Is Your MLM Opportunity Legal?

Lawyers who work regularly with network marketing clients are often asked in casual conversation to give their opinion as to the legitimacy of some new company with a “hot” new program. Unless the lawyer has already spent considerable time researching details of the company’s management and operations, it is unlikely that he or she will offer any comments that aren’t both general and carefully couched with “if-then” or “depending on.”

The lawyer is not deliberately trying to be longwinded, vague, or evasive. It’s simply that, in making a determination of MLM legitimacy, there is relatively little that is sufficiently clear-cut to allow for an unstudied categorical response. Nonetheless, the applicable legal standards have been in use for decades. This article briefly outlines these standards and offers tips to aid readers in making their own quick-and hopefully not too superficial-analysis of a given MLM program, when access to an experienced lawyer is not an option.

To survive serious legal scrutiny, the company and its MLM opportunity must:

1. Involve the sale of a real product or service;
2. Not require a headhunting fee; and
3. Maintain operational integrity.

Product or Service

It is a relatively rare venture that positions itself as an MLM opportunity, and yet offers nothing that one could call a product or service. Such a program is very likely a pure money game and is governed (probably attacked and shut down) as a security, lottery, pyramid, or chain letter. Examples include the spate of “gifting” clubs that became prominent during the late 1990s or some of the less sophisticated gold coin programs that proliferated in the previous decade.

Most new MLM ventures offer at least an ostensible product or service, the sale (or resale) of which forms the core around which the “independent business” opportunity is constructed. A close look at the history of MLM regulatory enforcement, however, shows clearly that not every alleged “product” or “service package” will necessarily satisfy this element of scrutiny. To pass muster, the featured product or service must be both retailable and retailed. This means the product or service must have real value to some market segment of end-use consumers who are not affiliated with the MLM venture. Further, the product or serviced must actually be sold by program participants to non-participating buyers who are not purchasing the product or service as an element in the process of enrolling to become a participant in the compensation. Most companies, in the interest of evidencing compliance with this element, have one or more provisions written into their compensation plan, which either require or strongly encourage retailing by the sales field. Such provisions, however, mean relatively little, if actual retail sales are not occurring in significant numbers or volume.

Pyramid statutes have long provided that, to be legal, the compensation paid to participants in a program must be derived “primarily” from the sale of “goods, services, or intangible property by the participant or other persons introduced into the plan,” rather than from monies received “from any person’s introduction of other persons into participation in the plan.” Focusing on this use of the term “primarily,” regulatory authorities have established enforcement policies requiring that, say, 50 percent or 70 percent of a company’s total commissioned sales revenue be derived from sales to non-participants. Many experienced practitioners, however, dispute this approach.

The fact that a considerable portion of a company’s total commissioned product or service sales may end up only in the hands of its program participants should not necessarily be fatal to the company’s legitimacy. If the participants are purchasing for personal consumption, because of the intrinsic value that the product or service provides them and not merely in order to reach some volume qualification level in the compensation plan, then a powerful argument can be made that the sales ought to be treated as “retail.” It is also an entirely acceptable practice in many legitimate programs for participants to accumulate an inventory of products (in their closet or garage, say) for ready resale, at least so long as the inventory quantities remain reasonable for purposes of facilitating the participant’s actual business operations, and so long as the company adheres to acceptable product return and buyback policies. (See discussion of Home Office Legal Compliance below.)

A full and fair application of this test to a given venture can require some subtle analysis, as well as careful accumulation and documentation of evidence. Literally dozens of articles have been written about the underlying rationale of this element of the legitimacy test, as well as its specific application, and it is beyond the scope of this article to explore the topic in greater detail. As a general rule of thumb, however, if the company’s product or service is the same sort of item that is sold in normal retail channels by non-MLM companies, and if the company’s participating representatives are selling the product or service to non-participants in any significant volume, the company’s program probably meets this element of the legitimacy test.

Headhunting Fee

The heart of any analysis of the legitimacy of an MLM opportunity is whether it embodies a headhunting fee. This element actually is the central feature of virtually all-statutory definitions of a “pyramid.” In short, a “headhunting fee” is:
1. a payment required to be made by a prospective participant for the right to earn compensation,
2. which compensation is derived from the recruitment of others who also pay the fee.
Despite its apparent simplicity, this element has spawned more confusion and overzealous regulation than any other aspect of MLM regulation. It is, unfortunately, also the arena in which a seemingly endless array of destructive program abuses has been, and continues to be, created and perpetrated.

Occasionally, regulators have applied a very loose interpretation of the headhunting fee test, omitting any regard for whether a questioned payment made at enrollment was actually “required” to be made as a condition of participating in the compensation plan. The more prevalent and sensible view, however, is that truly optional payments made at start-up are, under appropriate circumstances, justifiable and may be left out of the legitimacy equation. Even though such payments might be incented by higher award level qualification in the compensation plan and may result in commissions flowing to the up-line, they are permissible, so long as the payment amount and purpose is reasonable, so long as there is no evidence of undue pressure by the recruiting participant to sell the option, and so long as the company adheres to reasonable return and buyback policies.

Unfortunately, this more enlightened regulatory approach is under constant challenge, because of the continuing gestation of new and different scams incorporating subtle twists in the program structure and advertising as a means of masking the true headhunting fee. In recent years, such abuses have been constructed around training programs, support service packages, seminars, web sites, and tape-of-the-week programs. Of course, legitimate and respected companies also offer these types of support service options. The difference is in the devilish details.

More than with any other element of the legitimacy analysis, proper application of the headhunting fee test requires skills, experience, and care. Whenever warranted, one should consult an experienced MLM lawyer to conduct this complicated aspect of due diligence. The best rule of thumb for non-lawyers to use would be to tread very carefully around any program in which a high percentage of new participants enters at an advanced award level or makes any large start-up purchase or payment (exceeding $200), which is not expressly subject to a full refund well beyond 45 days after payment.

Operational Integrity

Despite having substantial sales of its products to end-use consumers and the absence of a headhunting fee in its compensation plan, many an MLM venture has been attacked and destroyed by civil litigants or regulators, because of its failure to maintain operational integrity-that is, rigid adherence to acceptable standards of business practice. This practical requirement is not unique to MLM. It applies to all business ventures. What is unique to MLM are certain of the specific standards or practices that are mandated. It is beyond the scope of this article to detail (or even mention) every type of mandated business practice that applies to an MLM company. The following discussion notes only the most important areas of discipline and describes certain MLM-specific standards. These areas of discipline include:

1. Product advertising
2. Program (compensation plan) advertising
3. Enforcement of sales field compliance
4. Home office legal compliance

Product advertising: A pervasive web of overlapping federal and state statutes and regulatory authorities governs virtually all aspects of advertising for virtually all types of products and services that are sold in the United States today, including those offered in the MLM channel of distribution. These advertising regulations govern content and performance claims for products and services, whether those claims are made on labels, in sales literature, on audio or videotape, telephonically, or in web site copy, as well as claims made orally by independent resellers in the form of personal testimonials or endorsements. The FTC, FDA, FCC, and the UDSA enforce this panoply of laws on the federal level alone. Parallel state-level authorities and enforcement exists in all states for most of these categories of regulation. The specific statutes and their criteria are obviously far too numerous to detail here, but their general approach is to require that all claims, and particularly claims regarding performance and other material product attributes, be both truthful and be substantiated by competent documentary evidence.

Program (compensation plan) advertising: Another array of both federal and state laws and enforcement policies governs the making of MLM income opportunity advertising claims. These restrictions apply not only to specific earnings representations, such as the display of checks, but also to numerical sales projections, recruiting projections, hypothetical commission computation examples, and stories or life-style profiles of successful independent sales representatives. Although, as with product advertising, substantiating the accuracy and truthfulness of a scrutinized claim is imperative, even more is required to legitimize many income claims.

A long-standing enforcement policy of the Federal Trade Commission has been to require that even truthful and documented claims of specific earnings (or related performance), which exceed the actual average of such earnings for a given population of typical participants, must be accompanied by appropriate disclaimers containing such actual averages (determining what constitutes an appropriate population of typical participants for this purpose is purely the craft of experienced lawyers). The policy also applies to hypothetical representations, such as charts indicating how any given income above the actual average might be earned. The Attorneys General of virtually all states enforce similar policies.

Home office legal compliance: In addition to the array of laws and authorities governing advertising described above, MLM companies, like all business enterprises, are faced with a veritable alphabet soup of statutes and agencies governing many aspects of their home office internal operations. These include OSHA, EEOC, FLSA, and ERISA covering safety, employment and payroll practices, and the IRS and SEC governing taxation, accounting, and financial affairs. Again, for each of these federal regulatory schemes, parallel state-level frameworks exist in all states. Although a company’s compliance record with respect to much of this regulation does not necessarily determine the legitimacy of its MLM opportunity, that record often does reflect the quality of the company’s management and its prospects for long-term survival as a business enterprise.

Moreover, there are aspects of securities regulation that have unique application to the MLM industry and reflect very directly on the legitimacy of a company’s opportunity. In situations where repeat sales of the company’s products or services is operationally insignificant to the company’s bottom line if compared to the “sales” of the opportunity (recruiting/starter kits), the program may be deemed by the SEC or state securities regulators to be the offer of an unregistered security (if not a pyramid). The consequences of such a determination, if not quickly corrected, are catastrophic to the program, the company, its executives, and often to individual participants in the pay plan.

Finally, in the US market at least, MLM companies are constrained to meet a rigorous and, in some ways, unique set of customer service criteria, in the form of product returns and inventory buyback policies. Competitive market pressures have caused most successful companies to provide their product users with some form of personal satisfaction money back guarantee. Government regulation as well as leading industry trade association member codes, on the other hand, have imposed analogous policies requiring companies to buy back from terminating participants their unused resalable inventory of products purchased within, say, the last year at 90 percent of the wholesale price paid by the participant. A handful of states have adopted statutes requiring such buybacks regardless of when the inventory was purchased.

MLM companies that fail to conduct their internal operations in substantial compliance with the standards imposed by this governing web are at significant exposure to damaging, perhaps fatal, regulatory attack. Though the opportunity plans offered by such companies may be legal, if viewed in isolation, the internal operational failings of such companies can ultimately result in collapse of their enterprise.

Sales field enforcement: A brief reading of the terms and conditions incorporated into a typical MLM participant application and agreement form will readily demonstrate the extent to which the “independence” of the relationship between the company and its participants has been circumscribed. In order to reduce legal risk and expense, well-managed companies have been compelled to impose and enforce upon their sales field populations many of the same legal standards that evolved to regulate company behavior.

Such standards include the product and program advertising regulations described above, as well as customer protective requirements such as proper use of retail sales receipts and adherence to return policies. The FTC and state Attorney Generals have made it abundantly clear that a company will be held at least jointly, if not primarily, responsible for independent participant behaviors in violation of such regulations, at least insofar as the company is unable to satisfactorily demonstrate a history of fair and consistent internal enforcement of the standards throughout its sales field.

Evaluating an opportunity: A prospective participant conducting a due diligence inquiry into the legitimacy of a given MLM opportunity is faced with a potentially daunting task. Although careful review of the company’s application form and recruiting/sales literature is often sufficient to reveal likely problems with a possible headhunting fee or, say, a lack of genuineness in the company’s product or service offerings, making a reliable determination regarding a company’s operational integrity can require considerable investigation. Fortunately, much useful information is accessible (often via the Internet) in public records at the applicable enforcement agencies. Additional sources of information include company news releases and local or regional news media. Cross-referencing multiple sources is an excellent way to build a more complete and reliable profile of the company’s adherence to sound business practices.

When collected, the information must be evaluated-a process that is made easier with experience and expertise. This is where a short consultation with your MLM attorney can be well worth a reasonable fee. The prospect choosing to make his or her own assessment, however, must let logic be the guide. For example, even a large company faced with a regulatory attack or civil lawsuits challenging the key advertising claims for its most important product may well be in serious jeopardy, and may well not represent a reliable opportunity for the prospect, even if the compensation plan is defensible and the product is being sold at retail in significant volume.

An illustration of this, in a non-network marketing context, is the demise of Mark Nutritional and its Body Solutions weight loss product, which began in 2002. The company, which had generated nearly $200 million in sales over the prior few years, ended up in bankruptcy after facing several private class actions, as well as complaints filed by the FTC and several state Attorneys General, all alleging fraudulent weight-loss claims. Similarly, any MLM company that relies upon large-thousands of dollars per month-income calculations in its presentations, without providing disclaimers and charted average earnings figures, is on a collision course with the regulators and should be avoided. It’s just like the representations sound-too good to be true.

Of course larger companies with substantial capital reserves are better able to weather legal or regulatory storms than are small start-ups. However, a major lesson learned from the Enron and WorldCom debacles is that no commercial enterprise is big enough to ignore safely the climatic threats of its regulatory environment.

Summary

The legal concepts that determine the legitimacy of an MLM opportunity have been in use for decades. Nevertheless, reliably assessing a given company or program can require considerable time and effort. The process has been complicated by the numerous and subtle variations of compensation plans which have developed as a consequence of the competitiveness of the MLM marketplace. Unfortunately, many of these variations are merely cleverly masked pyramid schemes. Regulators justifiably attacking these programs have produced some unnecessarily restrictive interpretations of the applicable legal concepts, thereby frustrating the legitimate entrepreneur’s quest for clarity. Still, a prospective participant can, with some time and personal initiative, make a reasonably accurate assessment of the legitimacy of an MLM company and its opportunity by carefully applying the rules of thumb set out in this article.