INSIDER Law
Multi-Level Marketers Gain Pyramid Scheme Resource in FTC Guidance

Multi-Level Marketers Gain Pyramid Scheme Resource in FTC Guidance

<p>Guidance adopted by FTC thoroughly articulates the agency&rsquo;s views on factors the staff considers in determining whether an MLM is operating within the law or engaging in practices that may violate the Federal Trade Commission Act.</p>

The Federal Trade Commission (FTC) recently published detailed guidance for multi-level marketers (MLMs) of nutritional supplements and other products, providing the staff’s thinking on myriad factors that help distinguish a pyramid scheme or illegitimate operation from a lawful business.

The business guidance is not legally binding and doesn’t create new law. Lawyers, nonetheless, said the document thoroughly explains the commission’s views on the various factors its staff considers in determining whether an MLM is operating within the law or engaging in practices that may violate the Federal Trade Commission Act (FTC Act).

Adopting business practices consistent with the guidance could help MLMs stay off FTC’s radar. Lawyers who advise MLMs said the guidance provides an opportunity for companies to reassess their business practices and avoid potential exposure to an enforcement action by state and federal regulators.

“Responsible companies in this space need to just pause and assess, step back and have a look at what you’re doing,” said John Villafranco, a partner in Washington with the law firm Kelley Drye & Warren LLP, in a phone interview. “There’s no company out there that if they do that wouldn’t find a way to improve their operations [and] decrease their risk.”

The 2018 guidance “essentially establishes safe harbors, and if you can conform your practices to that guidance, you’re not going to have any issue with the Federal Trade Commission,” asserted Villafranco, who co-authored a blog post on the guidance the day it was published.

For the likes of Amway and other MLMs, the guidance is just one consideration in assessing the state of the law and FTC’s views on pyramid schemes. Other considerations include court settlements, FTC lawsuits and administrative decisions, appellate and district court rulings, and FTC’s 2004 advisory opinion on pyramid schemes.

Many of the principles set forth in the guidance are reflected in a stipulated order for a permanent injunction and monetary relief involving Herbalife.

Orders obtained through settlements of FTC enforcement actions—such as the Herbalife agreement entered in the U.S. District Court for the Central District of California—don’t bind companies that aren’t a party to the agreements. On the other hand, the commission pointed out such orders may be useful to the broader industry.

“We believe that the FTC’s guidance to the direct-selling industry provides companies with guidelines that protect consumers, and we are in agreement with the basic tenets of the FTC’s guidance, particularly the need to base compensation on legitimate retail sales,” Herbalife Nutrition said in an emailed statement.

In assessing whether an MLM is lawfully operating, FTC officials examine a multitude of factors. Some of the considerations noted in the guidance include:

  • Whether compensation is based on actual sales to customers rather than wholesale purchases or other payments by business participants (often referred to as “distributors”) in an MLM;
  • Internal consumption of products by distributors—namely whether a compensation plan encourages them to purchase products for a reason other than satisfying legitimate demand, and whether purchases were genuinely made to meet personal demand;
  • Whether MLMs allow distributors to return unsold products to the company;
  • Documentation of retail sales, such as sales receipts; and
  • Representations about the business opportunity, including earnings claims.

Retail Sales and Internal Consumption

“The guidance makes clear that MLM compensation must be based on actual sales to real customers,” said Douglas Brooks, a Massachusetts-based lawyer who has represented distributors in class-action litigation against MLMs for alleged deceptive practices. “To assess whether an MLM plan is a pyramid scheme, the FTC will look at a variety of factors, including how the plan is marketed, whether the compensation plan creates incentives for distributors to purchase products they don’t need and can’t sell, and how the compensation plan functions in practice. Importantly, having a refund policy does not prevent an MLM plan from being a pyramid scheme.”

JB Kelly is a lawyer in Washington who helped Herbalife negotiate its settlement with FTC. He said now is a good time for MLMs to compare the various factors cited in FTC’s guidance to their current business practices and examine where they fall on the spectrum of risks.

“And that’s not to say that there’s not legal defenses if the FTC were to come knocking, but the question is … will you be looked at?” Kelly of the law firm, Cozen O’Connor, said in a phone interview. “Where are you on this list?”

Kevin Thompson, a founding partner in Franklin, Tennessee, with the law firm Thompson Burton PLLC, commended the commission for publishing the guidance.

“The guidance was carefully written to provide much-needed clarification to the law,” said Thompson, who advises MLMs.

Former FTC Chairman Edith Ramirez, the lawyer argued in an emailed statement, “overstepped the boundaries and caused significant confusion in the industry.”

FTC suggested individuals are especially vulnerable to financial losses in an MLM in which participants are provided incentives to buy products and recruit others to buy products so they can advance in a marketing program.

“Where such an unlawful compensation structure exists, a participant is unlikely to be able to earn money or recover his or her costs through selling product to the public,” the guidance explained.

The fact that distributors purchase products from an MLM for their own internal consumption is not necessarily evidence of deception. As the guidance noted, the court order involving Herbalife allowed “the payment of compensation based on personal consumption, subject to specific limitations and verification limits.”

However, Villafranco, who represented Herbalife in negotiating its agreement with the commission, cautioned, “There’s no doubt that the FTC views internal consumption with suspicion. They always have.”

Fact-Intensive Evaluations

FTC emphasized its evaluation of a compensation plan is specific to the facts. For instance, in its lawsuit against BurnLounge, the company argued its participants purchased product packages of sales websites and music-related merchandise because they wanted the goods. However, FTC’s guidance proclaimed monthly sales of the packages plunged by nearly 98 percent after the packages were untied from the business opportunity.

In 2014, a federal appeals court upheld an order granting a permanent injunction against BurnLounge based on a finding that its MLM business was an illegal pyramid scheme.

FTC doesn’t favor a single method for documenting legitimate retail sales. However, Kelly observed a receipt or direct purchase of products from an MLM is more persuasive evidence of a sale than a recitation by a distributor that it made a retail sale.

Some of the old business practices adopted by MLMs are rooted in court and FTC decisions going back decades. In a 1979 decision involving Amway, the commission discussed rules that encouraged the sale of Amway products to consumers.

For example, an Amway distributor had to show proof of retail sales to at least 10 customers each month before he could receive his performance bonus. Amway distributors also couldn’t get their bonus unless they resold at least 70 percent of the products they purchased each month.

FTC’s guidance suggests conformance to the above rules doesn’t provide a safe harbor from enforcement action and isn’t the most persuasive on whether consumers are buying from an MLM distributor, Kelly said.

“Many companies just had distributors jot down, ‘I sold to Joe. I sold to Jane,’” the lawyer said, commenting on the 10-Customer Rule with roots in the Amway case.

FTC Guidance v. Federal Legislation

Joseph Mariano is president of the Direct Selling Association (DSA), whose board of directors is comprised, in part, of several MLMs selling supplements, including Amway, Herbalife, Nu Skin Enterprises and USANA Health Sciences.

Mariano said he appreciated the distinction in the guidance between unfair and deceptive practices and legitimate direct selling companies. However, he noted the guidance was “of limited precedential value” and not binding on FTC.

Some of FTC’s enforcement positions against alleged pyramid schemes, he proclaimed, have contributed to creating ambiguity “for the public at large and direct selling companies” concerning “the standards that would be used to prosecute pyramid schemes.”

DSA continues to support federal legislation (the Anti-Pyramid Promotional Scheme Act of 2017, H.R. 3409) and similar language in an appropriations bill passed in 2017 by the House of Representatives.

According to DSA, the bill “would define a pyramid scheme for the first time in federal statute, using the same definition as codified by 21 state legislatures and in numerous court decisions.

“It would also require all direct selling companies to adopt the same gold-standard buy-back policy as required under DSA’s Code of Ethics,” the association noted on its website.

H.R. 3409, Mariano said, has garnered bipartisan support and is largely based on the combination of existing Texas and Tennessee laws on the books for many years. Reps. Marsha Blackburn (R-Tennessee) and Marc Veasey (D-Texas) introduced the legislation.

The language in the appropriations bill resembles H.R. 3409, defining and prohibiting pyramid schemes, said Mariano, who added the language suggests distributors’ personal use of products “is not necessarily a piece of evidence that should be used to prove something is illegal.”

It’s unlikely both chambers of Congress would vote on a standalone bill like H.R. 3409. According to Skopos Labs, the bill has a 7 percent chance of being enacted. Mariano also acknowledged pyramid scheme language may not be included in any final appropriations bill passed into law to fund the federal government for the current fiscal year.

“If that’s the case, then of course we will continue to actively support and solicit more support for this anti-pyramid consumer protection legislation, and I hope successfully,” Mariano said.

Others have argued pyramid scheme language introduced in Congress would weaken FTC’s ability to protect consumers.

In an Aug. 3, 2017 column for The Hill, FTC Commissioner Terrell McSweeny said language attached to an appropriations bill “would handcuff the FTC and enable deceptive and unfair MLM schemes to continue to victimize consumers.

“Despite statements to the contrary, the language of the bill is entirely inconsistent with established case law,” McSweeny maintained. “Rather, it simply allows illegal actors to hang window dressing and creates a safe harbor that would bar law enforcement.”

Brooks also slammed the House appropriations bill and H.R. 3409.

“These bills would upend decades of pyramid scheme case law and prevent effective pyramid scheme enforcement actions by the FTC by permitting MLM compensation to be paid on purchases by MLM distributors that are intended to advance or preserve their status in the plan, and by insulating MLM plans from any pyramid scheme liability so long as they have a refund policy,” he said.

Earnings Claims

In examining potentially deceptive business practices, the Commission scrutinizes representations by a company and its independent sales force to prospective distributors regarding the potential for earnings.

According to DSA, 89 percent “of direct sellers decide to work part-time, offering busy parents, caregivers, military spouses, veterans and others flexibility and work-life balance.” But companies have come under fire over the years for implying prospective distributors can earn gobs of money.

To avoid being deceptive under Section 5 of the FTC Act, the guidance noted, an MLM’s representations regarding the business opportunity must be truthful and not misleading.

“A company must have a reasonable basis for the claims it makes or disseminates to current or prospective participants about its business opportunity,” the guidance stated. “A ‘reasonable basis’ means objective evidence that supports the claim. If a company lacks such objective supporting evidence, the claims are likely deceptive.”

The nonprofit Truth in Advertising (TINA.org) recently identified false income claims by MLMs that are DSA members. According to the organization, its investigation uncovered more than 3,000 examples of companies and/or their distributors making inappropriate earnings claims on their websites and social media platforms.

The representations included implied claims showing expensive boats, cars and homes, as well as claims that people could quit their jobs, be stay-at-home parents and earn a full-time salary by working part-time, said Bonnie Patten, executive director of TINA.org.

The group’s investigation demonstrated “companies and distributors either have not understood the law—or worse, have been ignoring it,” she said in a phone interview. “And I think hopefully this [FTC guidance] sends a message that the kinds of claims that have been made in the past are simply not acceptable.”

Mariano said DSA’s ethics code has long prohibited unreasonable and unsubstantiated earnings claims. He noted the standard was expanded in 2016 to provide clearer guidance to the public, companies and the DSA's ethics code administrator.

“We take earnings representations, and the accuracy of those representations, extraordinarily seriously, as does the DSA membership,” Mariano said in a phone interview.

Commenting on TINA.org’s investigation, Mariano said his preliminary review of the data indicates many alleged instances of inappropriate claims date back several years. He also said a preliminary review suggested the nonprofit organization overstated the ethics code and state of the law.

“Merely the fact that somebody says you can earn a little bit of extra income is not a violation of the DSA code, and I would respectfully suggest to [TINA.org] and others that it’s not a violation of any standard of law either,” Mariano said.

He added, “If there is a violation, or if there is an overstatement by either a company or an individual salesperson, we’ll take that seriously and take action.”

Assessing Risks

Despite FTC’s 2018 guidance, it remains difficult to fully assess the risks facing MLMs due to uncertainty over enforcement in the Trump administration.

McSweeny and Acting FTC Commissioner Maureen Ohlhausen are the only two commissioners representing the agency. While antitrust lawyer Joseph Simons and former Obama administration official Rohit Chopra have been nominated by President Donald Trump to serve as FTC commissioners, they have not been confirmed by the U.S. Senate.

“We know what the precedent says and we know what the … current staff believes, but we don’t really know what the Federal Trade Commission under President Trump is going to believe or assert,” Villafranco said.

It “remains to be seen” whether Ramirez’s FTC “was the high-water mark in this area or whether it was just the latest stop in a linear progression,” he added.

The commission, though, is not the only government entity policing MLM activities. Kelly—a member of Cozen O’Connor’s State Attorneys General Practice—said it’s conceivable the guidance could give state attorneys general a sense of how to evaluate cases against MLMs because they have “mini FTC” laws that they enforce in their own states.

In 2016, in conjunction with the FTC agreement, Herbalife reached a $3 million settlement with the Illinois attorney general to resolve complaints about false and misleading claims.  

Case-by-Case Approach

For its part, the commission will continue to evaluate on a case-by-case basis whether an MLM has violated Section 5 of the FTC Act.

FTC’s approach, the guidance noted, enables the agency to target “bad actors engaged in a specific harm, without directly affecting an entire industry,” while limiting “the potential unintended consequences that can result from one-size-fits-all industry standards in statutes or regulations.”

The case-by-case approach doesn’t sit well with Brooks, who for decades has represented victims of alleged pyramid schemes.

“As a practical matter, this is a problem because the FTC does not have the time or resources to investigate all MLM plans,” he said. “I have been arguing for many years that the case-by-case approach is inadequate and fails to protect consumers from unfair and deceptive practices in the MLM industry.”

Responsible Industry?

Others with ties to the direct selling industry said many MLM companies act responsibly and are committed to the rule of law.

“They have their eye on the ball here, and they’re doing their very best to police the market,” Villafranco said.

Asked whether MLMs have turned the corner in recent years by adopting business practices to prevent deception, Mariano responded, “I would suggest absolutely that our business practices have always been beyond question, and we’ve always been committed to serving the interest of the consumer and our sales people and distributors.”

Moreover, he cited “a renewed commitment to self-regulation,” with plans to expand DSA’s ethics code and devote additional resources to its enforcement, work in collaboration with consumer organizations—including government entities like the commission—and enforce standards that exceed the requirements of the law.

“Everything we have done, and are doing, and will do over the course of the next 12 months,” Mariano said, “is actually at the behest and direction and counsel of the Federal Trade Commission itself.”

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