Legitimate Mlm Or Pyramid Scheme How Can You Tell

www.theadvocategroup.net
www.facebook.com/mlmlaw

As an attorney in the network marketing industry, I’m most often asked the question
“What in the world is an MLM attorney?” After doing my best to answer that
question, and oftentimes feeling like I’ve just spoken in tongues, the next question is
always “Is this XYZ business I’m in an illegal pyramid scheme?” The answer is
always the same.

It depends
The analysis is always fact-driven, meaning a number of factors need to be
considered. Although there is a cheat-sheet / mathematical formula available to help
measure the legality of a business, it unfortunately requires sensitive data from a
company that is never publicly available. So if you really need a concrete answer, you
need to sue the company, get the data via discovery requests and depositions, hire a
professional expert at $500 an hour to plug in the numbers, and then, $100,000 later (if
you're lucky), you’ll have your answer.

The Federal Trade Commission has recently admitted to the challenge of
distinguishing between legitimate companies and pyramid schemes. They said:


While there is a significant concern that some pyramid schemes masquerade as
legitimate MLMs, assessing the incidence of such practices is difficult...While economic
analysis can reveal if an individual company is operating legitimately or if it clearly is
a pyramid scheme, it is difficult to draw an appropriate line in the gray area. 1

In 2009, I published an ebook titled “Pyramid Schemes: Saving the network marketing
by defining the gray”that calls for regulators and legislators to “define the gray”
between legitimate MLMs and pyramid schemes masquerading as MLMs. But until
the gray gets defined, we’ve got to follow our gut instincts.

1
Federal Register, Revised Proposed Business Opportunity Rule, 16 C.F.R. 437, p. 36 (proposed March
18, 2008), available at http://www.ftc.gov/os/2008/03/R511993business.pdf


Legitimate network marketing companies pay commissions on the sale of products
and services to customers. The issue of legitimacy hinges on the definition of
"customer" and the amount of revenue required to come from customers, not
distributors. Legally, companies are required to generate a substantial amount of
revenue from customers outside the program. Is it ok if 99% of a company's revenue
comes from its distributors buying the products for
● ● ●
personal use? Would you be suspicious if you drove
Legally, companies are down the street and saw a sign at McDonald's that said
required to generate a "Over 1 billion burgers sold" and then read the fine
substantial amount of print that said "99% of the burgers were bought by
revenue from franchise owners"? If the vast majority of revenue
customers outside the comes from the sales force, it would seem that the only
way to advance in the company would be to recruit
program.
additional distributors to purchase the products and
● ● ● recruit other participants. And therein lies the

problem.

With pyramid schemes that try to appear as legit network marketing companies,
people under the influence of a faux opportunity might purchase products they

otherwise would never purchase at prices they would never pay at quantities they
would never consume...all with the hopes of recruiting others to do the same. When
there are hardly any customer sales, the products being sold might be considered
"token products" designed to disguise the illegal nature of the endless scheme.

So why are recruitment schemes that look like MLMs dangerous? First, they harm the
reputations of everyone in the industry. But mainly, people are harmed in alarming
quantities. As an example, let's suppose there’s a network marketing company that
sells tap water at $100 per bottle. Theoretically, distributors could purchase this water
and mark it up to $120 per bottle for retail sales, thus earning an immediate $20 profit.
Since there would be very little demand for this expensive water, it would be unlikely
that people unaffiliated with the business would buy the water. Instead, distributors
would be forced to focus on finding other distributors and encourage them to buy the
water for themselves (“personal consumption”) and recruit others to do the same.
Commissions are paid on the downline volume regardless if the products are re-sold
to customers.


Totality of the Circumstances
Absent guidance from regulators and legislators, there are some tell-tale signs
exhibited by illegitimate operations to help you sniff out the good companies from the
bad ones. If you've ever been deep sea fishing, the best indicator of big fish below is
surprisingly not an electronic fish finder, it's birds. If there's a bunch of birds picking
at a spot in the water, they're eating something...and that something was probably
killed by another something you'd like to catch. See one bird? It's probably lost.
Two? They're looking. Ten? Cast the line!

Despite my gruesome analogy, there's a point there;) With pyramid schemes, it’s
more art than science and you're never totally sure. Although you'll never be able to
"see" the fish (sales numbers), you can definitely spot the birds (behavior that's typical
with pyramid schemes). When regulators pursue a company, it’s usually a
combination of several factors that work in disfavor of the business. If you look at the
recent network marketing companies that regulators have shut down, and if you look
at how the regulators drafted their lawsuits, you can get a gist of the types of behavior
that irks regulators.


So to save you the misery of having to thumb through those court pleadings, I’ve
prepared a list of factors to help you tell the difference between good companies from
bad. If the business gets past the GOALIE test, you've got a great opportunity.


● ● ●
You've been making purchasing decisions your whole life. You When analyzing a
know the value of a dollar. Deep down, you know that paying $3
network marketing
for a coke is a bad idea. Over the course of your life, we've all
opportunity, your gut
developed a spidey sense about the value of our money. We
instinct is the most
know how far a dollar goes.
informative factor.
When analyzing a network marketing opportunity for legitimacy, ● ● ●
your gut instinct is probably the most informative factor in the

GOALIE test. Ask yourself, “If there was no income opportunity
associated with this product, would I still buy it as a customer?" If the answer is
“yes,” odds are you’re not alone and you’ve found a good company with a desirable
product. It's imperative that direct sellers be able to sell the products to people outside
the network. Can a participant (you) make decent money without sponsoring another
participant? If the answer is “no,” the design is fatally flawed. If the price is wrong,
there will likely be financial incentives for you to endlessly recruit other participants to
purchase the products for their own use i.e. buying the $100 tap water and recruiting
others. Business models dependent on constant recruitment akin to the Bernie Madoff
scheme are untenable, unsustainable and illegal.


Gerald Nehra, a fellow attorney in the industry, once wrote that regulators "look past
the paper" when reviewing a company. It takes more than having rules in place
ostensibly designed to encourage retail sales...the sales need to actually happen.

It's interesting to note that the FTC is undefeated in all of their cases against
MLMs...all except for one. In 1979, Amway dodged lightning when the court held
Amway was not a pyramid scheme. Similarly, in 2008, the United Kingdom's efforts
to shut Amway down were met with similar results. If Amway were a movie
character, it would be like Michael Myers of the Halloween series. It appears to die, it
comes back, it appears to die, it comes back...creepy in its discipline, its power
mysterious.

So enough with the pop culture throw back, you're probably asking why I'm
referencing Amway in the section about Operational Integrity? Well in 1979, when the
court issued its opinion in FTC v. Amway, the court said that Amway's saving grace
was its policies and procedures. The court held the policies actually encouraged retail
sales, which was contrary to the pyramid allegations. Among the rules, the court

referred to three important ones: the buyback rule, the 70% rule, and the ten customer
rule. Since nearly every company has a 70% rule and a good return policy, I want to
focus on the most important rule of all: the ten customer rule.

Amway's ten customer rule stood for the idea that if a distributor failed to sell
products to 10 customers in a given month, they were ineligible for their bonus.

The rule theoretically puts financial pressure on distributors
to sell the product to nonparticipants. The rule also puts
pressure on the company to offer marketable products at
fair prices. The rule is designed to protect both distributors
and consumers.
If the products do not get bought by nonparticipants, the bonuses get frozen,
distributors quit, and all hell breaks loose. It's a great rule...when it's enforced. In
some of its lawsuits, the FTC alleged that the companies had rules "ostensibly
designed" to encourage retail sales. If those rules are not enforced, they're worthless
and disregarded by courts and regulators.

Now this is where you have to "look past the paper" to ensure the company enforces
its own policies. As a lawyer in the industry, it's easy to ensure my clients look good
on paper. But where I really make a difference for my clients is by advising them to
maintain institutional discipline to enforce those rules.

If you're presented with a network marketing opportunity, ask your sponsor the
following questions:

• Is there a retail sales rule? If the answer is no, that's a factor.

• If there is a retail sales rule, how much product must I sell each month to
remain eligible?

• Does the company require you to make these sales, or is there a work-around?

• Do you have a hard time making the sales?

• Have you ever heard of a distributor not receiving a bonus for lack of retail
sales?

• Can I see some receipts of your most recent sales?

If your mother is showing you the business plan, it might be tough to ask for proof;)
But if you're about to get in business with someone, a business that might require a
rolling investment of tens of thousands of dollars, more information is a good thing.
And as people in a sales business, they should be able to provide receipts.


If the compensation plan requires you to recruit other participants in order to advance
up the pay scale, it's a factor to consider. Ask yourself: "Do I advance my position and
potential income potential by recruiting additional distributors down a fixed hierarchy of
distributors beneath me, who in turn advance by recruiting other distributors, etc.?" If yes,
the result is self-appointment through recruitment to increasing payout levels in the
distributor hierarchy. Translation: If a person climbs up the compensation ladder by
recruiting active distributors, it strongly suggests a pyramid scheme.

An easy example is with forced matrix plans. If a plan is 5 x 5, the only way to
advance to the next level is to fill the first level by recruiting 5 active distributors.
Retail sales are not part of the equation towards advancing up the pay scale.
Advancement requires recruitment. When the financial incentives reward
recruitment, the distributors will naturally follow the rewards.

Another example can be found in the marketing plan. If you're being shown a
business plan for the MLM, how does the presenter define success? Is it described in
terms of customer sales i.e. if you sell x amount of product you earn $y?


Or is success described in terms of the number of distributors in your downline i.e. if
you get x people below you, you can earn $y. If advancement is explained in terms of
recruitment, it's a factor.


If the business offers a truly unique and remarkable product, one that cannot be found
in traditional retail channels, then disregard this factor. However, if the product is a
slightly different shade of a similar product at other retail establishments, then a
bloated compensation plan makes it difficult for distributors to make retail sales due
to the high costs built into the price of the product. One way to check to see if a
compensation plan is bloated is to count the number of levels. If there are more than 7
levels in the compensation plan, it's a factor to think about. The rationale is simple.
With traditional distribution channels for products (retail stores), the product changes
hands a few times before it reaches the consumer i.e. manufacturer, national
wholesaler, regional wholesaler, retail store, consumer.

With each link in the chain (or compensation plan), the costs are built into the final
price of the product. The more links in a chain, the more expensive the product. Just
ask K-Mart. With several levels, companies will be hard pressed to compete with
anyone on price, UNLESS the company offers a truly unique product. Although the
actual distributor payout is more relevant than the levels in a pay plan i.e. company X
pays out 40% of profit to the distributors, distributors are seldom privy to that
information. So in the meantime, count the levels.


If the product is truly unique, they can have as many levels as they want so long as
there's legitimate demand from consumers outside the distributor network. Although
the number of levels is a factor, it's not a determining factor. Really, counting the
number of levels in a compensation plan should only confirm what your gut already
knows...is the product marketable or is the price inflated due to a fat compensation
plan. I've personally represented a company that pays out via several levels while
maintaining very competitive prices. It is possible.


Does the company require you to purchase a minimum amount of product each
month to remain eligible? If so, it's not necessarily a bad thing. But as with all things,
moderation is important. Inventory loading is a dangerous practice where
companies require its distributors to purchase an inordinate amount
of product each month to remain eligible for bonuses. It's sort of like
waterboarding (but voluntary) where the distributor is forced to consume more than
he or she would naturally consume under reasonable circumstances. If a company has
excessive inventory requirements, it's a huge red flag for regulators.


● ● ●
Courts have defined inventory loading as, "Occurring when
distributors make the minimum required purchases to receive When companies
recruitment based bonuses without reselling the products to require excessive
consumers.” Again, and this point cannot be stressed enough, sales inventory, an amount
to nonparticipants must occur. When companies require excessive rational people would
inventory purchases, an amount rational people would never never purchase without
purchase without an income opportunity, they might be trying to an income opportunity,
artificially beef up sales by forcing their distributors to purchase the
they might be trying to
products. However, assuming the levels are low, a company can
artificially beef up sales
require inventory purchases. For example, if a company has a 10
by forcing distributors
customer rule, they can require their distributors to purchase
sufficient quantities to service 10 customers, assuming the sales to
to purchase products.
customers are actually occurring. ● ● ●

As an example, prior to Amway making some of its changes, members of its sales
force produced a “300 PV household” brochure. It explained how the average
distributor could purchase 300 points a month for their own household with no
reference to selling. It ended up costing over $900 each month. $900 a month. That's a
little high, don't you think?

Ask your sponsor, "Will I be required to purchase products each month?" If so, ask
how much. If the quantity seems steep, there’s a problem. But if the quantity matches
the company's retail sales requirement (assuming there is one), it's probably fine.
Trust your gut. There's no science here, only art.


Enrollment fees are the costs associated with the registration. In all things business,
you’ve got to pay to play. How much are you being asked to pay to enroll in the
network marketing company? Registration fees to join the program must not be
excessive. In my view, and I advise clients in this regard, registration fees must be tied
to legitimate administrative costs born by the company. The act of registration must
not be a profit center for the business. Companies cannot charge $400 at sign-up and
use that money to compensate its distributors. It would be considered a disguised
way of paying a recruitment fee for signing up distributors.

Commissions must only be triggered by product sales. In order to be commissionable,
those products must have legitimate demand from people outside the program.
Registration fees and sales aids (training material designed to help
distributors sell products i.e. personal websites, company literature,
brochure, sales kits, etc) are “non-commissionable” because they’re
only relevant for distributors, not for customers outside the network.
I’ve heard them referred to as “non-products” because MLM companies are in the
business of selling products to consumers, not in the business of training distributors.


The sale of training aids to distributors is done to facilitate those sales to consumers.
It’s important to note that separate companies can be created to develop training
materials for distributors. But the MLM company itself cannot pay commissions on
the sales of these items.

In Burnlounge, the most recent target by the FTC, distributors were required to pay
over $400 to join, which included a personalized website (a sales aid). With the
personalized website, they were empowered with the ability to sell music to customers
through their website. Burnlounge captured the money during registration and
allegedly used it to pay its distributors.

Since the personalized websites were only relevant for distributors (it helped them
make sales to customers), the FTC argued that the money was improperly paid out to
distributors. Remember, commissions can only be paid out when product volume is
moved to end-users. The products must be “commissionable” and have legitimate
demand from nonparticipants.

If you're pitched a business and the enrollment fee is over $100, I would ask why. If
you're getting lots of bells and whistles with your enrollment, it might make sense.

Also check to see if the company pays out a commission when its distributors sell sales
aids i.e. personalized websites, brochures, etc. Remember, there’s no need for a costly
registration fee and it’s illegal if the company is paying commissions on the sales of
training materials.


So did your company make it past the GOALIE test? If so, you've found an
outstanding opportunity. If not, at least you know. The GOALIE factors are tell-tale
signs to help you distinguish the good companies from the bad ones.

In a perfect world, companies would be required to disclose the percentage
of revenue they get from nonparticipants.

If a company gets 30% of their business from customers, it's a good company with a
proven product. 50%? Even better. 10%? Danger! However, since we'll never be
privy to the sales data, and most companies will never provide it, all we can do is
track the signs. The network marketing industry is fabulous. Average people are
given excellent opportunities to represent exciting products and change their finances.
Network marketing is also a great vehicle to introduce innovative products into the
marketplace. When fraudulent schemes masquerade as legitimate companies, it
affects the reputations of all companies in the industry. By being informed of the
issues and spreading this information to your friends and family, you ensure that
these fraudulent schemes lack fertile ground to spread. So go ahead, be a cool person
and share this article. Everyone is doing it;)


ABOUT THE AUTHOR
Kevin is a lawyer, entrepreneur, and agent of change. He’s an MLM
attorney and the founder and president of The Advocate Group that
specializes in transactional work and start-up formation for network
marketing companies. Kevin provides entrepreneurs with the tools
necessary to get their businesses successfully off the ground on secure
legal footing.

Prior to starting The Advocate Group, Kevin gained valuable experience
while serving as Chief Counsel for Signature Management Team, LLC,
also known as Team. Team is one of the largest providers of sales aids
for distributors in the network marketing industry. While at Team,
Kevin worked closely with Amway and Mona Vie’s compliance departments to ensure Team’s
marketing materials passed regulatory review. Also during his tenure at Team, Kevin helped guide the
company through commercial litigation with Amway. He’s recently published a widely read, 80 page
ebook on the changing state of the law in the network marketing industry, titled “Defining the Gray.”
Read the ebook here, free of charge, to learn more about the laws in the industry.

For more information, please contact Kevin directly at: Kevin [at] theadvocategroup [dot] net. Or call at
615.412.9876. You can read Kevin’s commentary on his blog, Next Generation Law.


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