Regulators want to dismantle all multi-level marketing companies
By: David Bland
The paper indicates that the FTC views all companies with a multi-level compensation plan structure as dangerous to the public, and it recommends removing the levels as the best course of action.
The FTC authors suggest three actions that could prevent the risk of pyramid operations.
First, they state that an obvious option would be to end the recruitment aspect of the business.
Second, they suggest that changes to recruitment incentives could “reduce an operator’s ability to induce or allow participation in a transfer scheme.”
Third, they argue that if sellers were not required to make purchases in order to qualify for recruitment rewards, the company would no longer be able to convince the seller to accept retail losses in hopes of gaining back profits with future recruitment.
Until recently, any company in the direct selling channel with viable products and consumer demand for those products could consider themselves operating under Federal Trade Commission (FTC) favor. However, the agency appears to be changing its mind about practices it previously accepted, as indicated first by AdvoCare’s surprising abandonment of its multi-level compensation plan a year ago under FTC pressure.
In the fall of 2019, Texas-based Neora filed a lawsuit challenging the FTC’s authority to unilaterally and retroactively change the law regarding whether a direct selling Multi-Level Marketing Company (MLM) is an illegal pyramid scheme. Later that same day, the FTC filed suit alleging Neora is operating as a pyramid scheme.
One month later, in December 2019, a little-known international journal covering research in the social sciences and humanities published a paper titled, “The Alchemy of a Pyramid.”
The paper was written by Andrew Stivers and Douglas Smith, both currently with the FTC’s Bureau of Economics, as well as Ginger Jin, formerly director of the FTC’s Bureau of Economics and currently in the Department of Economics at the University of Maryland. The authors claim their paper addresses the central question, “What makes an MLM a pyramid?”
Deborah Heisz, co-CEO of Neora, says she believes the paper is no surprise because it reflects the thinking used in the FTC’s negotiations with her company.
The authors constructed a complicated mathematical model with multiple assumptions and variables to evaluate potential outcomes for a theoretical MLM contract. They define the basic structure of MLM as a business contract that provides potential sellers with both the right to sell a product and the right to recruit new sellers.
The variables introduced included such factors as product cost, the reward for a participant who successfully recruited other sellers, fees charged by the business for participation, and whether the participant only sold product or sold product as well as recruited new sellers. As one might expect, the authors found that the outcome of the model for multi-level companies is poor.
Despite their public statements to the contrary, this paper indicates that the FTC views all companies with a multi-level compensation plan structure as dangerous to the public, and it recommends removing the levels as the best course of action. In short, the FTC wants to take the “multi” out of multi-level marketing.
Dissecting the underlying assumptions made by the authors of the paper is important to understanding not only their point of view, but also how they reached their conclusions.
Assumption: People will not agree to participate with a multi-level company unless they expect to benefit from the experience.
The paper states:
“We presume … parties will voluntarily agree to participate in a venture if they have some expectation at the time of the transaction that they are better off for having done so. Conversely, we would not expect economic actors to voluntarily agree to a transaction where they expected to be worse off for having done so.”
On its face, everyone in the channel would agree with these statements; however, it appears the FTC has a further definition of what it means to be “better off for having” joined a direct selling company.
Heisz says that although the FTC authors do not address the idea directly in their paper, financial outcome is the only metric they consider to be beneficial for a participant. In short, the authors argue that if the participant does not make what they consider to be “enough” money, then the entity is operating as a pyramid scheme.
“We all know from surveys and research that the Direct Selling Association has provided that many people join network marketing and direct selling because they like the product and they want to purchase it at a discount. Others join because of the social aspect and want to be around other people who are involved in the business. Still others join to merely supplement their income,” she says.
This research paper, Heisz adds, completely discounts product value and makes the assumption that people only join companies or buy products in order to meet a sales target. To her point, the paper indeed states that “a transaction that is not wealth-generating” by definition harms the independent contractor.
Heisz says, “The reputable companies in our industry, of which there are myriad, were built on product and product value. To discount that as even being a driver is the fundamental flaw in this paper.”
Assumption: Direct selling companies rely on a sufficient number of sellers to reduce distribution costs
The FTC paper says that while both standard retail and direct selling businesses share the risk of overestimating demand for their product, when a direct selling venture overestimates product demand, it is also overestimating the availability of potential sellers. The authors suggest that estimating the availability of sufficient numbers of sellers to maintain a successful direct selling company represents the fork in the road where pyramid operations usually begin.
The reason they view this as pyramid territory is because they believe all sellers who do not earn a significant profit have a zero-sum benefit or a negative-sum benefit, all while the operators maintain profit. A zero-sum benefit is one where participants end up at the same place they started. A negative-sum benefit means that participants are worse off than they were at the start.
One major problem with this assumption is their underlying hypothesis that starter kit and personal consumption purchases are considered “business expenses” by the FTC and thereby automatically create a “negative-sum” situation for all independent contractors. The authors argue that none of the purchases made by independent representatives are legitimate “end use” purchases, even though the courts decided differently in BurnLounge.
It is increasingly clear that the FTC lumps all independent contractors who do not show a bottom-line profit at the end of the taxable year into the category of zero- or negative-sum beneficiaries, and thereby dismiss personal consumption as a benefit.
Assumption: Offering viable products does not rule out a pyramid scheme.
In conventional understanding, a Ponzi scheme is a “pure pyramid” system, where there is no actual product. Rather, participants pay to be involved in a referral system with the understanding that they only receive payouts if they recruit others to pay in. Since anyone participating is having to expend resources to find new participants, and there is no product to sell to bring in outside money, the overall system operates at a net loss, by definition.
The authors of this paper assert that a multi-level company, even if selling viable products, will become a pyramid scheme when it knowingly misrepresents to potential sellers both the value of the product itself and their prospects of recruiting sellers.
They argue that the company operators then use payments from distributors to profit in such a way that is detached from the success or failure of the product itself. This puts a new participant at risk not only for errors in product demand estimates, but also for errors in recruiting estimates. As a result, the authors are morphing what would have previously been considered an income claim into a pyramid scheme claim.
The underlying assumption is that multi-level firms can promote recruitment as a way to compensate for low or non-profitable product sales, thus “proving” that legitimate products do not exclude companies from scrutiny. While a standard retail business model is ultimately limited by the success of its product, a direct selling company that knowingly misrepresents to a new participant their optimism for future recruiting is no longer bound by this internal, self-limiting factor. Thus, the authors state, “transfer loss” can continue indefinitely.
What troubles CEO Heisz and many experts in the channel is that the FTC appears to be changing course and ignoring the law in order to target product-based, legitimate companies that happen to have multi-level compensation plans. She says, “While historically there have been some MLM companies not built around a quality product and a sound customer base, today a significant number of companies have quality products, a sound customer base, and have customer programs.”
Heisz adds, “Our structure is virtually identical to the sales structures you might find at standard retail businesses whereby the seller makes money off their own sales, and off of the salespeople they manage and train below them. To isolate MLMs is not fair.”
The authors conclude that only by encouraging unrealistic seller optimism can multi-level business operators maintain profits while the sellers are experiencing loss, thus creating a pyramid/negative transfer situation. They assert that the greater the level of seller optimism, the greater the share of the money transfer the operators can keep.
The authors believe that in a multi-level system, this seller optimism can have two components, product demand and recruitment potential. When evaluating the effects of product demand optimism, the authors recognize that the chance of financial success will ultimately be determined by the demand for the product, just as with a traditional retail business.
However, when the authors introduced the variable of recruitment optimism into the model, they claim that a seller can be induced to make profit-losing payments to the company even if the seller knows that the demand for a product is low. When a seller believes that recruitment rewards will make up for losses from low product demand plus commission payments, they will continue to participate in the system.
The authors argue that this gives the company incentive, not only to overstate product demand, but also overstate recruitment potential. Thus, a participant’s willingness to pay for the right to participate will depend on their combined optimism about both product demand and recruitment success—the two things that are “bundled” in a direct selling company contract. If all participants in the multi-level group are highly optimistic, the authors conclude, then there is no outside factor to limit a negative transfer of wealth to the operator.
Dr. Branko Jovanovic, Principal at The Brattle Group who has a Ph.D. in economics, addresses this point, saying “Companies attempt to police this, but creation of expectations is something largely out of their control because they cannot police every single participant who is trying to recruit people with unsupported or overly optimistic statements.”
Industry Provisions to Answer FTC Concerns
The Brattle Group authors expand on other ways that direct selling companies can avoid negative transfer results, and by extension, FTC intervention. Jovanovic points out that this FTC model did not include as a variable the “Undo Option.” This is a reference to a previous stipulation used by the FTC requiring a company to allow its distributors the option to return and refund unsold product.
Jovanovic says, “This gives people protection from making their own overly enthusiastic expectation.” He adds that, “More and more MLMs are allowing distributors to return product with full refund, including shipping costs. This seems like a pretty typical way to ensure that there is no harm.”
Another tool used by direct selling companies to prevent unwarranted pyramid labels and scrutiny are segmentation programs that clearly separate those who only want to purchase discounted product versus those who wish to be distributors.
Jovanovic says that a company can utilize a “preferred customer” designation option to recognize participants who are seeking non-monetary gain, i.e., product discounts.
He says, “The preferred customers are the ones enjoying the product but are not participating in a business opportunity. If they enjoy the product enough, they may switch to the designation of distributor and can then start participating in a full compensation program. There are still direct selling companies out there that don’t have the preferred customer designation and I’m not sure how long that can stand. I think it’s a helpful designation because you are able to demonstrate to a regulator, to the FTC, that there is genuine consumption because these people don’t have any other motivation other than consuming the product at discount.”
Jovanovic adds, “You can use the behavior of the preferred customers to infer what level of personal consumption would be allowable or would be reasonable for the people who are participating in the business.”
Heisz says, “Neora is in total compliance with all state and federal law and the guidance put forth previously by the FTC. Their lawsuit against us appears to be an effort by the agency to change the laws around MLMs.”
“I do view this as a threat to the industry, and I think it elicits a desire by the FTC to change the industry,” she adds. “I think the industry needs to engage in dialogue to prevent that because there are millions of Americans whose livelihoods are threatened by this.”
Perhaps Mike Collins, longtime direct selling executive and now consultant to the channel, sums it up best: “The FTC has been pursuing us for decades on the same grounds, under political administrations that were ostensibly far more hostile to our business model than this one. Yet here we are, having created the DSSRC, and having had the flagship brands in our industry turn heavily towards retail customer marketing, and purchaser classification, etc., now on the brink of having to live under this draconian set of policies.”
Collins concludes, “Neora’s move looks more and more like the right thing to do.”
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