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Multi-Level Marketing and Pyramid Schemes

Practical Law Legal Update w-012-3010 (Approx. 5 pages)

Multi-Level Marketing and Pyramid Schemes

by Practical Law Commercial Transactions
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Multi-level marketing (MLM) is a long-established method of marketing and distributing products and services directly to the general public. However, some MLM plans are fraudulent pyramid schemes, defrauding participants of millions of dollars. This article provides guidance for consumers who are considering joining an MLM plan by highlighting the differences between a legitimate MLM plan and an illegal pyramid scheme.
Multi-level marketing (MLM) is a time-tested method of marketing and distributing products and services directly to the general public. Yet, every year, thousands of consumers are defrauded of millions of dollars by MLM plans that in reality are illegal pyramid schemes.
This article briefly reviews both legitimate MLM plans and fraudulent pyramid schemes, and provides guidance for consumers considering joining an MLM plan on how to differentiate between the two. For advice to businesses on how to stay on the legal side of MLM plans, see the FTC's Business Guidance Concerning Multi-Level Marketing released on January 4, 2018.

Multi-Level Marketing

MLM involves the marketing and distribution of products or services through independent sales agents, also referred to as representatives, distributors, members, participants, affiliates or independent business owners, who:
  • Sell directly to consumers by making in-person sales, for example by visiting their homes, organizing sales parties, or on social media.
  • Recruit other agents who:
    • also sell the products or services; and
    • in turn recruit more agents, and so on.
While the precise compensation structure can vary widely from company to company, MLM participants are generally compensated by earning commissions for:
  • Their own sales.
  • Sales made by their recruits.
MLM companies may also compensate for purchases by downstream distributors for their own personal use or their inventory, but that could be a warning sign of an illegal pyramid scheme.
MLM companies are diverse and encompass numerous industries, but classic examples include Mary Kay (cosmetics) and Amway (household and beauty products). Companies engage in MLM because it is an inexpensive way to advertise and market their products and services by word-of-mouth and in-person sales. They can also use a cheaper work force consisting of independent contractors rather than employees.
Thousands of consumers join MLM plans every year as sales agents. They are attracted by the opportunity to make money working flexible hours out of their homes, while retaining the ability to hold a traditional full-time job, or spend more time with their families.

Pyramid Schemes

Pyramid schemes are illegal business models where participants typically pay an entry fee when they join, and then earn commissions when they recruit others to join the program. Compensation is not based primarily on selling products or services, but predominantly on getting others to join as new agents, who in turn recruit more agents, resulting in a layered, pyramid structure. The entry fees paid by the new recruits, also referred to as downline distributors, are then used to compensate agents in the higher tiers.
The problem with any pyramid scheme is that it is mathematically unsustainable and will eventually collapse, with all but a very few at the top of the pyramid losing their money. The only way to make money is to continuously bring in new members, but the number of potential members, no matter how big, is finite. With time, there will not be enough participants at the bottom of the pyramid to sustain the higher levels, and the pyramid collapses. Therefore, pyramid scheme operators go to great lengths to hide the true nature of the business, misrepresenting the business opportunity and defrauding consumers of millions of dollars.
Consequently, all 50 states have passed some form of legislation prohibiting pyramid schemes. At the federal level, both the SEC and the FTC have brought numerous enforcement actions against companies allegedly engaged in pyramid schemes, often resulting in substantial settlements (see, for example, Legal Update, FTC Mails Redress Checks to Nearly 350,000 Victims of Multi-Level Marketing Scheme).

Multi-Level Marketing Versus Pyramid Schemes

Legitimate MLM plans and illegal pyramid schemes can be difficult to differentiate. Both involve multi-tiered marketing and sale of products or services by several tiers of sales agents. The defining difference between the two is that legitimate MLM plans tie compensation primarily to retail sales to the general public, while illegal pyramid schemes compensate participants primarily based on the recruitment of more participants.
Since pyramid schemes do not rely on retail sales, but on money flowing in from new participants, they typically involve:
  • A substantial entry fee, also referred to as a membership fee, headhunting fee, or bookkeeping charge, in return for the right to sell the company's products or services.
  • Mandatory purchases of large quantities of the product, a practice known as inventory loading, where the participant has difficulty selling it all because of a lack of demand which may be due to a number of factors, such as high volumes, inferior quality, or inflated prices.
  • Significant ancillary expenses, such as expensive sales aides or other training materials, which are not needed or wanted by the agents but are either mandated by the company or a prerequisite for the highest bonuses or commissions.

Tips for Consumers Evaluating an MLM Plan

The main goal for a consumer considering joining an MLM company as a distributor is to ascertain whether an agent's income is derived primarily from either:
  • Retail sales to the general public. If most of the income is sales-driven, the plan is likely a legitimate MLM plan.
  • Recruiting others to join. If most of income is recruitment-based, it is likely that the plan is an illegal pyramid scheme.
Determining whether compensation is sales-based or recruitment-based is easier said than done. Pyramid scheme operators are adept at misrepresenting the true nature of the business. To help determine whether the prospective venture is a legal MLM plan or a fraudulent pyramid scheme, consumers should:
  • Be wary if there is an entry fee. Having to pay money for the right to sell the product or service is a warning sign. Pyramid schemes rely on entry fees by new recruits to pay agents at a higher rung of the pyramid.
  • Ask if there is a requirement to purchase inventory. Inventory loading, where sales agents are required to purchase nonreturnable inventory, is typical in pyramid schemes. Even if the company accepts returns of inventory, consumers should investigate if there are disincentives, for example, a reduction or forfeiture of commissions or bonuses.
  • Research whether the product can reasonably be sold for a profit to the general public. Consumers should compare the suggested retail price (SRP) with prices of competitive products, for example by checking eBay, Amazon, and other online stores. If the SRP is considerably higher, or the product is of inferior quality, it may be difficult to sell. Consumers should also keep in mind that initial sales to friends and family, who may purchase the product or service at the outset to help with the new venture, may not be the best benchmark for ongoing sales to strangers.
  • Read the compensation plan. Consumers should read and make sure they can understand the compensation plan. Convoluted compensation plans are another warning sign that the company may be trying to hide that compensation is really recruitment-based rather than sales-based.
  • Research where most of the income will come from. If a sales agent can make more money by recruiting other agents than by making retail sales to general public, the plan is likely an illegal pyramid scheme. Retail sales to the general public do not include:
    • the consumer's own consumption;
    • sales to recruits; and
    • other persons working for the company.
  • Estimate expenses. Consumers should research not only their prospective income from an MLM plan, but also their expenses. The most common expenses include shipping and handling, gas, and other ancillary expenses such as training materials and conferences.
  • Beware of rags-to-riches and easy-money testimonials. These may seem convincing but may not be representative of how most agents in a pyramid scheme fare. Instead, consumers should ask the company:
    • how much their distributors make on average; and
    • what percentage of agents recoup their initial investment.
    A company that is not forthcoming with this information, whether it ignores these questions or does not track this information, is another warning sign. The vast majority of people joining a pyramid scheme lose money.
For more information on questions to ask before joining an MLM plan, see the FTC's Multi-level marketing: Questions to ask. For more information on FTC consumer protection actions, see Practice Note, FTC Consumer Protection Investigations and Enforcement. For more information on consumer protection generally, see Practice Note, Consumer Protection: Overview.
End of Document
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Resource ID w-012-3010
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Published on 09-Jan-2018
Resource Type Legal update: archive
Jurisdiction
  • United States
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