Reese's tenure at Melaleuca, he was responsible for all of the company's litigation, attorney general and regulatory relations, distributor compliance, FDA and FTC compliance, and protection of corporate intellectual property and trade secrets. Mr. Reese received his law degree from Washington University in St. Louis, Missouri in 1986. He is a member of the Direct Selling Association's Lawyer's Council, the Government Relations Committee, and the Internet Task force. He is a member of the Idaho, Missouri and Colorado bars.
2. 79 F.3d 776 (1996).
3. 86 F.T.C. 1106, 1181 (1975).
4. 79 F.3d at 783.
5. Id. at 783.
6. 93 F.T.C. 618, 715 (1979).
7. 79 F.3d at 783, note 3.
8. Id. at 782.
9. Id. at 783.
10. Id. at 783.
11. Id. at 783.
12. Id. at 783.
13. This statement is not intended to imply that Omnitrition was not honoring its buy-back policy. The Court of Appeals only stated that the company did not present any evidence in support of its summary judgment motion that the buy back policy was enforced. The court left it to the trial court to determine if Omnitrition actually enforced the policy.
14. Georgia - GC §10-1-415; Maryland - MD Bus. Reg. §14-302; Massachusetts - M.G.L.A. 93 § 69; Puerto Rico - 10 L.P.R.A. §997b; Wyoming - W.S. §40-3-105; Louisiana - L.A.C. §16:III, 503B. In addition, the Direct Selling Association provides for a 90% repurchase policy in its Code of Ethics.
15. Id. at 784.
16. MD Bus. Reg. §14-302; 10 L.P.R.A. §997b.
17. Companies that offer services can easily avoid inventory loading situations. Distributors for long distance telephone services, for example, cannot inventory load because there is no merchandise to hold in inventory; commissions are paid based on actual usage by their customers and downline distributors rather than inventory purchases. Service companies must nevertheless ensure that they have sufficient retail sales to ensure commissions are properly payable.