Pyramid scheme. It’s a dirty word, especially here in Grand Rapids, Michigan, hometown of the Amway Corporation, which has been accused of being one for years. But what is a pyramid scheme, and what makes it so wrong? Generally, a pyramid scheme (also called franchise fraud) is a business model that involves promising participants payment, services, or ideals, for enrolling other people into the scheme, rather than supplying any real investment or sale of products or services to the public. The problem with a pyramid scheme is that its model is based on paying commissions for recruiting new distributors. As such, it will inevitably collapse when no new distributors can be recruited.
The Federal Trade Commission has established a test for determining what constitutes a pyramid scheme. According to the FTC, pyramid schemes are characterized 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 the sale of the product to ultimate users. In many countries, including the U.S., pyramid schemes are a form of fraud, because it is believed that the programs will inevitably harm later investors. Webster v. Onmitrition Int’l, Inc. 79 F.3d 776, 781 (9th Cir.)
All multi-level marketing businesses (MLMs), however, are not necessarily pyramid schemes and many may be legitimate. Companies such as Amway, Avon, Electrolux, Tupperware, and Kirby operate under a multi-level compensation plans. So what separates a valid MLM business model from an illegal pyramid scheme? No clear line separates illegal pyramid schemes from legitimate MLMs; to differentiate the two, regulators evaluate the marketing strategy (e.g., emphasis on recruitment versus sales) and the percent of product sold compared with the percent of commissions granted.
However, courts have found that “The key to any anti-pyramiding rule … is that the rule must serve to tie recruitment bonuses to actual retail sales in some way.” Only in this way can the second factor of the FTC test (that participants are rewarded for recruiting other participants regardless of ultimate sales) be defeated. Omnitrition, 79 F.3d at 783. The Amway programs escaped sanction because they satisfied this anti-pyramiding rule: participants earned commissions not through recruitment, but by product sales (their own sales and the sales of their recruits). See Matter of Amway Corp., Inc., 93 F.T.C. 618, 716 (1979) (“It is only when the newly recruited distributor begins to make wholesale purchases from his sponsor and sales to consumers, that the sponsor begins to earn money from his recruit’s efforts.”).
On the other hand, participants in a marketing plan developed by Koscot Interplanetary paid an initial amount up to $5,000 to the company for inventory and the right to recruit others. The distributors who recruited others received $2,650 of the recruit’s $5,000 payment. In the Matter of Koscot Interplanetary, Inc., et. al., 86 F.T.C. 1106, 1179 (1975). The only way a Koscot distributor could get the payment back was to recruit more distributors. Koscot, 86 F.T.C. at 1131. The court found that Koscot and its distributors were primarily in the business of selling distributorships, classifying the business as an illegal pyramid.
Similarly, participants in a marketing plan used by Ger-Ro-Mar, Inc. bought non-returnable inventory for up to $1,950. In the Matter of Ger-Ro-Mar Inc., 84 F.T.C. 95, 108-10 (1974). Recruiters received compensation based on the fact of recruiting regardless of whether products were sold to the consumers, dubbing Ger-Ro-Mar an illegal pyramid. Ger-Ro-Mar, 84 F.T.C. 148.
The pyramid marketing program discussed in Holiday Magic, Inc., 84 F.T.C. 748 (1974) required distributors to buy in at various levels for up to $4,500. At the highest level, distributors received $2,500 of the $4,500 for recruiting another distributor at the same level. The inventory purchased in this manner was non-returnable and the company paid little attention to consumers. Holiday Magic, 84 F.T.C. at 1035. Again, this system was determined to be in illegal pyramid.
Despite many accusations to the contrary, the Amway model is useful to show how a MLM can work properly. The Amway system does not involve an ‘investment’ in inventory by a new distributor. A kit of sales literature costing a very small sum is the only requisite. And that amount will be returned if the distributor decides to leave Amway. Instead, the Amway system is based on retail sales to consumers. Amway has avoided the abuses of pyramid schemes by (1) not having a ‘headhunting’ fee; (2) making product sales a precondition to receiving the performance bonus; (3) buying back excessive inventory; and (4) requiring that products be sold to consumers. Amway, therefore, is not simply in business of selling distributorships. Amway, 93 FTC 618.
Recently a new Grand Rapids phenomenon is rapidly taking over the market with its MLM opportunity. Body by Vi is a new purveyor of dietary supplements that is capitalizing on the United States’ obesity epidemic. There are several ways to be involved in Body by Vi: (1) a customer can buy a set of products directly; (2) a customer who refers three people to buy a kit of products is entitled to receive his or her own kit for free; or (3) a distributor makes an initial capital contribution and then may sell products directly to consumers and may sell distributorships to other would-be distributors. The initial distributor, or “promoter” as called within the Body by Vi culture, gets commissions on the sale of all products sold and also gets commissions on the sale of other distributorships, if such distributorships include products for such distributor. Based on these limited facts, it is clear that receiving the commissions based on actual sale of the Body by Vi products is legal and valid. And in the Body by Vi system, commissions are not given for a distributorship sold without product. Commissions thus, are earned only by the sale of products that comes with a higher end distributorship. Therefore, a distributor could not fail to sell any product and still profit off of the sale of other distributorships.
MLMs will always be popular, as they operate with low overhead and create fantastic incentives for their sales force. Will you be breaking even as a distributor? Will you be making a profit? Will you be driving a pink Cadillac, a black BMW or a Mustang? Only you know. Are you associated with a company selling the right products? Have you studied the market? Do you have a business plan in place? Having an answer to all these questions is very important because becoming a distributor for a company that operates as an MLM is like starting any other business; it takes time to be successful and the success element in any business venture only comes with hard work, dedication, and a little bit of luck. For now, just make sure to get involved with an MLM program that follows a very simple rule: all commissions must be tied to actual sales of product to the end consumer.
By: attorneys Raquel A. Salas and Elizabeth Lueder