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The following Article is in lawyer language. Here’s what it says: Don’t require a fee or purchase of any kind for someone to be a Distributor. If a fee or purchase is not required but if made results in a Distributorship—don’t do that either.
ILLEGAL PYRAMID SALES COMPANIES Over the past decade, enforcement actions against MLM companies have resulted in our understanding that there are two specifically defined types of illegal pyramid companies, certain regulatory authorities enforcing against one type, and other regulatory authorities enforcing against the other type. For our purposes, we will call these two distinct types of illegal pyramids Type A and Type B pyramids. TYPE A ILLEGAL PYRAMIDS. Type A illegal pyramids are sales operation which violate traditional lottery concepts. While lotteries are not per se illegal in the United States, they become illegal when someone can become a participant in the lottery program by paying money, including purchasing something. In MLM companies an illegal lottery arises when participants may join as distributors by paying money or things of value for the right of participation in a compensation system which has a significant and ongoing element of chance as regards how much the participant will receive in commissions. The payment resulting in illegality may be required, or not, and may be a purchase of sales aids, products or services. If the payment results in participation in the lottery program, a Type A “Lottery” illegal pyramid is present. The three necessary concurrent elements of an illegal lottery are these: The transfer of money or things of value for the right of participation, and An expectation of financial gain, and The financial gain is determined in significant part by chance as opposed to the skill and participation of the participant. It is not difficult to understand why MLM sales programs can fit this illegal “lottery” mold almost perfectly. Distributors traditionally pay for their distributorships by fees, sales aids purchases, product/service purchases, or any combination of these. And they do so with the expectation that they will obtain financial gain through the receipt of commissions. All that remains to complete the presence of an illegal lottery on the part of MLM programs is an ongoing element of receiving commissions by chance. The chance aspect of MLM commissioning has bee debated and litigated, with the companies almost always losing. The enforcement authorities have come to understand, and the courts are coming to understand, that although some very talented distributors will actually work with their downline distributors, most can’t and don’t. The reality is, below the second downline level, that participation by the upline commission recipient in commissionable downlines sales is practically impossible and rarely ever accomplished, resulting in commission earnings occurring substantially and continuously by chance. An example of chance commissioning: A sponsors his friend B, B then sponsors his cousin C who is several states away from A and B. This is a common and ongoing occurrence in MLM. The fact of the matter may be that C is a wonderfully talented and effective distributor. But B most probably will not have participated in the sales and downline building activities of C and A probably doesn’t even know who C is until he learns of C on his downline commission report. FACT. The payment of commissions in an MLM compensation plan, every type of MLM compensation plan, to an upline distributor more than 2 levels removed from the downline commissionable transaction, occurs more often by chance than by the upline commission recipient’s participation in the commissionable event. ENFORCEMENT AGENCIES: Lottery statutes and regulations are sometimes, but not often, enforced by state agencies. Likewise, the U.S. Federal Trade Commission has seldom undertaken enforcement activity against Type A illegal “lottery” pyramid sales plans. Lottery concepts, however, are at the very heart of and the basis for enforcement actions by the United States Postal Service under its Postal Lottery Regulation, and by the United States Securities and Exchange Commission. The United States Securities and Exchange Commission, and occasionally state Securities Commissions, understand that wherever the illegal lottery features are present and there is the added factor of a common business activity between the investor seeking financial gain the company taking his money, (precisely the relationship between the MLM distributor) there is being offered and sold by the company a classical investment security. The company either registers investment securities with the appropriate state and federal agencies, and offers them by way of a complex prospectus, or one is violating the law by the offering and sale of unregistered investment securities. Compliance Solution. The MLM industry cannot change the fact that there is a significant and ongoing element of chance in the receiving of commissions from downline commissionable activities, nor can it change the fact that there is a common business enterprise between MLM distributors and the MLM company. The one thing that the MLM industry can change, a compliance solution which totally avoids the presence of a Type A illegal pyramid, is to have no money or things of value required or means to become an MLM distributor. Although MLM companies selling wholesale to their distributors for resale may require reasonable ongoing wholesale purchases by a distributor to retain distributor’s commissionability, there are very precise and limiting rules connected to such wholesale periodic wholesale purchases, and an initial purchase resulting in a participation as a distributor is not part of this narrow “required wholesale purchase” exception. TYPE B ILLEGAL PYRAMIDS. Type B illegal pyramids are characterized by the customer becoming a distributor of the MLM company, their purchase automatically obtaining distributor status and then being commissioned when the distributor brings in other persons who do the same. This type of MLM company sales program is characterized as a “customer-to-customer chain referral scheme” or “endless chain scheme.” Those features of this type of illegal pyramid distinguish it from the Type A lottery based illegal pyramid, because: No element of chance is necessary for illegality, the mere ability to sponsor other customers who automatically become distributors is all that is necessary to establish a violation of the law, and Enforcement results are much more easily obtained against Type B pyramids than against Type A pyramids, one either grants the purchasing customer distributorship and then commissions them when they bring in someone who also becomes a customer/distributor, or one does not. Although MLM companies are traditionally adept at clouding the true methodology of their compensation plans from non-participants or causal observers, customer-to-customer chain referral schemes are almost impossible to effectively disguise and, when prosecuted, are difficult to defend in a court or administrative agency proceeding. THE SOLUTION AND THE PROBLEM. The obvious solution to avoid the presence of a Type B illegal pyramid, i.e. to avoid being characterized as a customer-to-customer chain referral scheme (endless chain scheme), seems simple enough: Don’t allow product or service customers to become distributors. This is also the problem. The nature of this problem can be seen by the following fictional discussion: AN EXCHAGE BETWEEN THE MLM COMPANY AND AN ATTORNEY GENERAL: Attorney General: “If you let a customer automatically become a distributor, even if you have in your printed materials that customership does not equate to distributorship, we know that the reality of MLM prosecuting is such that the person being prospected has either been told, or at least led to believe, that the way to get the distributorship is to become a customer.” MLM Company: “There’s something wrong here, a distributor ought to be able to be a customer if they want to be a customer, and a customer ought to be able to be a distributor if they want to be a distributor. Your position, Mr. AG is inherently unfair and really means that our distributors can’t be customers of our product.” Attorney General: “We are willing to give you some leeway on this, we adhere to and enforce the FTC policy, which used to be 70%, but which is now “over 50%”—this means that your distributors must sell over 50% in dollar value of your products or services to non-distributor end-user consumer, whether they sell it directly by taking orders or buy at wholesale for resale. If you do this, you’ll be okay.” MLM Company: “That’s easy, we already do that. It’s right here in our distributor agreement that they have to make over 50% of their sales to end-user non-distributor consumers, we require in our distributor agreement that over half of the sales that they turn in for us to fulfill are to non-distributor customers. So what’s the problem?” Attorney General: “Not so fast, we understand how the MLM distributor operates. The fact of the matter is that the vast majority of them ignore those requirements as if they weren’t there, and the companies ignore them too. It’s easy for use to call witnesses to prove that both the distributors and the companied ignore this requirement. That’s why we have a policy, suggested by several recent court cases involving MLM companies, that the companies have a duty to continuously verify a small but real percentage of their distributors’ sales. This means that your distributors buying wholesale and reselling have to turn in sales reports identifying their non-distributor customers, and those distributors turning in orders for company fulfillment have to likewise identify whether or not their customers are distributors. You’ll have to verify 2-5% of your distributor’s sales every month or find a better way to be sure your distributors are making end-user sales.” MLM Company: “What you ask is impossible. If we call for just 2-5% of the transactions to be the subject of verification, a lot of our distributors just won’t do it; even if we could get all that information, we would have to verify thousands if not tens of thousands of transactions every month, something which would be so expensive it would put us out of business. Besides, what do we do if we’re unable to reach the reported customer to verify that they were a non-distributor at the time of purchase? Attorney General: “Verifying those non-distributor consumer sales is our policy, you’re just going to have to do it no matter what the volume of transactions involved, and no matter how difficult and costly it may be to go through the verification process. We’re not going to let you commission those distributors whose sales are being verified, unless they can be verified to the tune of over 50% of their wholesale purchases or company fulfilled sales being to non-distributors.” MLM Company: “What you ask is impossible, we can’t afford to do it and you know as well as we do that there are some sales which we could try and try to verify, but we would never be able to reach the customer. Your are suggesting that if we a re unable to verify enough sales for each of the reporting distributors, even though they may have been true non-distributor consumer sales, that we have to punish the distributor by not paying them commissions even though they have earned them under your own criteria.” Even if distributors turned in the thousands and tens of thousands of monthly consumer sales information records, which they won’t in reality, and even if the companies could institute verification procedures to verify the sales which is prohibitively expense, and even if the most diligent attempts were made to verify the true customer non-distributor nature of over 50% of the sales, which is impossible (companies attempting to verify sales pursuant to consent decrees and court orders are hard pressed to verify 35-40% of the sales), the suggested “verification” solution does not effectively address the problem, because: Selling over 50% to non-distributor consumers means that 40.99% of the transactions can be truly bogus, distributor to distributor or not consumer sales at all, and that’s somehow okay, and FAILED SOLUTIONS. To avoid being a Type B illegal pyramid, a customer-to-customer chain referral scheme-endless chain scheme, the MLM companies have periodically ratcheted up their appearance of compliance. Let’s take a look at what the MLM industry has done in seeking to at least appear to comply with the enforcement authorities’ policies (requirements): Stated in the literature and sales aids that customership is not required. Result: Enforcement authorities haven’t fallen for this one, they understand that in the real work of distributor presentations and recruiting that this “boiler plate” statement in the distributor application, and perhaps in other materials, is simply ignored by both the distributors and by the companies. In recent years the regulatory authorities, mostly attorneys general, have been attempting to have network marketing compensation plans found to be illegal pyramids even though there is no fee or purchase required or a way to obtain a distributorship, by looking at the number of distributors who also become customers or make a sales aids purchase—where the number is high, they may claim that the sales plan has a hidden required purchase. Beware of this type of incorrect claim. The law is clear that the number or percentage of Distributors who also become customers and/or make sales aids purchases is not relevant in determining the presence of an illegal lottery/pyramid. It has no fee or purchase required to become an MLM distributor. Not an administrative fee, not a kit at cost (allowed only in a few states), just no fee or purchase. Most states permit a modest refundable deposit, but it has to be truly refundable with nothing to be returned. Does this mean that every distributor, even though they might not purchase what must be an optional sales kit, must receive a sales kit? Yes it does, because if I need literature and sales aids to start my distributor business and I have to buy them to start my business, that is a requirement that I make a purchase. Thayer C. Lindauer July 2002
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