FTC Staff Challenges Status Quo on Pyramid Scheme, Income Disclosure Guidelines

May 17, 2024

Revised directives to DSA, DSSRC signal a major shift in Commission’s interpretation of existing standards

By:  David Bland

In a significant move aimed at refining its stance on regulatory compliance within the direct selling industry, the Federal Trade Commission (FTC) staff issued two notable letters on March 15, 2024, signifying a shift in its approach towards the evaluation of pyramid schemes and income disclosure statements.

The letters, addressed to the Direct Selling Association (DSA) and the Direct Selling Self-Regulatory Council (DSSRC), BBB National Programs, underscore the FTC staff’s current interpretation of legal standards, despite a previous court ruling that rejected such a standpoint. The correspondence highlights the FTC’s endeavor to supersede older guidelines with new interpretations of the law.

Revising Pyramid Scheme Criteria

In a two-page letter to the DSA, the FTC staff addressed what it considers to be misconceptions about the “Koscot test,” historically employed as a benchmark to discern pyramid schemes.

Following discussions at the DSA’s Legal & Regulatory Seminar in September 2023, the staff letter aimed to correct the direct selling channel’s interpretation of a 2004 FTC staff advisory opinion that was sent to the DSA and had been widely cited to differentiate legitimate direct selling operations from pyramid schemes based on revenue sources.

Signed by Lois C. Greisman, associate director, division of marketing practices, the March 2024 letter clarified the FTC staff’s belief that the legality of a multilevel-marketing (MLM) company is not determined by a simple “primary source” test—where the focus is on whether sales to end-users exceed recruitment-related income—but rather by the company’s compensation structure and its emphasis on recruitment over product sales. 

Moreover, the letter marked a significant shift in the FTC’s position by rescinding its 2004 advisory opinion, indicating that it no longer reflects the FTC staff’s views due to its purported misuse and the evolving landscape of the direct selling industry. 

This adjustment points to a new evaluative framework for the FTC that focuses on qualitative analyses of network marketing companies’ business models and incentivization schemes, moving away from previously held percentage-based criteria.

Donnelly McDowell, partner at Kelley Drye & Warren LLP, provides a critical perspective on the recent communications from the FTC, highlighting their significance beyond mere legal directives.

“The letters are more notable for what they symbolize than for any substantive legal point,” McDowell says.

“We’ve heard the FTC say for years that industry has misinterpreted the 2004 advisory opinion letter, and disavow a ‘primary source test’ that looks at whether revenue is generated by legitimate retail sales to end-users to evaluate whether a company constitutes a pyramid scheme.  The FTC attempted to distance itself from that language in Neora and other recent enforcement, and instead focus on whether compensation plans incentivize recruiting over retail sales. 

“Of course, the FTC cannot make law by edict, and ultimately its attempt to move the law in this direction was rebuffed by the court in Neora.  I see the letter to DSA as doubling-down on that position – and as a deliberate signal to industry that it does not intend to accept the Neora decision as settled law or to let it impact its approach to enforcement,” McDowell says.

Scrutiny on Income Disclosure Statements  

In a separate communication from the staff of the FTC’s Bureau of Consumer Protection to the DSSRC, concerns were raised about the “Fall 2023 Guidance on Income Disclosure Statements” (IDS) issued by the DSSRC. The letter pointed to areas where the FTC staff believes that guidance appears to diverge from federal law, specifically regarding the substantiation of earnings claims by direct selling companies. 

The FTC staff letter highlighted “only a few of the multiple thorny issues that the DSSRC’s Guidance on IDSs simply fails to address.” 

One such issue is the DSSRC’s allowance for companies to make earnings projections based on limited data such as “some indication” of participant expenses or “an estimate of mandatory costs.” 

According to the FTC staff, this practice does not align with the legal requirement that earnings claims are to be based on a solid, reasonable foundation at the time they are made.

This correspondence underscored the FTC Bureau of Consumer Protection staff’s broader initiative to ensure that MLM companies engage in transparent and honest marketing practices. 

The staff’s critique of the DSSRC’s focus on “mandatory” costs rather than the full scope of expenses faced by participants suggests a concern for potentially misleading earnings claims. The letter expressed apprehension that the guidance could inadvertently facilitate deceptive practices, potentially misleading individuals regarding the financial outcomes of direct selling participation.

Peter Marinello, vice president of the DSSRC, BBB National Programs, tells SSN, “DSSRC acknowledges the importance of ensuring compliance with federal law and maintaining consistency with FTC regulations within the direct selling industry. The DSSRC is committed to upholding the highest standards of transparency and consumer protection.

“While we are disappointed with the Commission’s assessment of the Guidance which aligns with the foundational principles of advertising law established by the FTC, we appreciate the FTC staff’s commitment to consumer protection and value their input in this matter,” Marinello continued. 

“DSSRC remains dedicated to promoting integrity and accountability within the direct selling industry. As part of our ongoing efforts to enhance industry standards, we welcome continued dialogue and collaboration with regulatory authorities to ensure compliance and foster consumer trust.”

Regulatory Stance Undeterred by Neora Ruling

Notably, the arguments presented by the FTC staff in both letters echoed positions that were scrutinized and ultimately rejected in the Commission’s case against direct seller Neora. This trial, a landmark legal confrontation within the direct selling channel, critically examined the FTC’s interpretation of what constitutes an illegal pyramid scheme and the requirements for substantiating earnings claims. 

The court’s decision in the Neora case challenged the FTC’s revised approach to evaluating practices of direct selling companies, specifically questioning the agency’s shift away from traditional criteria including the “primary source” test and leaning towards a more qualitative assessment of a company’s compensation structure as well as its emphasis on recruitment over product sales. 

Despite this judicial rebuff, the FTC staff’s recent letters to the DSA and DSSRC indicated a steadfast commitment to these contested views, underscoring an ongoing effort to refine and assert these standards within the industry. This persistence highlights a significant tension between regulatory intentions and judicial interpretations, suggesting a complex landscape for future legal and regulatory actions within the sector.

 

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