SA Legislation

Legal Principles of Multilevel Marketing
 
I.  Multilevel Marketing/Pyramids :
 
Federal and state multilevel marketing and anti-pyramid statutes are components of a comprehensive consumer protection umbrella. These laws are designed to protect individuals from being defrauded through illegitimate programs which lure participants with the promise of easy money by compensating them from the investments of additional participants rather than legitimate product sales. These programs have been called “Ponzi Schemes,” “airplane plans,” “Pyramids,” “chain letters,”  programs have cost their participants hundreds of millions of dollars. Federal business opportunity, franchise, Lottery and security laws. (Each of these areas will be discussed below)
 
Whether a program is legitimate multilevel marketing plan or illegal pyramid depends principally on: (1) the method by which the products of services are sold; and (2) the manner in which participants are compensated.  Essentially, if a marketing plan compensates participants, directly or indirectly, merely for the introduction or enrollment of other participants into the program, it is a pyramid.
 
A. Legislative intern and Judaical Interpretation
 
As a practical matter, it is impossible for legislators to anticipate the infinite creativity of individuals who devise, implement and promote legal and illegal marketing programs. Accordingly, anti-pyramid and multilevel statutes, like most consumer protection legislation, are drafted and interpreted very broadly so that the might encompass all of the possible permutations of an illegitimate scheme, and thus have jurisdictional basis for regulating and eliminating them.
 
The analysis used by regulators to evaluate multilevel marketing programs is essentially two-fold. The first of the two foci (“focuses” if ou are from Idaho) involve a review of the theoretical or conceptual design of the compensation plan. More precisely stated, does the compensation plan, as written, appear to compensate participant: (1) merely for the introduction of additional participants into the program; or (2) for the sale of goods and services “end consumers.” If it is the former, it constitutes the most classic example of a pyramid. IF it does the latter, it will pass through the first prong of analysis. Suffice it to say that the vast majority of new MLM companies do not run afoul of this first hurdle. Historically, they, as well as many existing companies, have had problems with the second component of the analysis.
 
The second aspect of the analysis involved the “operational analysis” of the compensation plan. Notwithstanding the conceptual or theoretical design of the plan, what in fact do distributors spend their time doing. More precisely stated, I actual operation, what type f acticity does the compensation plan incent -- the recruitment of additional distributors or sales. As discussed below, despite the sale of products or services by distributors, the compensation plan nevertheless constitute a pyramid.

The operational analysis involves factual and subjective determinations. Over the decades, court have the developed a litany of factors by which they evaluate compensation programs. The definitive (and amorphous) test is, “what is the emphasis of the program?” If the emphasis of an MLM program is on recruiting (rather than product or service sales), it will be a pyramid. While none of us has a crystal ball by which we can devise the future operation of an MLM program, Having reviewed countless plans, we have developed substantial prognosticating skills.
 
B. Is Your Program Multilevel?
 
Multilevel marketing companies must guard against being classified as a pyramid on both the state and federal levels. The majority of states statutorily regulate multilevel, or more precisely anti-pyramid, activity. Federal regulation, on the other hand, is primarily a function of administrative and judicial decisions arising from a series of private party and Federal Trade Commission litigation.
 
1. State Statutory Approaches
 
As regards pyramids and multilevel plans, state statutes have taken two distinct approaches. A sophisticated Minority  (I) of state laws specifically define and regulate multilevel plans. Georgia statue provides a typical definition of multilevel marketing company:	
	
	“multilevel distribution company” means any person, firm, corporation, or other business entity 	which sells, distributes, or supplies for a valuable consideration goods or services through 	independent agents, contractors, or distributors at different levels wherein such participants 	may recruit other participants and wherein commissions, cross-commissions, bonuses, refunds, 	discounts, dividends, or considerations in the program are or may be paid as a result of the sales 	such goods or services or the recruitment, actions, or performances of additional participants. 
 
The definitions of a multilevel company or the multilevel marketing plan in the other states specifically define multilevel marketing are identical or very similar to Georgia’s.
 
Broken into individual components, the elements that must be met establish a multilevel company or multilevel plan Include : 
 
Elements of a Multilevel Compensation Plan
Does Your Program Meet These Elements
(1) A person, firm, corporation or other Business entity
 
(2) Which
(a)  sells
(b) Distributes, or
(c) Supplies
 
 
(3) For Consideration
 
 
(4) Goods and services
 
(5) Through independent agents, contractors, or distributors
 
(6) at different levels
 
(7) Participants may recruit other participants
 
(8) Compensation to participant is paid as a result of
 
(a) the sale of such goods or services; or
(b) the recruitment, actions or performance of other participants
 
 
C. Is Your Program a Pyramid?
 
The vast majority of states utilize an indirect approach by defining a “pyramid”, “chain distributor scheme” or “endless-chain scheme” and proscribing such programs. Regardless of the name used by the statutes, their intent is to prohibit plans or programs that reward participants, either directly or indirectly, on the basis of recruitment or enrollment of other participants rather compensating them for sales of products or services to end consumers. For example, North Carolina defines a “pyramid” as:
	
[a] ny program utilizing a pyramid or chain process by which a participant gives a valuable consideration for the opportunity to receive compensation of things of value in return for inducing other persons to become participants in the program.
 
N. C. St. 14-291.2(b)
 
New York’s definition of a “chain distributor scheme” is more precise, but nonetheless representative of anti-pyramid statutes.
 
[A] “chain of distributor scheme” is a sales device whereby a person, upon condition that he make an investment, is granted a license or right to solicit or recruit for profit or economic gain one or more additional persons who are also granted such a license or right upon condition of making and investment and may further perpetuate the chain of persons who are granted such license or right upon such condition. A limitation as to the number of persons who may participate, or the prescience of additional conditions affecting eligibility for such license or right to recruit or solicit or the receipt of profits therefrom, does not change the identity of the scheme as a chain distributor scheme. As used herein, “investment” means any acquisition, for a consideration other than personal services, of property, tangible or intangible, and includes without limitation, franchises, business opportunities and services, and any other means, medium, form or channel for the transferring of funds, whether or not related to the production or distribution of goods or services. It does not include sales demonstration equipment and materials furnished at cost for use in making sales and not for resale.
 
 
N.Y. Gen. Bus 359-FFF.
 
The laws if Texas contain similar definition for “endless chain” schemes.
 
	“Endless chain” means any scheme for the disposal or distribution of property whereby a 	participant pays a valuable consideration for the chance to receive compensation for introducing 	one or more additional persons into participation in the scheme or the chance to receive 	compensation when a person introduced by  the participant introduces a new participant
 
V.T.C.A., Penal Code 32.48.
 
Anti-pyramid statutes provide that pyramids, endless chain schemes, or chain referral schemes are illegal. Thus, so long as a multilevel compensation plan does not fit within the parameters of the prohibited activities, it is permissible (at least as regards anti-pyramid laws).
 
Elements of a Pyramid
Does Your Prgram Meet These Elements?
(1) A scheme, plan or program
 
(2) For which a participant renders consideration to join
 
(3) For the right or chance to receive compensation or other things of value
 
(4) Which is contingent upon the introduction of additional participants into the scheme, plan or program.
 
 
If any of the elements listed above are absent, the program does not violate state anti-pyramid legislation.
 
 
1. Federal Administrative and Judicial Decisions
 
There is no federal anti-pyramid statute in the United States. Nevertheless, decisions of the Federal Trade commission and the Federal Courts, more so than legislation from any individual state, have largely supplied the legal framework upon which multilevel marketing companies have developed their programs. The most often cited definition of a “pyramid” scheme is found in the Federal Trade Commission’s decision in  In Matter of Koscot Interplanetary, Inc. Therein, the F.T.C. held that “entrepreneurial chains” are characterized by the “payment by participants of money to the company in return for which they [the participants] receive the right to sell a product and the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of the product to ultimate users.
 
Elements of Pyramid - Federal Decisions
Does Your Program Meet These Elements?
 
(1) Payment of money to the company
 
(2) The participant receives the right to sell a product (or service)
 
(3) The participant receives compensation for recruiting others into the program
 
(4) The compensation is unrelated to the sale of products (or services) to the ultimate user.
 
 
D. Important Issues
 
The above discussion and tables are representative of the pyramids issues facing the multilevel marketing industry. Companies should be careful when developing their marketing plans to stay within the parameters of these laws. However, designing a program strictly adheres to the literal items of the law will not guarantee the program will overcome all legal challenges. There are variables among the states in the definition of a “pyramid scheme” which may result in a program being entirely legal in one state yet illegal in a neighboring state. In addition, judicial interpretation of a statute or a prior decision may result in a decision that is seemingly inconsistent with its literal fails to enforce its policies which guard against pyramiding dangers, the program faces the same risks as a program which does not incorporate appropriate safeguards into its plan.
 
Although the inconsistencies among the states and federal law pose difficulties when designing a marketing plan, there are factors which both federal and state forums consider when conducting a pyramid analysis. Although these criteria are typically not specified by statute, they are taken into account because they provide evidence that the dangers posed by a pyramid scheme are mitigated.
 
1. Substantiatable Sales of Products to End Users
 
As discussed above, a program that compensates its participants for the mere act of recruiting or enrolling others into the program is a pyramid. Unscrupulous promoters have attempted to circumvent the traditional definition of a pyramid through a practice called “inventory loading”. Although participants in an inventory loading scenario are technically compensated for the sales of products, the sale is in actuality a subterfuge.
 
In an inventory loading scenario, new recruits are required or pressured to purchase large quantities of products (often unconscionably overpriced and nonrefundable). This, in turn, produces a large “commission” for upline participants. The emphasis in such a program is not on the sale of products, but rather on recruiting if new participants with the goal of “loading” them with as much inventory as possible. In addition, there is usually a substantial improbability that the average distributor would either use or be able to resell the quantity of goods that are involved in an inventory loading setting. Because of these factors, courts have consistently held that notwithstanding the “sale of products,” such transactions are tantamount to a “headhunting” or “recruitment” bonus and thus constitute a pyramid. Accordingly, it is important that sales to distributors be reasonable in amount and price and documented to reflect this.
 
2. Sales to “Ultimate Users”
 
Many multilevel marketing companies want to develop compensation programs under which distributors receive commissions based on the purchase and consumption of products by downline distributors rather than retail sales to third persons. This is logical approach since one of the greatest deterrents to enrolling in a multilevel program stems from the general public reluctance to engage in sales. Indeed, the entire industry has been built almost entirely upon the personal consumption of products by distributors. Under a literal interpretation of the  Koscot definition of a pyramid, personal consumption satisfies the second element of the test because distributors can be classified as “ultimate users” if they personally consume the products they purchase.
 
Despite the literal language of the Koscot test, courts have interpreted and state Attorneys General is increasingly interpreting the term “ultimate users” to mean persons who are who are not participants in the program, that is to say persons who are not distributors. The most recent federal decision on this issue was rendered by the ninth Circuit Court Appeals on March 4,1996. In Wbster v. Omnitrition International, Inc. the court found that personal consumption by a distributor’s purchases result in true retail sale to persons who do not participate in the compensation program.
 
3. Inventory Repurchase Requirements 
 
The more sophisticated multilevel jurisdictions of Georgia, Louisiana, Massachusetts, Maryland, Puerto Rico, and Wyoming require multilevel companies to repurchase inventory that is returned vy their distibutors, Additionally, these these states mandate that a written notice of the policy must be given to distributors in the distributor agreement. The rationale underlying buy-back requirements is that they tend to prevent substantially reduce the risks and concomitant evils of inventory loading.
 
Under some statutes, the requirements are only triggered when a distributor terminates his relationship with the company.  In other jurisdictions, Like Maryland and Puerto Rico, the companies must repurchase returned inventory simply if the distributor was unable to sell it within three months from its receipt. These Statutes require multilevel companies to repurchase resalable products from their distributors for not less than 90% of their original price. Any commissions or bonuses that have been paid to the product-returning distributor which are attributable to the product being returned (as opposed ti commissions paid due to downline sales) may be deducted from the repurchase price. Sine statutes, like Georgia’s, also mandate that the multilevel company repurchase goods that are no longer marketed if hey are returned to the company within one year from the date the company discontinued marketing the goods.
 
We emphatically recommend that all MLM companies include 90% (or Higher) repurchase policy. Such a buy-back policy is probably the single best way to avert the “cookie-cutter” class-action lawsuits that have plagued direct selling companies during the last four years. (These lawsuits will be discussed below in Section VII,B.) Additionally, a repurchase policy should provide that commissions previously paid to upline Distributors will be “recaptured” or deducted from their respective future commissions payments to further reduce the incentive for inventory loading.
 
 
II.  Buying Clubs : 
 
“Buying clubs” are regulated by a significant majority of states. While they are not illegal,  they require compliance with several burdensome regulatory criteria which are better avoided. In general, the term means any business organization that holds itself out as offering discounted criteria which are much better avoided. In general, the term means any business organization that holds itself out as offering discounted prices to members by virtue of its “buying clout”. A buying club need not possess any specific set of business or operational characteristics. Whether a business oganization is buying club is simply a function of the claims it makes. More precisely, the mere acts of an organization: (1) claiming to offer discounted merchandise; (2) as a consequence of its size or other similar attribute; and (3) allowing only “members” to purchase such merchandise, result in that organization being a “buying club.” In Minnesota, buying club is defined as 
 
	[A]ny corporation, partnership, unincorporated association or other business enterprise 	organized for profit with the primary purpose of providing benefits to members from 	cooperative purchase of services or merchandise
 
Other states define buying clubs identically or similarly.
 
Elements of a Buying Club
Does Your Program Meet These Elements?
(1) Is the organization a corporation?
 
Partnership?
Unincorporated association?
Other business enterprise?
 
(2) Is the enterprise organized “for profit”
 
(3) Does the enterprise have “members”
 
(4) Is the primary purpose of the enterprise to provide benefits to members (I.e., Discounted goods or services)?
 
(5) Do these benefits result from, or are they promoted as stemming from, the cooperative purchases of goods or services?
 
 
The absence of any of these elements allows an organization to avoid buying club classification.
 
If a business enterprise is a “buying Club,” several onerous impediments to doing business exist. Buyijg club status triggers several requirements, including: (1) registration with the state (usually the Attorney General); (2) the payment of registration fee; (3) The posting of a bond; (4) a right of cancellation; and (5) notice of the right cancellation on the membership agreement. Additionally, other states make even more burdensome demands. For example, Florida requires that if a buying club (or any of its agents -- arguably distributors) represents irally or in writing that use of its services will result in savings to its members, the buying club must disclose in writing in the contract that:
 
[a]ll savings claims made by the buying club are based on price comparisons with retailers doing 	business in the trade area in which the claims are made if the same or comparable items are 	offered for the sale in the trade area and with the prices at which the merchandise is actually 	sold or offered for sale.
 
Some states limit the maximum duration of members’ contracts, although most allow for their extension after an introductory period of usually six months. Other states require additional written disclosures, such as the fact that goods can only be bought through catalogs with no opportunity to inspect samples, if such is the case. Certain statutes mandate that membership agreement must be approved by the state prior to use, while others impose record keeping requirements which include the right of inspection of corporate books and records by the state.
 
The legal requirements spanning the country of Myriad, inconsistent, and arduous. If a buying club fails to meet each requirements , it is  subject to enforcement action by the state, which may take the form of injunctive action to prevent the organization from conducting business 9or simply shutting it down), and possibly civil penalties. In Minnesota, each civil penalty may be as a high as $25,000. For all of these reasons, companies are strongly urged to avoid buying status. This can be accomplished quite easily, mainly by eliminating references to “buying clubs” and discounts due to membership in your company.
 
 
III.  Business Opportunity Statutes:
 
Most states have enacted “business opportunity” statutes. To the vast majority of the population, the term “business opportunity” is an amorphous phrase that relates to any commercial opportunity or business venture. To regulators, however, it has a precise statutory meaning and is yet another component of most states’ consumer protection programs.
 
Like buying clubs, “business opportunities” are not illegal, however, they mandate compliance with a host if onerous regulatory requirements. The intent behind such legislation is to provide consumers certain protection from large investments for income producing opportunities. Historically, such “opportunities” have ranged from ostrich farms to vending machines businesses. The protection includes disclosure of information about the opportunity and its promoters, contracts rescission rights, bonding, and state registration. As a practical matter, business opportunity statutes encompass most business activities for which the promoter asserts that a certain amount of income may be earned. A “business opportunity” is essentially defined as a sale or lease of any products, equipment, supplies or services for which the seller represents that: (1) the purchaser may or will derive income which exceeds the price paid for the opportunity; or (2) it will provide a sales or marketing program to enable the purchaser to derive income which exceeds the price paid for the opportunity.
 
Elements of a Business Opportunity
Does Your Program Meet These Elements?
(1) Is there a  sale or lease or offer or lease any goods or services?
 
(2) To a purchaser?
 
(3) That are to be used by the purchaser in beginning or operating Business
 
(4) Involves an initial payment by the purchaser of more than two hundred dollars?
 
(5) Involves a solicitation of purchaser in which the seller represents that:
 
(a) The purchaser will provide sales or marketing plan pursuant to which the purchaser may or will earn an amount in excess of the initial payment as a result of the investment
(b) A market exist for any goods to be made or services to be rendered by the purchaser
(c) The seller may buy from the purchaser any good to be made or services to rendered by the purchaser;
(d) The seller or a person referred by the seller to the purchaser may or will sell, lease, or distribute the goods made or services rendered by the purchaser; or
(e) The seller may or will pay yo the purchaser the difference between the initial payment and the purchaser’s earnings from the investment?
 
 
As with buying clubs, the impact of opportunity statutes is manifold and burdensome. Generally, business opportunities must be a registered with the state (usually the Attorney General). Significant personal disclosures about the promoters, the promoters’ backgrounds, and the promoters’ personal finances are mandatory. In addition, substantial factual disclosures, much like a stock prospectus, must be provided to potential purchasers regarding the opportunity. The rationale behind such disclosures is to afford prospective purchasers the ability to make a fully informed decision regarding the opportunity. Purchasers enjoy expansive rights to rescind their contracts. Further, bonding is typically required in each state in which the opportunity is offered. Some states require that business opportunities establish an escrow account into which all or significant portion of the purchase price must be placed until the goods are received by the purchaser.
 
Fortunately, the intent behind such legislation is to protect consumers from large swindles. To that end, and because the risks substantially decline below a minimum investment level, statutes defining business opportunities contain minimum initial investment threshold exemptions. However, to make matters difficult,  the minimum threshold differs among states and the Federal Trade Commission’s Franchise and Business Opportunity Rule. Under the F.T.C. rule, as well as the majority of states, the minimum threshold is $500.00. The threshold in some states however, such as Maryland, is as low as $200.00.
 
It is important to note that business opportunity statures are concerned only with the initial investments that are required to become a distributor. Under the various statutory schemes, these costs often extend beyond those initially needed to “acquire the opportunity.” Again, the states and F.T.C. differ on what constitutes an “initial investment.” The F.T.C. and mojority rule is that any required purchases within the first six months of joining a program comprise part of the initial investment. Other states specify that the “initial investment” extends for the duration of the term of the contract governing the parties’ relationship. Still others to define the term altogether. Other under  Indiana’s business opportunity statute, a business opportunity excludes only “not-for-profit sale of sales demonstration equipment, materials, or samples or a total price of five hundred dollars ($500) or less.”
 
IV.  Referral Sales:
 
A “referral sale” is typically defined as the provision or offer to provide a customer a prize, discount, rebate, or other compensation as an inducement for a sale that required the prospective customer to give names of other prospective customers to the seller, if earning the prize, discount, rebate or other compensation is contingent upon a sale to one of the “referred” customers. To the surprise of most people, particularly sales persons, referral sales are illegal throughout the United States.
 
 Elements of a Referral Sale
Does Your Program Meet These Elements?
(1) Does the seller offer or promise to a protective buyer a 
 
(a) Price reduction;
(b) Commissions;
(c) Credit;
(d) Any other consideration
 
(2) Is the promise or offer an inducement for a sale or lease?
 
(3) Must the purchaser provide the seller names of other potential customers?
 
(4) The offer or promise is contingent upon the seller’s ability to make a sale to one of the potential customers?
 
 
As discussed above, referral sales are illegal in all state. Accordingly, Companies are strongly encouraged not to make any references to “referral sales” or “referral marketing,’ or to offer incentives contingent upon the company’s successful sale to, or enrollment of, a person referred by participants.
 
V.  Securities:
 
Although most people would not think of a pyramid as a “security,” the Federal Securities and Exchange Commission (SEC) has used its statutory mechanisms to prosecute pyramids. In some cases, the SEC has been able to show that pyramid was an “investment contract” and thus, a security. Once it overcame this hurdle, it was relatively easy to show that the promoters were unlicensed securities brokers engaged in selling unregistered securities.
 
The Securities Act of 1933, the Securities and Exchange Act of 1934, and most state securities acts (Blue Sky Laws) include the term “investment contract” withing the definition of a security. None of these statutes, however, defines the term. Thus, the United States Supreme Court, in Securities & Exchange Commission v. W. J. Howey Company, set forth the following three-prong test to determine f an instrument constitutes an investment contract:
 
	An investment contract purposes of the Securities Act means a contract, transaction or scheme 	whereby a person invest his money in a common enterprise and is led to expect profits solely 	from the efforts of the promoter or a third party,…
Elements of a Security
Does Your Program Meet These Elements?
(1) Has there been an “investment of money”?
 
(2) Does a “common enterprise” exist?
(a) Horizontal commonality
(b) Vertical commonality
 
(3) Are persons led to expect profits from the efforts of the promoter or a third party?
 
 
 
 
A. An investment of  Money
 
The fact that an application fee must be paid lends itelf to an argument that “an investment” is required to become a Distributor. Indeed, if the fee is excessive, it will be classified as “an investment.” However, if the application fee is low and only covers the company’s cost of producing sales and training literature and materials necessary for a person to become a distributor, a company may avoid having its application fee categorized as an investment. For this reason, and to avoid the purview of many business opportunity and anti-pyramiding statutes, to the extent of companies require distributors to purchase starter kits, they should sell them to new distributors at the company’s cost.
It is also helpful in avoiding classification as an investment for companies to refund application fees to Distributors who elect to terminate their relationship with the company. With such a policy in place, payment of the fee presents minimal risk of loss to a Distributor, and therefore mitigates the potential that it will be deemed an investment. Consequently, multilevel marketing companies should ensure that their Policies and Procedures provide that application fees will be refunded if a Distributor terminates his agreement with the company within a finite time (e.g.,  30 days, 6 months, or 1 year). Companies are further urged to sell their enrollment kits at cost to keep the initial charge as low as possible.
 
B. Commonality
 
The second prong of the Howey test requires that a “common enterprise” exist between a promoter and an investor. A “common enterprise” is defined as:
 
	[an enterprise] in which the fortunes of the investor are interwoven with and dependant upon 
the efforts and success of those seeking the investment or of third parties.
 
 A common enterprise requires a showing of either “horizontal commonality” or “vertical commonality.” Horizontal commonality requires a pooling of investors’ funds into a common fund, and pro-rata distribution of profits from that fund. In order for horizontal commonality to exist: (1) the participants pool their assets; (2) they give up any claim to profits or losses attribute to their particular investments; (3) in return for a pro rata share of the profits of the enterprise; and (4) they make their collective fortunes dependant on the success of a single common enterprise. Typically, there is no horizontal commonality between the Company and its Distributors because there is no pooling of assets between them. Secondly, Distributors usually do not give up claims to profits attribute to their individual efforts for a pro rata share of the profits of a single enterprise. Each Distributor’s commission is earned when sales are generated within his sales organization, and is paid regardless whether the Company has positive or negative earnings for the month. Moreover, the company’s corporate earnings are not distributed to Distributors. Because the profits earned by Distributors and the Company are derived and distributed from completely different sources, horizontal commonality seldom exists. Nevertheless, Companies should be extremely careful not to offer bonuses or commissions which are related in any way to company revenues or profits.
 
Vertical commonality, on the other hand, requires that the “investor and the promoter be involved in some common venture without mandating that other investors also be involved in that venture.” In order to find the existence of vertical commonality sufficient to establish a common enterprise between a promoter and investor, a direct relation must exist between the success or failure of the promoter and the individual investor. Vertical commonality usually does not exist in a multilevel marketing program as the success of a Member’s business is independent of the success or failure of the Company.
 
C. Expectation of Profits Solely From the Efforts of Others
 
The their prong of the Howey test requires that investor “is led to expect profits solely from the efforts of the promoter or a third party…” Interpretation of the word “solely” has generated considerable debate among the courts. This debate has ultimately lead to a more expansive application of the test than the literal definition would allow. In Securities and Exchange Commission v. Glenn W. Turner Enterprises, Inc., 474 F.2D 476 (9th Cir.1973),  the Ninth Circuit Court of Appeals refined the third prong of the test by holding:
 
[W] e adopt a more realistic test, whether the efforts made by those than the investor are undeniably significant ones, those essentially managerial efforts which affect the failure or success of the enterprise
 
A properly developed multilevel marketing program should not meet this third prong of the Howey test for two reason. First, the essential managerial efforts which affect the failure or success of a direct sales business are the generation of sales and enrollments, and these functions should be performed exclusively by Distributors - not by Company employees. This is the critical issue. Companies, as well as many distributors, have frequently advised distributors simply to get people to attend company sponsored meetings. Once the recruits get to the meeting, company is engaged in the essential managerial efforts which make the program operate, and the risk that a court will find the third prong of the Howey test satisfied is substantial.
 
Secondly, a properly developed and present program should avoid violating the third prong of the Howey test by emphasizing to new Distributors that their success is dependent on their own efforts and abilities. Distributors should not be advised to rely on the managerial efforts of their upline or anyone else to build their business. It is for the reason important that companies take action to ensure their sales force does not promote the program with the all too common representation: “Just get in and I will put people in for you”
 
A particular word of caution is also urged upon companies in relation to the third prong of the Howey test. It is this element on which the courts have focused in determining whether a multilevel program constitutes an investment contract security. Although the test calls for a three-part analysis, some courts have glossed over the first two elements (or avoided addressing them altogether) when handling MLM cases. For this reason companies should take extreme care to avoid any indication that distributors ma rely on the efforts of the company, their distributors, or any other third party for their success.
 
VI.  Lotteries:
 
The majority of states have laws that proscribe the operation of a lottery. Lottery laws were not designed to regulate pyramids, but rather to prevent illegal gambling. Although lottery laws have been used to prosecute pyramids, more appropriate vehicles, namely anti-pyramid and multilevel laws, are now used. Consequently, the application of lottery laws to pyramids and multilevel companies rarely occurs in regulatory proceedings.
 
A lottery consists of a disposition of property, on contingency determined by chance, to a person who has paid valuable consideration for the chance of winning the prize. California Penal Code 319 defines a “lottery” as:
 
[A] ny scheme for the disposal or distribution of property by chance, among persons who have paid or promised to pay any valuable consideration for the chance of obtaining such property or a portion of it, or for any share or any interest in such property, upon any agreement, understanding or expectation that it is to be distributed or disposed of by lot or chance, whether called lottery, raffle, or gift enterprise, or by whatever name the same be known.
 
Each of three elements must be present to constitute a “lottery” namely, a prize, distribution of the prize by chance, and consideration for the opportunity to win the prize.
 
As applied to pyramids, if the element of chance, rather than skill, determines the receipt of “the prize,” such plans have been held to be lotteries. The most notable case illustrative of this is U.S. Postal service v. Unimax, Inc. In Unimax, the administrative Law Judge determined that a participant’s compensation was beyond his control, and thus, determined by chance. Rather than allowing its distributors to place their downline distributors where they desired in their organization, Unimax assigned distributors to positions in the donwline organization. This resulted in a matrix of unrelated distributors who were spread throughout the country and were thus, less controllable. The judge determined that the compensation received by Unimax distributors was based “principally on the exertions of other over whom they have no control and no substantial connection… (and that) success of such marketers is determined by chance.”
 
Under a legitimate multilevel marketing program, a Distributor’s compensation (the prize) is earned (won) not by chance, rather by his skill and efforts in building and maintaining a downline organization. In a lottery analysis, a Member’s efforts in building his organization would constitute “consideration,” however, this is of no consequence because the element of “chance” remains absent. Thus, a proper multilevel program is not lottery.
 
Two other similar programs, contests and sweepstakes, are perfectly legal. Each combines only two of the three “lottery elements.” For example, contest combines the elements of prize and consideration, however, the element of chance is absent, In a contest, the prize is awarded to on the basis of skill rather than luck (e.g., the person who sells the most cars, or reaches a certain goal faster than his competitors). A sweepstakes awards its prize solely on the basis of luck, however, a participant need to provide “consideration” ( anything of value, frequently money or effort). The most common examples of sweepstakes are magazine sweepstakes. Although they welcome your purchase, none is necessary to participate.
 
VII.  Recent Litigation:
 
In recent years, several direct selling companies have been systematically targeted plaintiffs’ securities and class action law firms. The first class action was filed in 1991 by plaintiffs’ firm from San Francisco against NuSkin International, Inc. of Provo, Utah. The complaint alleged three counts of securities laws violations, three counts of the federal racketeering act (RICO), and three counts of common law fraud. NuSkin settled the case in less than 10 months. The exact amount that the settlement cost NuSkin is confidential and hence, unavailable to the public. The success of the San Francisco firm enticed it to file an identical class action complaint later in 1991 against a second direct selling company, Nikken, Inc. Nikken is a U.S. subsidiary of a Japanese direct sselling organization. Nikken settled its case even faster than NuSkin did. Neither NuSkin nor Nikken had, at the time the lawsuits, a 90% inventory repurchase policy. Interestingly, the remedy fashioned by the parties simply involved allowing distributors to return resalable products for 90% of their purchase price, less any commissions or bonuses that had been paid to them. It is widely suspected throughout the direct selling industry that these settlements cost their respective companies many millions of dollars.
 
The San Francisco firm and another plaintiff’s securities firm out of Boston, Massachusetts quickly filed multiple “cookie-cutter” complaints against several medium-size and larger U.S. direct selling companies. Although each company has handled its defense differently, those that have been careful to structure a legitimate multilevel marketing plan that include the protections enumerated in this analysis, have been able to successfully defeat the pyramiding, securities, RICO, and fraud Claims, The significance of these cases underscores the paramount importance of ensuring that a direct selling company’s marketing/compensation plan is well within the bounds of federal and state legal constraints.
 
VIII.  Conclusion:
It is equally important that direct sellers also include reasonable mechanisms in their programs to prevent the risk of pyramiding, securities, violations, lotteries, business opportunities, and other legal maladies. This requires: (1) distributor agreements; (2) policies and procedures; and (3) the enforcement of policies and procedures intended to ensure the legitimate of the program. Indeed, in the Omnitrition decision discussed above, one of the reasons the Ninth Circuit Court of Appeals rejected the defendant’s arguments that its plans was not a pyramid was based on the finding that the company failed to provide sufficient evidence that it actually enforced its policies. Although the company has policies in place identical to those implemented by Amway, the court stated that the mere existence of policies, without evidence of enforcement, renders the policies nugatory. Multilevel companies are therefore well advised that “staying legal” requires much more than developing a program that meets state federal requirements. Rather, it is an ongoing process that calls for vigilance and action to ensure that distributors stay within the rules.
 
In summary, the emphasis of any multilevel program must be on product sales rather than the enrollment of new distributors. To exist in the 90s and beyond, companies and distributors must make a paradigm shift from business based primarily  upon recruitment of downline distributors and internal consumption. Distributors should be taught that their primary function is to gather customers. Their second priority is to build a downline and to teach it about the first priority. To assist you in developing a multilevel marketing program, we have developed the non-exhaustive list of suggestions below.
 
IX.  Footnotes:
1. These states include Georgia, Louisiana, Maryland, Massachusetts, Puerto Rico and Wyoming
2. Georgia code 10-1-410
3. Statutes do not define the terms “supply” or “distribute”
4. Unlike the United States, Canada has passed federal anti-pyramid legislation. See section 55 of the Competition Act.
5. 86 F.T.C. 1106, 1180 (1975)
6. 79 F.3d 776 (1996)
7.  For example, section 10-1-415(d) of the Georgia Code provides:
 
(1) If the participant has purchased products ot paid for administrative services while the contract of participation was in effect, the seller shall repurchase all unencumbered products, sales aids, literature and promotional items which are in a reasonably resalable or reusable condition and which were acquired by the participant from the seller, such repurchase shall be at a price not less than 90 percent if the original net cost to the participant of the goods being returned…
 
(Emphasis added.) The 90% buy back requirement is also a condition of membership in the Direct Selling Association (“DSA”).
 
8. There is some protection afforded to multilevel companies, In certain circumstances, goods which are no longer marketed by a multilevel company not need be repurchased if they were sold to participants as nonreturnable, discontinued, or seasonal items and the nonreturnable, discontinued, or seasonal nature of the goods was clearly disclosed to the participant seeking to return the goods prior to the purchase of the goods by the participant.
9. “Member” means status by which any natural person is entitled to any of the benefits of a club. Minn. Stat., Chapter 325G.23., Sybd. 7
 
10. Minn. Stat., Chapter 325G.23., Subd. 6
11. The definitions of buying a club in Kentucky, New Hampshire, South Dakota, Tennessee, To name but a few, are identical to Minnesota’s. In Florida, a “buying club,” or “club” means “any corporation, nonprofit corporation, partnership, unincorporated association, cooperative association, or other business enterprise which is organized with the primary purpose of providing benefits to members from the cooperative purchase of service or merchandise and which desires to effect such purose through direct solicitation or other business acivity. “Florida Statures Annotated 559.3902. North Carolina defines a “discount buying club” is “any person, firm or corporation, which in exchange for any valuable consideration offers to sell or to arrange the sale of goods or services to its customers at prices represented to be lower than are generally available.” General Statutes of North Carolia, 66-131.
12. Every buying, health, or social referral club doing business in this state shall register with the attorney general and provide all information requested on forms the attorney general provides. The person shall furnish the full name and address of each business location where the club’s memberships are sold as well as nay other registration information the attorney general considers appropriate. Minn. Stat., Chapter 325G.27., Subd 1(a).
13. The initial registration fee in Minnesota is $250. For eacg year thereafter, the fee is $150. Minn. Stat., Chapter 325G.27., Subd 1(b). Registration fees should be paid in eac state in which your company is doing business.
14. Minn. Stat., Chapter 325G.24. states:
	
	Any person who has elected to become a member of a club may cancel such membership by 	giving written notice of cancellation any time before midnight of the third business day following 	the date on which membership was attained. Notice of cancellation may be given personally or 	by mail. If given by mail, the notice is effective upon deposit in a mailbox, properly addressed	and postage prepaid. Notice of cancellation need not take a particular form and is sufficient if it 	indicates, by any form of written expression, the intention of the member not to be bound by the 	contract. Cancellation shall be without liability on the part of the member and the member shall 	be entitled to a refund, within ten days after notice of cancellation is given, of the entire 	consideration paid for the	contract. Rights of cancellation may not be waived or otherwise 	surrendered.
 
15. Minn. Stat., Chapter 325G.25. Provides
 
	A copy of every contract shall be delivered to a member at the member at the time the contract is 	signed. Every contract must be in writing, must be signed by a member, must designate the date 	on which the member signed the contract and must state, clearly and conspicuously in bold face 	type of fourteen points, the following
“Members right to cancel”
 
	“if you wish to cancel this contract, you may cancel by delivering or mailing a written notice to 	the club. The notice must say that you do not wihs to be bound by the contract and must be 	delivered or mailed before midnight of the third business day after you sign this contract. The 	notice must be delivered or mailed to: (Insert name and mailing address of the club). If you 	cancel, the club will return, within ten days of the day on which you give notice of cancellation, 	any payments you have made.”
 
If the contract does not contain this notice, it may be canceled by the member at any tie by giving notice of cancellation by any means,
 
 
16. Florida Statutes Annotated, 559.3904.
17. Minn. Stat., Chapter 325G.28. Requires the Attorney General to investigate and prosecute violations of the buying club statutes.
 
Subdivision 1. The attorney general shall investigate violations of sections 325G.23 to 325G.28, and 
when from information in is possession he has reasonable ground to believe that any person has violated or is about to violate any provision of sections 325G.23 to 325G.28, or that any club is insolvent, he shall ne entitled on behalf of the state
 
(a) To sue for and have injunctive relief in any court of competent jurisdiction against any such violation or threatened violation without abridging the penalties provided by law
(b) To sue for the recover for the state, from any person who is found to have violated any provision of sections 325G.23  to 325G.28, a civil penalty, in an amount to be determined by the court, not in excess of $25,000; and in the club has failed to maintain the bodn required by sections 325G.23 ti 325G.28, or is insolvent or in imminent danger of insolvency, to sue for and have in order appointing a receiver to wind up its affairs. All civil penalties recovered under this subdivision shall be deposited in the general fund of the state treasury.
 
18. See 16 C.F.R. 436
19. MD Bus. Reg. 14-103
20. Indiana Revised Statute 24-5-8-1.
21.  Minnesota Statute, Section 325F.69., Subd. 2. provised:
	
	Referral and chain referral selling prohibited. (1) With respect to any sale or lease the seller or 	lessor may not give or offer rebate or discount or otherwise pay or offer to pay value to the 	buyer or lessee as an inducement for sale or lease in consideration of the buyer’s or lessee’s 	giving to the seller or lessor the names of prospective purchasers or lessees, or otherwise aiding 	the seller or lessor in making a sale or lease to another person, if the earning of the rebate, 	discount or other value is contingent upon the occurrence of an event subsequent to the time the 	buyer or lessee agrees to buy or lease.
 
22. See SEC v. Glenn W. Turner Enterprises, Inc., 348 F. Supp. 766 (D.Ore. 1972), aff’d 474 F.2d 476 (9th Cir. 1973), cert. Denied 414 U.S. 821 (1973),
23. 328 U.S. 293, 66 S.CT. 1100, 90 L.Ed. 1244 (1946).
24.  In a comprehensive securities and pyramiding analysis, the Federal Trade Commission analyzed the Amway marketing plan in In the Matter of Amway Corporation, Inc., 93 F.T.C.618 (1979). The FTC carefully considered Amway’s requirement that an individual purchase a %15.60 sales literature kit to become a distributor in order to determine if the purchase constituted an investment sufficient to warrant a finding that the Amway plan constituted an illegla pyramid and an unregistered security. The FTC’s initial decision held there was no investment involved in the purchase of the sales kit:
 
	[t]he Amway system does not involve an “investment” in inventory by a new distributor. 	(Finding 61) A  kit of sales costing only $15.60 is the only requisite. (Finding 34) And that 	amount will be returned if the distributor decides to leave Amway. (Finding 37)
 
93 F.T.C. at 700
 
25. It is important that sales kits be sold “at cost” for te purposes of avoiding pyramid classification as well as securities investment classification. If Profits are made on the sale of starter kits, it can be deemed an initiation or headhunting fee under a pyramid analysis,
26.  Brodt v. Bache & CO., Inc., 595 F.2d 459, 460 (9th Cir. 1978),  quoting SEC. V. Glenn W. Turner Enterprises, Inc., 474 F.2d 476, 482 n. 7 (9th Cir. 1989).
27. Hocking v. Dubois, 885 F.2d 1449, 1455 (9th Cir. 1989).
28. Brodt, 595 F.2d at 460.
29. Hocking v.Dubois, Supra, 885 F.2d at 1459.
30. Brodt, 595 F.2d at 461.
31. 474 F.2d at 482.
32.  Although violation of anti-lottery laws is not a primary focus in most regulatory actions, it is commonly included as a cause of action in civil actions brought by private party plaintiff against multilevel companies. Multilevel companies are therefore advised to be cognizant of lottery issues, particularly when developing promotional programs and sales contest for their distributors.
33. P.S. Docket No. 28/77, June 10, 1988.
34. Also of significance was the lack of any training or supervisory requirement upon upline distributors.
 
 
Pyramid Networks versus Pyramid Schemes
 
When presenting a Network Marketing concept, one often hears the expression: “This looks like a Pyramid Network or a suspicious Pyramid Scheme!” This misconception is the reason why 90% of South Africans remain poor.  This is also why they will keep on spending most of their life being unhappy at work. The sad thing is that they do not bother to educate themselves and find out what the difference between a Pyramid Network and Network marketing is. When a someone tells me it is a Pyramid Scheme I normally ask them “What is a Pyramid Network?” and only  out of  100 of those people have an answer. The other 95 do not have a clue what a Pyramid Network actually is. They perpetuate the negative pyramid network myth and bury it with other illegal schemes.
 
Unfortunately the South African media does not help either. In fact they are just as misinformed concerning pyramid networks and are always looking for ways to run these business down. Rapport, Moneyweb and itiweb are among those who like to publish one sided views about other businesses for the sole purpose of creating sensational reading. These poor folks do not understand what network marketing is and while earning measly salaries, working themselves to death, they have to run down a good idea in order to justify their own media positions.
 
Even the Internet giant, atlantic launched their own pyramid network this year. All those pyramid network skeptics better ready to run. The pyramid network structure is here to stay. Within a couple of years from now more than half of everything you use on a daily basis will be distributed by means of network marketing. You can either adapt to the modern world or benefit from it, or you can remain narrow minded and suffer for the rest of your life.
 
It is true, that there were a lot of illegal pyramid networks and many people have lost huge amounts in them.
 
So the first thing you must do is to educate your potential clients and teach them the difference between an illegal pyramid scheme and a legitimate network marketing structure.
 
The law in South Africa clearly sets out the parameters for LEGAL NETWORK MARKETING structures. The three most important requirements are: 
(a) The pyramid network and it’s business must have a product or render a service.
(b) The pyramid network must have limited levels in order to prevent the top person from earning the most - (it must be an equal opportunity business)
(c) The pyramid network may not be sustained only from the registration fees of members. The first point is easy to explain. If the company you signed up with provides a product or service, it adheres to that portion of the law. The product or service must be fairly priced. A good way to test this is to take the business part away from the product or service and see if you are then with a fairly priced sustainable product or service.
 
The second point is the most important. People tend to think that everything about pyramid network structure is illegal. What they do not realize is that any successful business, government, family, church or organization, after a certain size takes on a pyramid structure.
Furthermore, a network business must be limited to a certain number of levels in order to prevent the top person earning all the money - this makes it an equal opportunity business which will give anybody the opportunity to become the top earner, irrespective of where he / she is in the pyramid network.
 
Example:
Lets say your friend Peter joins a network business and the business is limited to 4 levels. Now Peter is a bit slow and e and all the people under him only signs up 2 people each.
 
Peter’s business will look like this:
 
Levels						Peter
1 							II
2  							IIII
3  							IIIIIIII
4  							IIIIIIIIIIIIII
 
But now you sign up on Peter’s  level 4. Now Peter has potential. You are a live wire. You are eager and hard working and you and everybody in your business each sign up 5 people. Your business and Peter’s business will now look like this:
 
1 						II
2  						IIII
3  						IIIIIIII
4  					You + IIIIIIIIIIIIII
Levels
1 							IIIII
2 						IIIII IIIII IIIII IIIII IIIII IIIII
3  						IIIII IIIII IIIII IIIII IIIII IIIII IIIII IIIII IIIII IIIII IIIII
4  						IIIII IIIII IIIII IIIII IIIII IIIII IIIII IIIII IIIII IIIII IIIII IIIII IIIIIIIIIII
So let’s assume that you get paid R10 per person per month for each person in your business in the example above. Who will earn the most money? Peter (at the top) or You (at the bottom of your business)?
 
Obviously you will earn the most. So it is clear that the person at the top or the first person in DOES NOT make all the most money. It is the person who works the hardest who earns the most. This makes it an EQUAL OPPORTUNUTY BUSINESS. No matter who or what you are, if you have the drive, the passion and the motivation, you can be the person who then earns the most. Each person’s business starts with that person and not with the above that person. There is a general misconception that the people at the top of a network always the money. The above example clearly disproves this.
 
Now lets look at the another interesting example.
We all know a big companies like Pick & Pay, Telkom, etc. Let’s see what their structures look like:
 
The Company
(CEO) 					I
(Director)  				IIIIIIII
(managers) 				IIIIIIIIIIIIIIIIIIIIIIIII
(branch managers)             		IIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIII
(supervisors)                         	IIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIII
(employees) 				IIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIII
 
WOW!!!  	WHAT a nice Pyramid!
 
The Million dollar question: Can the employee at the bottom, the person whp puts the tins on the shelves, EVER earn more than the CEO at the top while he is in level 6 ????? NEVER!
If you follow the logic of most comments on pyramid networks then most successful big business should be 100% illegal! The above example is not an “equal opportunity business” as the first one in earns the most money!
 
Where do they get the money to pay the commissions?
 
This is why people are skeptical about marketing network marketing. They do not understand the concept and they do not understand where the money comes from. It always sounds to good to be true, giving them all the excuses they can think of not to get involved.
 
Explanation: I can get people to market a product for me. I decide that if I sell the product for R150.00 I can afford to spend R40.00 on commissions. So, now I can involve people to market my product for me and pay them R40.00 commission on each successful transaction they conclude.
 
With the scenario above we go back to traditional business. If the consultant does not sell anything, that consultant will not earn any money. If the same consultant goes on maternity leave for six months, she then does not have an income for that period.
Now if we decide o split the R40.00 into 4 payments. We decide to pay 4 people R10.00 each rather than paying one person R40.00 per sale. We can create more jobs for more people. We tell the lady in this example (lets call her Stephanie) that if she refers or introduces another sales consultant to the business we will pay her R10.00 if each sale that person makes. And that person can do the same and the next one can do the same. We continue that up to four levels. So now Stephanie gets paid for her efforts And she gets paid on the efforts of the people she signed up under her. She has just started her own business. She now has consultants working in her business and she earns a portion of their commission, she now has consultants working “for” her but still each one runs his/her own business. If Stephanie goes on holiday, she still earns her part of the commission even though she has actively done very little.
 
Now Stephanie can actually go on maternity leave for six months and still earn an income. The money to pay commission must therefore be built into the price or monthly service dee rendered by the company. This is also a food check to see if a network marketing business is legal and sustainable. You must be able to see that the commission money is paid by the product or service. If you find a product offered at R100.00 per month with commission promised at R400.00 per months then instinctively you should know that is illegal.  Rather run a mile than getting involved with something like that.
 
So network marketing is nothing other than the distribution of commission or the distribution of wealth. We do not pay one person big commissions, we pay several people smaller amounts from the same total commission amount.
Types of Pyramid Network Structures
 
There are different types of network marketing business available. Some sell physical stock and others market a service or an insurance product. There are even systems where you can get discount on your cell phone bill and get paid for the people under you and on their cell phone usage.
 
So if you do get involved in network marketing you can choose a company with which ou feel comfortable. The company you choose will depend on your interests and needs. If you need something that can build you a good income in a fairly short, it is important to look at the the commission structure. Do not look at the potential income with everybody having signed up 10 people. That can take three or more years and be unrealistic. Look at the shorter term results. Work out an example where everything signs up at 3 people and see what your income will be after levels 2 and 3 have also recruited 3. This will give you an achievable indicator of what you could earn. If you urgently need money is is important to be sure that the company you a good income in short period of time otherwise you will discouraged and give up. All your hard work will be lost.
 
There are network marketing companies that will offer you an excellent product and support, but it will take you two to four years or even longer to earn a proper income. These are good if you  are looking for a pension fund or long term benefits instead.
 
My experience is that you can be successful in almost any network marketing company. It all depends on YOU. It depends on your need and your desire to achieve success and, very important, on your own MOTIVATION.
 
You may find companies which sell physical products. Many people make a lot of money in companies like  this so there is wrong with product based network marketing. The problem is that your market is limited to the people who need and can afford that specific product. Your income will also depend on the sales on the sales of your down-line. If they do not sell you will not earn a sustainable income.
 
Ideally look dor a network marketing company which renders a service or financial product which pays monthly by debit order. In that way you  only have to sign up a client once and are assured of getting paid for a long as the client pays his premium. Also remember if that client is earning commission, he will never ever cancel, and you will have a client and an income for the rest of your life.
 
Most companies who run networks as above normally offer charity fun raising, insurance products, shares, motivation or monthly magazine subscriptions as products.
 
A good example of a well managed Network Marketing company which pays out monthly is BE MOTIVATED TODAY. They offer a 14 day trial period and are well worth joining now that they have expanded globally. The future looks bleak for most people on this planet. Everything is getting more and more expensive each day. The fuel price is rising at an alarming rate and we all know that the price of everything follows. Do you have a plan? How are you going to survive during the coming years?
 
I suggest you get involved in Network Marketing and start building a PASSIVE INCOME. The sooner you start the better.
			

								

										

						
					

				

			

		
		
	
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