Lessons in Missing the Point

by Kevin D. Grimes, Thompson Burton, PLLC

Why Do MLM Companies Keep Getting Sued by the FTC For the Same Stuff as Others Have Been Sued for Decades?

Part 1

The recent FTC v. Neora lawsuit raises a question – Do MLM leaders (corporate executives and field leaders) “get it” when it comes to the legal and regulatory requirements that govern MLMs?

In light of the long litigation history of the FTC against MLMs and purported MLMs (JewelWay, FutureNet, Equinox, Fortune Hi-Tech Marketing, BurnLounge to name but a few), the answer seems to historically be “No”. In light of the recent litigation history against several significant MLM companies (Vemma, Herbalife, AdvoCare, and now Neora), the answer still seems to be “No”.

When it comes to FTC enforcement actions, it appears to be – different day, different company, same stuff.

The FTC is not bringing lawsuits against MLM companies alleging completely new theories of law. Yes, I concede that the FTC and the federal courts have been “moving the goal line” with respect to what constitutes: (1) a pyramid; and (2) a legal MLM. However, one of the realities of the business world is that laws and legal standards evolve and change.

What is there about MLM legalities that MLM leaders do not know, do not want to know, or could not care less whether they know?

Having represented more than 1,000 MLM companies over the last 27 years, the intersection of MLM executives, entrepreneurs and field leaders, and MLM legalities is perhaps most appropriately called – “Lessons in Missing the Point.”

For decades, the corporate and field leaders who manage and influence so many MLMs simply “don’t get it” when it comes to MLM legalities.

They think they do.

But the substantial factual regulatory fodder they provide to the FTC and federal courts says otherwise.

If you ask the typical MLM exec or field leader exactly what the game-changing cases hold and what they mean for an MLM company’s day-to-day operations, he or she cannot tell you.

The bottom line is – Every federal case and FTC enforcement action is a seminal case!

If MLM leaders don’t know what these cases say, how can they guide their companies and organizations toward compliance . . . and continued operation? What excuse is there for making the same mistakes over and over, year after year, decade after decade?

I am reminded of one of the greatest and simplest truths I have ever heard.

“Those who neglect history are doomed to repeat it.” – George Santayana

What is astounding to me is that many of the people who lead MLM companies are absolutely brilliant…but…epically poor students (or non-students) of MLM history.

As such, they supply the unfortunate first ingredient of Mr. Santayana’s quote. Consequently, we have seen the second part of Mr. Santayana’s quote continue to unfold for the MLM industry during last three decades.

Being a poor student (or an unteachable student) of MLM history has the potential for a devastating effect. The purpose of this series of articles is to briefly review the history and messages of the last 23 years of FTC enforcement actions and federal court decisions, articulate the current state of the law (the vast majority of which continues to be ignored by most MLM companies), and propose appropriate changes of operations to avoid FTC enforcement actions, class actions and other legal/regulatory problems.

The Lessons of History

This article will touch on a few of the important lessons and “take-aways” from MLM regulatory history. But it is too brief to address all of them. Accordingly, subsequent articles will address additional lessons, take-aways and strategies for decreasing regulatory and legal risks. (So, please come back next month.)

Lesson 1 – The Majority of Distributor Compensation MUST Be Derived from Sales to Customers (Non-Distributors)

As Nerium does in its very courageous and brilliant lawsuit against the FTC, we can debate whether this is the current federal legal standard for determining whether a program is legitimate MLM or a pyramid. What is not debatable is that the FTC is, and has been, suing MLM companies that fail to generate more than 50% of their revenues and more than 50% of all distributor compensation from sales to Customers.

The FTC’s thinking is – If the majority (more than 50%) of distributor compensation does not flow from sales to customers, the program is not sales-based. If the program is not sales-based, it is de facto recruitment-based, and therefore, a pyramid.¹

We see this thinking reflected in paragraph 12 of the FTC’s Complaint against Nerium.

Purchases by BPs (Brand Partners) have accounted for more than half of all company revenues.

In paragraph 123 of the Complaint, the FTC asserts that Nerium is a pyramid because participants “pay money to the company in return for which they receive . . . the right to receive rewards which are unrelated to the sale of products to the ultimate users.”²

The federal courts and the FTC have been banging the drum for pre-eminence of customer sales for 23 years! But the MLM industry has repeatedly turned a deaf ear to the increasingly shrill warnings of the federal courts and the FTC.

It started in 1996 in the infamous Webster v. Omnitrition decision, in which the U.S. Court of Appeals stated:

The key to any anti-pyramiding rule in a program like Omnitrition’s, where the basic structure serves to reward recruitment more than retailing, is that the rule [compensation plan eligibility requirements] must serve to tie recruitment bonuses to actual retail sales in some way.

In the Omnitrition case we see the first indication from the federal courts regarding the “tying” of distributor compensation to sales to non-distributors – Customers. However, I will concede that the Court’s language is about as imprecise as it can be – “tie recruitment bonuses to actual retail sales in some way.”

What does “in some way” mean? That question was answered elsewhere in the Omnitrition decision.

Omnitrition (the company) argued that because it had the three “Amway Rules” written into its contractual documents, as a matter of law, it could not be a pyramid. The Court of Appeals rejected that argument and wrote:

. . . plaintiffs 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 [i.e., sales to distributors] cannot satisfy the requirement that sales be to “ultimate users” of a product.

This called into question whether any personal product usage by distributors could be considered legitimate and legal.³

What was the industry’s response to the Omnitrition Court’s admonition that compensation needed to be tied to retail sales?

It completely ignored it.

Fast forward a few years to 2004. In the FTC’s Staff Advisory Opinion – Pyramid Scheme Analysis to the Direct Selling Association, it wrote:

In a pyramid scheme, participants hope to reap financial rewards well in excess of their investment based primarily on the fees paid by members of their “downlines”. Downline members pay these fees to join the scheme and meet certain prerequisites for obtaining the monetary and other rewards offered by the program. A participant, therefore, can only reap rewards by obtaining a portion of the fees paid by those who join the scheme later. The people who join later, in turn, pay their fees in the hope of profiting from payments of those who enter the scheme after they do. In this way, a pyramid scheme simply transfers monies from losers to winners. For each person who substantially profits from the scheme, there must be many more losing all, or a portion, of their investment to fund those winnings. Absent sufficient sales of goods and services, the profits in such a system hinge on nothing more than recruitment of new participants (i.e., fee payers) into the system.

The Commission’s recent cases, however, demonstrate that the sale of goods and services alone does not necessarily render a multi-level system legitimate. Modem pyramid schemes generally do not blatantly base commissions on the outright payment of fees, but instead try to disguise those payments to appear as if they are based on the sale of goods or services. The most common means employed to achieve this goal is to require a certain level of monthly purchases to qualify for commissions. While the sale of goods and services nominally generates all commissions in a system primarily funded by such purchases, in fact, those commissions are funded by purchases made to obtain the right to participate in the scheme. Each individual who profits, therefore, does so primarily from the payments of others who are themselves making payments in order to obtain their own profit. As discussed above, such a plan is little more than a transfer scheme, dooming the vast majority of participants to financial failure.

In the Staff Advisory Opinion, we see the FTC talking about “fees paid by members of their ‘downlines’”. In light of its claim that pyramids “try to disguise those payments to appear as if they are based on the sale of goods or services” and “the most common means employed to achieve this goal is to require a certain level of monthly purchases to qualify for commissions”, it is clear that the FTC is saying that “fees paid by members’” can come from distributors’ purchases of products. Moreover, the most significant factor that turns potentially legitimate personal purchases into recruitment-based fees are “certain level of monthly purchases to qualify for commissions”.

Note also the FTC’s comment, “Absent sufficient sales of goods and services, the profits in such a system hinge on nothing more than recruitment of new participants (i.e., fee payers) into the system.”

Let’s keep moving forward in time. What kind of language have we more recently seen coming from the federal courts and the FTC regarding the need for sales to, and compensation flowing from, customers?

FTC v. Vemma

On August 17, 2015, the FTC sued Vemma Nutrition Company and Vemma International Holdings (collectively “Vemma”). In its Complaint, the FTC alleged that Vemma was a pyramid and made false and misleading income claims. One month later, the U.S. District Court granted a preliminary injunction against Vemma. The Order mandated that the Defendants were:

. . . preliminarily restrained and enjoined from:

A. Engaging in, participating in, or assisting others in engaging in or participating in, any Marketing Program that:

4. Pays any compensation related to the purchase or sale of goods or services unless the majority of such compensation is derived from sales to or purchases by persons who are not members of the Marketing Program;

(Emphasis added.)

In the Stipulated Order for Permanent Injunction, Vemma was permanently enjoined from paying

. . . a participant any compensation related to the sale of goods or services in a fixed pay period unless the majority of the total revenue generated during such period by the participant and others within the participant’s downline is derived from sales to persons who are not participants in the Business Venture.

The Bottom Line – In order for each individual distributor to be eligible to receive compensation, a U.S. District Court requires the majority of each distributor’s compensation to come from sales to Customers.

FTC v. Herbalife

The Stipulation to Entry of Order for Permanent Injunction and Monetary Judgment (the “Herbalife Order”) from the FTC v. Herbalife case limits the maximum amount of compensation an Herbalife Distributor can receive from her downline distributors’ personal purchases to 1/3 of her entire downline volume. The Herbalife Order provides:

Limitations on Multi-Level Compensation. The program shall include, and Defendants shall enforce, the following provisions:

1. Any Multi-Level Compensation paid to a Participant for a given period shall be generated solely by the following categories of transactions (“Rewardable Transactions”) . . .

a. * * *

d. All or a portion of Rewardable Personal Consumption transactions, determined pursuant to Subsection I.E., of the Participant’s Downline; provided that the Rewardable Personal Consumption transactions included in a Participant’s Rewardable Transactions shall be limited such that no more than one-third of the total value of the Participant’s Multi-Level Compensation may be attributable to or generated by such transactions.⁴

The Bottom Line – The FTC requires Herbalife to insure that at least two-thirds of a Distributor’s compensable volume to come from sales to Customers.

The Take-Away – For 23 years, sales to customers, and most recently, having the majority of revenues derived from sales to customers, are essential to the legality of an MLM program. An MLM that does not have the majority of its sales revenues and distributor compensation derived from customer sales may be at risk for a regulatory challenge.

Lesson 2 – It is Not Only the Compensation Plan that Determines Whether an MLM is a Pyramid – How it Operates in Practice is the Ultimate Determiner

As the U.S. Court of Appeals explained in the BurnLounge case, To determine whether a MLM business is a pyramid, a court must look at how the MLM business operates in practice.⁵

A proper analysis of the BurnLounge metrics is beyond the scope of this article, but will be discussed in a future article. In summary, the BurnLounge Metrics are:

1. The value of the company’s products
2. The operational realities
3. Who is buying what and how much?
4. The products or services cannot be a sham or smoke screen for a “pay-to-play” scheme
5. Some sales to non-distributors (customers) are not enough
6. Required purchases for distributors
7. Comp plan rules to promote retail sales
8. Meaningful opportunities for retail sales

In addition to the BurnLounge metrics, some additional “operational realities” about which the FTC has complained or a court has found problematic include:

1. Overemphasis on distributor recruiting
2. Inadequate emphasis on customer acquisition and customer sales
3. Large product pack purchases by distributors (not in the thousands of dollars, but in the hundreds)
4. Allowing distributors to “buy their way” to higher ranks in the compensation plan
5. Overemphasis on distributor autoship participation
6. Awarding a lower amount of PV or BV on Customer purchases versus Distributor purchases
7. High personal volume requirements and a failure to track sales to end consumers
8. Failure to enforce anti-inventory loading safeguards, such as the 70% Rule and 10 Customer Rule
9. Inadequate refund and buy-back policies
10. Lack of regulatory compliance training for distributors

It is worth noting that there are other operational realities the FTC has highlighted in its complaints to buttress patterns of deception and violation of the FTC Act, including:

1. deceptive income claims (perennial low-hanging fruit for the FTC)
2. lack of adequate substantiation for product claims

Conclusion

In future articles, we will look at issues related to income claims, autoship orders, substantiation for product claims, product packs, fast start bonuses and a long list of other operational realities that are providing ample ammunition to regulators and class action attorneys.

As I mentioned at the beginning of this article, one of the realities of the business world is that laws and legal standards evolve and change. Although the legal and regulatory requirements for MLM programs have changed substantially over the 23 year, for the MLM industry, it continues to be “business as usual”.

It is long past the time when MLM companies should have re-set their sails and adjusted their paradigms and business practices.

George Santayana was right – Those who neglect history are doomed repeat it. As we have seen from recent FTC cases, the consequences can be extreme.

• Trek Alliance – out of business
• BurnLounge – out of business
• Vemma – out of business
• Herbalife – $200 million for equitable monetary relief, sweeping changes to its compensation plan, an FTC-mandated compliance training program
• Advocare – $150 million for equitable monetary relief and completely out of MLM
• Nerium – ???

Dinosaurs could not adapt to climate change and they are now extinct. MLM companies that fail to adjust to the current climate change may also become extinct.

MLM companies must take an absolutely comprehensive and holistic approach to regulatory compliance. At the risk of sounding completely self-serving, all corporate resources (not merely the compensation plan) need to be reviewed for legal compliance. This means all videos, the entire website, all promotional materials, and all training resources should be reviewed by MLM counsel. Companies must be equally vigilant with respect to distributor compliance – training, monitoring, correcting and sanctioning (where appropriate) distributor activities.

The proverbial handwriting is on the wall.

In the fifth chapter of the Book of Daniel in the Old Testament, Belshazzar, the King of Babylon witnessed the supernatural handwriting on the wall of his palace. The inscription said:

Mene, Mene, Tekel, Parsin

Neither Belshazzar nor his advisors could interpret the message. So they called for Daniel who explained the meaning of the words.

• Mene: God has numbered the days of your reign and brought it to an end.
• Tekel: You have been weighed on the scales and found wanting.
• Peres: Your kingdom is divided and given to the Medes and Persians.

Belshazzar’s unwillingness to humble himself and change was ultimately the cause of his downfall.

May it not be so for MLM.

Let’s do it right!

¹There are unquestionably flaws in the FTC’s logic, but time and space do not permit me to address those flaws herein.

²Admittedly, there is a massive error in the FTC’s logic. In the BurnLounge case, the FTC argued that “internal sales to other Moguls [distributors] cannot be sales to ultimate users consistent with Koscot.” The U.S. Court of Appeals rejected the FTC’s position, saying that it was not supported by case law. The Court stated that, “[w]hether the rewards are related to the sale of products depends on how BurnLounge’s bonus structure operated in practice.” Nevertheless, it seems clear that the FTC is unwilling to acknowledge that some distributors can be “ultimate users” under the right circumstances.

³Eight years after the Omnitrition decision, the FTC issued an Advisory Memorandum to the Direct Selling Association regarding (in part) the issue of distributor personal consumption. The FTC wrote:

Much has been made of the personal, or internal, consumption issue in recent years. In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme. The critical question for the FTC is whether the revenues that primarily support the commissions paid to all participants are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture.

⁴Evidently, the FTC was not satisfied that the one-third/two-thirds provision by itself was sufficient to stop all of the problematic aspects of the Herbalife business model. The Herbalife Order also: (1) flushed any non-Rewardable Personal Consumption volume in excess of 1/3 of total organization volume; (2) prohibited Herbalife distributors from participating in an autoship program; (3) capped the maximum volume from a Distributor’s personal purchases that would be compensated via the compensation plan to $200 during the Herbalife Order’s first 12 months, and a lower threshold thereafter; (4) mandated that points [i.e., PV, BV, etc.] from distributor purchases and customer purchase be equal; (5) prohibited the automatic transition from a Distributor to a Preferred Customer, or from a Preferred Customer to a Distributor; (6) mandated the collection and verification of sales transaction data for Preferred Customers and retail customers; (7) allowed compensation plan eligibility criteria to be satisfied only by sales to Preferred Customers [that is to say, volume generated by Distributors does not count toward compensation plan volume requirements].

⁵FTC v. BurnLounge, 753 F.3d 878 (9th Cir. 2014); Webster v. Omnitrition International, 79 F.3d 776, 783-84 (9th Cir. 1996); see also United States v. Gold Unlimited, Inc., 177 F.3d 472, 479–82 (6th Cir. 1999); In re Amway Corp., 93 F.T.C. 618, 716 (1979).

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