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June 15, 2004
Pyramid Schemes and the FTC
By QBlog in
In September '03 I posted a blog entry titled "The Cycles of Pyramid Schemes where I sort of tried to figure out what Debra Valentine had to say about Pyramid Schemes and Amway.
Well, tonight I was reading back through her comments and was struck by the following excerpt:
What is a Pyramid Scheme and What is Legitimate Marketing?That selling to people within the "pyramid structure" is exactly how my wife and I were told to work the Quixtar business. In fact, Harvey Ostrander of Team of Destiny said pretty much the same thing at an open meeting. Not only that, but many Quixtar IBOs have told me the same thing, that the way to work this business is to simply change your buying habits and teach others (your downline) to do the same thing. Instead of shopping at Wal-Mart we learn to shop at Me-Mart.Pyramid schemes now come in so many forms that they may be difficult to recognize immediately. However, they all share one overriding characteristic. They promise consumers or investors large profits based primarily on recruiting others to join their program, not based on profits from any real investment or real sale of goods to the public.
Some schemes may purport to sell a product, but they often simply use the product to hide their pyramid structure. There are two tell-tale signs that a product is simply being used to disguise a pyramid scheme: inventory loading and a lack of retail sales.
Inventory loading occurs when a company's incentive program forces recruits to buy more products than they could ever sell, often at inflated prices. If this occurs throughout the company's distribution system, the people at the top of the pyramid reap substantial profits, even though little or no product moves to market. The people at the bottom make excessive payments for inventory that simply accumulates in their basements.
A lack of retail sales is also a red flag that a pyramid exists. Many pyramid schemes will claim that their product is selling like hot cakes. However, on closer examination, the sales occur only between people inside the pyramid structure or to new recruits joining the structure, not to consumers out in the general public.
This is Weird
What's weird about Valentine's very unambiguous comments on Pyramid Schemes is that I'm told her comments are linked by Matt Abraham (a lawyer in TOD) in his legal analysis of the Team of Destiny. This is the same Team of Destiny that claims the infamous "70% rule" primarily exists to ensure IBOs aren't "stocking their basements full of product" to reach a new level.
Very interesting. Raise your hand if you're confused.
Comments
Not even close, Jen.
"FTC guideline for an illegal pyramid is simply
1) the right to sell a product or service; and
2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of products or services to ultimate users."
You don't get it. It doesn't say only either. It says rewards. If some of the rewards are paid for non-retail sales, that would be "rewards which are unrelated to the sale of products to ultimate users." That isn't what the FTC intended either. Obviously SOME purchases will be made by the scheme's participants. That's why the FTC and many states have refined this definition to require the rewards to be paid "PRIMARILY" on true retail sales to non-participants. Thus, you see the following from FTC v. Five Star Auto:
Prohibited marketing scheme' means a pyramid sales scheme, Ponzi scheme, chain marketing scheme, or other marketing plan or program in which a person participates under a condition that he or she make a payment, directly or indirectly, to receive the right, license or opportunity to derive income as a participant primarily from: (1) the recruitment of additional recruits by the participant, program promoter or others; or (2) non-retail sales made to or by such recruits.
'Retail Sales' means sales of products, services, or Business Ventures by Defendants, their successors, assigns, agents, servants, employees, and those persons in active concert or participation with them to third-party end users. Retail Sales do not include sales made by participants in a prohibited marketing scheme or multi-level marketing program to other participants or recruits in that scheme or program or to such a participants' own accounts.
"Read Valentine comment again--she said "the sales occur only to [participants]". Only. Not mostly. Not primarily. Only. Only, as in 100%."
Actually, the word you are looking for is "primarily." As in the following sentence from her comments: "They promise consumers or investors large profits based PRIMARILY on recruiting others to join their program, not based on profits from any real investment or real sale of goods to the public."
As noted above, this is the standard the FTC actually uses to prosecute illegal schemes. "That some retail sales occur does not mitigate the unlawful nature of pyramid schemes." In re Ger-Ro-Mar, Inc., 84 F.T.C. 95, 148-49 (1974).
Somehow, Scott et al blow it up into a guideline that retail must be 70% or 50%.
If by "et. al." you mean the FTC, about a dozen courts including two federal circuit courts of appeal and 20+ state legislatures, then I agree.
"146. Amway's 70% rule deters inventory loading by sponsoring distributors"
It's pretty clear that moving product downline satisfy the 70% reselling and the the 70% rule deters inventory loading."
There's that selective reading again, Jenn.
The ALJ in In re Amway wrote: "To ensure that distributors do not attempt to secure the performance bonus solely on the basis of purchases, Amway requires that, to receive a performance bonus, distributors must resell at least 70% of the products they have purchased each month . . . The buyback rule, the 70% rule, and the tencustomer rule encourage retail sales to consumers."
The law has added considerably clarification since 1979, too.
"In the Omnitrition case, the court made 2 clarifications:
"Importantly, the requirement [70% rule] can be satisfied by non-retail sales to a supervisor's own downline IMAs. This makes it less likely that the rule will effectively tie royalty overrides to sales to ultimate users, as Koscot requires.
In addition, 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 cannot satisfy the requirement that sales be to "ultimate users" of a product."
All this said is that personal use can't be used to satisfy the 70% rule. But it never said reselling downline can't be used to satisfy the 70% rule. Reselling downline only weaken the tie between bonus & sale to ultimate user."
Actually is says both personal use and downline sales are a problem:"Importantly, the requirement [70% rule] can be satisfied by non-retail sales to a supervisor's own downline IMAs." Notice, that's the one that starts with "importantly" and it's the first one the court lists.
The test remains: is the bonus primarily paid on sales to recruits rahter than sales to non-participants?
"The test remains: is the bonus primarily paid on sales to recruits rahter than sales to non-participants? "
"The test remains: is the bonus unrelated to the sale to the ultimate users?"
Same differences.
My quibble is the "70% retail" part. I haven't read any ruling which define the test along this line. My quibble is the test is not "70% of the sale must be to the ultimate user", which Scott and other on this forum made it out to be.
As for Amway 70% rule, there is no selective reading. This rule is designed to deter inventory loading. The "inventory loading" is just a derivation of the sale to ultimate user test. Obviously, if the products are all sitting in somebody basement, there are no sale to the ultimate user.
I never said this rule by itself is adequate. As the Omnitrition case point out, selling to downline may be a problem in that the 70% rule doesn't guarantee sale to ultimate user. Obviously, the last distributor must retail 70% of his product in order to satisfy the 70% rule since he got no downline to resell to. But the top guy may not satisfy the "sale to ultimate user" test even if he moved 70% of his purchases.
In addition to this rule, the 10-customers rule, when applied to the higher distributor, along with the 70% rule may encourage retail sale. I said "may" because I haven't read the entire Amway court transcipt, so don't know how the court found these rules to encourage retailing.
My guess: based on the platinum index #, the average PV/IBO is 38. If we assume all 38 PV are personally consumed, then requiring 50 PV must to be retail will ensure the majority of the sale are to the ultimate user (50 PV >> 38 PV).
I know the potential for abuse, even with these 2 rules, still exist; eg, platinum purchase $18k, resell $13k to dowline (satisfying the 70% rule) and retail $125 (satisfying the 50 PV rule). He still got $5k worth of product on his hand. I don't know what the court would rule in this case. I can guess that the advocate for Quixtar will say almost no IBO personally consume $5k (average PV/IBO is 38). But is that enough? I don't know.
My response was to QBlog confusion arising from what the 70% rule meant. It doesn't means 70% must be to retail customer. Deterring inventory loading and encouraging retail sale are just 2 sides of the same coin.
Lawdawg, are you really arguing that deterring inventory loading is one of ways to encourage retailing???
As for the "mostly" or "primarily", is there a definition for that, like 70%, 50.1%, 99.99%?? In all the court cases I read, I haven't ran across any specific ruling as to which percentage constitute "primarily".
"The test remains: is the bonus primarily paid on sales to recruits rather than sales to non-participants? "
"The test remains: is the bonus unrelated to the sale to the ultimate users?"
Same differences.
THE SECOND QUOTE MAKES NO SENSE!!
"As for the "mostly" or "primarily", is there a definition for that, like 70%, 50.1%, 99.99%?? "
Schrader v. State, 517 A.2d 1139 (Md. App. 1986).
The General Assembly enacted Article 27, § 233D by Chapter 507 of the Acts of 1984, which took effect on July 1, 1984. Section 233D(a)(4) defines a "pyramid promotional scheme" as
'any plan or operation by which a participant gives consideration for the opportunity to receive compensation to be derived primarily from any person's introduction of other persons into participation in the plan or operation rather than from the sale of goods, services, or other intangible property by the participant or other persons introduced into the plan or operation.'
Subsection (b) states that "[ a] person may not establish, operate, advertise, or promote a pyramid promotional scheme." Violation of that prohibition renders a person guilty of a misdemeanor punishable by fine and/or imprisonment. Article 27, § 233D(c).
Pyramiding is a type of multi-level marketing operation which theoretically serves as a method of distributing a company's products to the public. Annot., 54 A.L.R.3d 217, 219 (1973). Participants in the operation are spread out over various distribution levels through which products are resold until they reach the consumer. Id. However, because "one profits merely by being a link in the product distribution chain, the emphasis is on recruiting more investor-distributors rather than on retailing products." Note, Pyramid Schemes: Dare to be Regulated, 61 Georgetown L.J. 1257, 1259 (1973).
A participant's recruitment of others into the pyramid operation results in creation of that participant's "downline," consisting of those persons recruited by the participant himself and by the participant's recruits. The downline is created by recruiting a preestablished number of individuals into the first level of the operation, each of whom then recruits an equal number of additional persons. The original participant moves up to the next level of the operation each time the bottom level of recruits in his downline is completed, with the process ideally continuing until the original participant's downline reaches a maximum figure determined by the number of levels in the pyramid. A participant may earn commissions from the sale of products to the distributors within his downline, but commissions are also received from entry fees paid by new recruits into one's downline.
The type of pyramid operation with which § 233D is concerned is one in which a participant's compensation is "derived primarily" from the participant's recruitment of others into the operation rather than from the sale of goods or services. With that consideration in mind, we now review the evidence in this case.
On February 4, 1985, the Montgomery County Police Department received a complaint concerning C.I. Systems ("CIS"), which was owned and operated by the appellant. Initiating an investigation into the company, Montgomery County Vice and Intelligence Officer John Sheridan called a telephone number obtained from a CIS flyer and heard a recorded message to the effect that "C.I. Systems would act as a consultant for a person that became involved. One could earn $ 300 to $ 700 a month in approximately three months. This amount could double every six to nine months." The recording further advised that "[n]o selling was involved, and four to six hours per week is all that it would be necessary to work." Two additional telephone numbers, one in Virginia and the other in Maryland, were then provided. Officer Sheridan called the Maryland number and heard another recording, this one giving directions to CIS meetings at an office located in Bethesda, Maryland and requesting that callers leave their names and the date of the meeting they would attend. Officer Sheridan gave an undercover name and stated that he would attend the meeting on February 6, 1985.
On February 6, Officer Sheridan attended a meeting at the address indicated in the second recorded message. Conducting the meeting was one Robert Schaffer, who identified himself as a member of CIS's board of directors. n1 Mr. Schaffer informed those gathered at the meeting that an initial payment of $ 45 could result in earnings of $ 300 to $ 700 a month within 3-6 months and of $ 2,000 a month within 6-12 months, without any selling required. He also advised that Erik Schrader was the founder and head of CIS.
Eight days later, on February 14, 1985, Officer Sheridan attended a second meeting at the same location. The meeting was again conducted by Robert Schaffer, who this time explained the various recruiting methods used by CIS. Among the methods discussed were flyers, tear-off slips, advertisements in newspapers and magazines, and the wearing of buttons to prompt inquiries from others. Mr. Schaffer stated that a $ 65 fee was required to join CIS, at which time flyers could be purchased at a special initial rate of $ 25 per 1,000. He then explained in further detail the overall nature of the operation, which involved the recruitment of others into the enterprise at different "levels." n2 According to Officer Sheridan's testimony at the appellant's trial, recruitment was emphasized as the focus of the operation; selling and the product line were incidental. To the extent products were involved, participants in the programs were generally buyers rather than sellers. n3
* * *
As defined in § 233D(a)(4), a pyramid promotional scheme is an operation in which a participant's compensation is "to be derived primarily from" recruitment of other participants into the operation rather than from the sale of goods or services. The word at issue in the statute is "primarily." The Court of Appeals in Bowers explained that "[a] statute is not vague when the meaning of the words in controversy can be fairly ascertained by reference to judicial determinations, the common law, dictionaries, treatises or even the words themselves, if they possess a common and generally accepted meaning." Id. at 125, 389 A.2d 341. We believe the word "primarily," as used in § 233D(a)(4), possesses a common and generally accepted meaning. Webster's New World Dictionary (2d College ed. 1982) defines "primarily" as "mainly; principally. In quantifiable terms, "primarily" is commonly understood to suggest a figure representing more than 50 percent. Thus, the definition of "pyramid promotional scheme" in § 233D(a)(4) imposes a standard requiring that participants in a pyramid operation derive more than 50 percent of their compensation from recruitment for the operation to fall within the definition. We find nothing ambiguous about the term "primarily" as used in that definition.
"Lawdawg, are you really arguing that deterring inventory loading is one of ways to encourage retailing???"
No. I've never said anything even remotely like that. To the contrary, I've maintained that they are separate things. However, each one can serve independently or they can be in unison as indicators of an illegal pyramid scheme. Thus, you see statements in FTC rulings about how retail sales rules and the 70% rule "serve to tie bonuses to retail sales" AND "deter inventory loading." But make no mistake, you can still have an illegal pyramid scheme without what is conventionally understood as "inventory loading." The real issue is whether the products serve as a front for what is primarily a recuiting scheme. If the products are legitimate products AND sold at reasonable market prices there is no reason why there shouldn't be a market outside the distributor force for them. But when 80%+ of the products are just purchased by the distributors themselves so that most of the bonus comes from recruiting, it is a recruiting scheme.
Sounds like the both of you are nit-picking a clause to serve your own bias. I agree with both and neither of you, respectively.
And they said it couldn't be done! :)
Thank you for the info, lawdawg. How do you do those research? You read 10,000 pages a day and remember everything???
We both saying the same thing--deterring inventory loading is important, but not enough, to encourage sales to end-user. At least, I hope you believe deterring inventory loading is important.
Would this be an accurate interpretation of the 2nd test: is the bonus tied to sales to whom, 50%+ are non-participants?
So MLM XYZ can prove that 50% of sales are to non-participants, then they're safe?
What's your take on this argument for MLM advocate:
70% of all IBO only got involved for the wholesale price http://harvardbusinessonline.hbsp.harvard.edu/b01/en/common/item_detail.jhtml;jsessionid=IXCBSUFI5FAKCCTEQENR5VQKMSARUIPS?id=598029 . Since they won't satisfy the 50 PV rule nor the 70% reselling rule, then they can't participate in the bonus. Since they can't participate in the bonus, they should be considered non-participants, thus their purchase should be counted toward the "ultimate users" number.
Jenn:
I would agree that a business with more than 50% in retail sales would not be illegal. It may still not be very profitable for many participants, but it shows that the products are real products sold at real prices and not a front for a recruiting scheme.
I also agree that deterring inventory loading is important. Very few pyramid schemes work that way anymore, though. In that sense, it's less significant because it comes up less often.
As far as the MLM advocate argument, it depends on what these people were told. If they sign up expecting to run a business, buy some stuff, find out it isn't what it's cracked up to be and quit then they should not be counted as IBOs.
I would wager that the scenario described above accounts for most the 85% to 95% you witness doing little or nothing.
The MLM Advocate argument is leaving out a big point, as lawdawg states. Are these participants knowlingly acting as end-users, or are they business owners trying to make a profit, and do not know they are end users? The easy way to determine this would be their tax returns. Fill out a Schedule C in the USA, and you are a business owner. And remember, the IRS says businesses are in business for one reason, and that is to make a profit.
And herein lies the problem. While non-qualifying IBO's might satisfy the retail sales rule, if they are knowlingly IBO's just to get a discount but are still claiming losses on their Schedule C, they are evading taxes! And if the non-qualifiers are in business to profit, then how can they be considered end-users, since end-users (consumers), know that they aren't going to profit by buying consumables?
I would venture to guess most IBO's are in business and file Schedule C's and believe they will make money. And I believe because of this, they do not qualify as end-users, because they are running a business.
The problem with the Amway Japan study, by the way, and its "70% got involved for the wholesale price" argument is that it is based on a very faulty assumption. They looked at the number of people who made a purchase but didn't sponsor anybody and assumed that they therefore only got in for the "wholesale price." That's an unwarranted assumption. First, it is harder than hell to recruit for Amway (or any MLM these days) and most people may simply not have any aptitude for it. Second, it fails to account for those who signed up under false promises, did their due diligence after the house party and went immediately inactive or gave up after the first three no-shows for plan showings.
Furthermore, there is a category now for those who wan to join just for the "wholesale price" - Members (I acknowledge that there wasn't at the time the Harvard study was conducted). If you are signing up people as customers why are they IBOs and not members?
Given the false income claims at just about every plan showing, isn't much more likely that the low rate of active participants is a result of people doing their due diligence or otherwise finding out that Amway is not what they were led to believe it was?
You're confused because you had been listening to Scott and his posse of conspiracy theorists for too long.
FTC guideline for an illegal pyramid is simply
1) the right to sell a product or service; and
2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of products or services to ultimate users.
Read Valentine comment again--she said "the sales occur only to [participants]". Only. Not mostly. Not primarily. Only. Only, as in 100%.
Somehow, Scott et al blow it up into a guideline that retail must be 70% or 50%.
In the 1979 case vs Amway, the court finding of fact & commissioner statement:
"30. Each Amway distributor has the right to sell Amway products to consumers and to sponsor new Amway distributors and to sell products to his sponsored distributors. "
"146. Amway's 70% rule deters inventory loading by sponsoring distributors"
It's pretty clear that moving product downline satisfy the 70% reselling and the the 70% rule deters inventory loading.
In the Omnitrition case, the court made 2 clarifications:
"Importantly, the requirement [70% rule] can be satisfied by non-retail sales to a supervisor's own downline IMAs. This makes it less likely that the rule will effectively tie royalty overrides to sales to ultimate users, as Koscot requires.
In addition, 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 cannot satisfy the requirement that sales be to "ultimate users" of a product."
All this said is that personal use can't be used to satisfy the 70% rule. But it never said reselling downline can't be used to satisfy the 70% rule. Reselling downline only weaken the tie between bonus & sale to ultimate user.
The test remains: is the bonus unrelated to the sale to the ultimate users?
That's it. The test is not: is the bonus tied to sale of which 70% are to retail customers?
Posted by: Jennifer Lee | June 15, 2004 6:36 AM