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The ABC's of MLM

Feb 8, 2008
What follows is from the legal perspective of an attorney who has had to defend MLM companies from regulatory scrutiny and attack. The creative genius of entrepreneurs is not discussed or highlighted in the following analysis. The marketing view is missing. The hype and the fluff and the attention-grabbing bells and whistles are left to be discussed by authors writing from a marketing perspective. When all extraneous twists and turns are scraped away, what is legally left needs to look something like this, or the MLM operation will not be allowed to continue long-term in the United States or Canada.
  1. The company brings a product or service to the marketplace that:
    1. is retailable
    2. is being retailed, and
    3. does not include a right to bring more participants to the company. A service that contains the right to bring customers to the company, like a shopping mall, can qualify, but not if it also contains the right to bring more income opportunity seekers (legally, "participants") to the company. Multilevel income opportunities CANNOT be sold in the United States or Canada.
  2. The product or service reaches the end user through efforts of direct sales representatives (independent contractors), rather than through traditional retail establishments or other channel of distribution choices like mail order or telemarketing. This channel definition is driven, not by any e-commerce techniques, but rather by the payment of money to an independent contractor for producing a result. Another characteristic of this channel is a lack of employees (involved in selling) to whom W-2s are issued and the presence of independent contractors to whom 1099s are issued.
  3. The company's compensation plan
    1. is designed to reward representatives for the sales of the product or service they are involved in, and
    2. includes an incentive and reward for the representative to be the "new representative finder" (legally, another "participant") in the form of payment to a representative who introduces an additionalrepresentative to the company, BASED ON the sales volume of the second representative.
It is the presence of the design plan feature described in C2 above that subjects a single-level direct selling company to multilevel laws and regulations, whether or not the company chooses to use the term "multilevel" in its literature. Not all companies or distributors agree with this definition. I respect differing views. At the time of this writing, I am unaware of any regulatory agency in the United States or Canada who defines an MLM company substantially differently fromwhat I have just stated. It is the compensation feature described in C2 above that brings the company under the microscope of regulatory scrutiny. A "participant" in the legal sense has the right to introduce another "participant." If your rights stop at finding, introducing, locating, or selling to "customers," you are not a "participant" in the legal sense, rather you are operating in the C1 portion of this analysis. Whether or not there are "participants" is very critical. The fact that you may receive a 1099 on the rewards of your efforts does not make you a "participant," unless you also have the right to introduce others who also have the same 1099 potential. No amount of e-commerce manipulation or affiliate program wording can change this. Only legislatures can change laws, and they are notoriously slow to act.

Personal consumption by representatives is much discussed. A lot of it is good for the company's bottom line, but too much of it is bad. How much is too much? One hundred percent personal consumption creates a presumption in the law and in the analysis of the business by regulators (in my view) that the only persons willing to buy the product/service are income opportunity seekers, and the amounts being paid are no more than disguised headhunting fees. Such payments are pyramidal and illegal.

"What percentage of sales to non-representatives do I need to be legal?" You do not want to ask the question, and you do not want it answered for you by government agencies. There are companies with very high percentages of "personal consumption" by their representatives that pose no risk of abuses, such as deceptive recruiting, inventory loading, or the "running out of people" pyramid risk. Also, an argument can be made that people who become representatives solely to buy products or services at wholesale, rather than retail, and who do not also buy for resale and do not sponsor, are customers, rather than income opportunity seekers. For the purpose of defending high amounts of personal consumption, an argument can be made that one does not become a "participant" in the legal sense until one introduces another participant, since only then can rewards flow based on the second participant's sales volume. If all of the elements of the analysis above are present, the percentage of personal consumption by representatives should not matter. If the question is even raised, it usually means A1, A2, or C1 is missing or flawed. But I will not duck the question. My answer is this: Twenty percent of total sales to non-representatives should be sufficient to rebut any presumption. Of course, other pyramid tests would still apply. One reason I say this is because companies with very high personal consumption percentages have been going strong for ten years or more and pose no pyramid risk.

A1, A2, or C1 in the above analysis cannot be missing or flawed. C2 alone, without A1, A2, and C1, is deemed an endless chain and an illegal pyramid. If in the design or in the implementation of an MLM program all that is visible--all that the regulators see, all that is really happening--is income opportunity seekers who find more income opportunity seekers who find more income opportunity seekers, etc. (legally, "participants"), the regulatory end is near, sooner or later. The regulators, with or without specifically drafted laws, state their position simply--you run out of people.

So, since retailing is so essential, let's examine it in more detail. What does "retailable" mean? It simply means "Will people buy my product or service?" The question appears almost too simple, so we need to be more specific about "people." The "people" need to be people in a "customer" sense, rather than in an "income opportunity seeker" sense. There are hundreds of reasons why people will not buy products or services: They already have one; the cost is too high; they have no need or desire to own one; what is being sold is of poor quality; etc. The test here does not need to find a specific reason. If no one but income opportunity seekers buys the product or service, the presumption is raised that the product or service is not retailable, and A1 in the analysis is flawed. Look at traditional companies by comparison. If no one buys what they offer for sale, they are out of business. If the MLM company continues in business anyway, regulators presume the company is selling the right to sponsor yet more people. Federal and state laws prohibit selling the right to sponsor.

Once the retailability of the product or service is questioned, the risk of the MLM element of the compensation plan (C2 above) being attacked as illegal greatly increases. An argument can be made that people who become representatives solely to buy products or services at wholesale, rather than retail, and who do not also buy for resale and do not sponsor or refer, are customers, rather than income opportunity seekers.

Examining A2 in more detail, it differs from A1 primarily in the focus placed on retailing by both the company and its distributors. If the product or service is not retailable, we do not even get this far. If the product or service is retailable, but little corporate or field focus is placed on retailing, A2 is flawed, possibly not in the design, but surely in the implementation. Some things to look for: Does information exist in paper or electronic form specifically designed to assist the retailing effort? Does training exist to assist the field in its retailing efforts? Is retailing discussed in opportunity meetings or on web pages if the company is primarily e-commerce driven? Once the lack of actual retailing activity is identified, the risk of C2 being deemed illegal greatly increases.

C1 and C2 are separated on purpose. It is a critical separation for legal positioning. The existence of a viable income opportunity, without the necessity of recruiting more income opportunity seekers, is absolutely essential. Simply stated, one test for the legality of a multilevel income opportunity is a single-level analysis. Can money be made by the income opportunity seeker without sponsoring? The form of the single-level income opportunity is not as important as the substance. Traditionally, the representative's first way to make money is to keep the difference between what he/she pays for the product and what is received for the product when he/she resells it. This "two passages of title" method of distribution has been replaced to a great extent by the representative being a "customer finder" and the company performing direct fulfillment. The e-commerce revolution may totally obsolete the "two passages of title" method of distribution. Some companies add to the first profit opportunity an additional profit opportunity in the form of bonuses, rebates, or commissions. The key to the C1 analysis is that sponsoring of another "participant" must be optional. There must be a place in the compensation plan for the non-sponsoring income opportunity seeker. If the ONLY way an income opportunity seeker can make money is to bring to the company more income opportunity seekers, the plan is fatally flawed. It is an endless chain. The argument that it "really is not" an endless chain, when you carefully examine the design and read all the fine print, will not hold up if the field force presents it only as a sponsoring opportunity. The fine print does not save the day. How a plan is implemented carries much more weight than how a plan is designed.

Some specific points need to be made about C2. No reward can be paid to the first representative for the act of introducing the second representative to the company. Such payments or rewards are called "headhunting fees" and are barred by law. No charge or required product purchase can be imposed on the second representative by the company or the sponsor as an entry fee. (A required purchase of an at-cost, non-commissionable sales or starter kit is permitted.) Simply put, neither the company nor the sponsor can profit from the sole act of recruiting. Profit to the company and profit to the representatives must come from the sale of products and services to customers, and only from the sale of products and services to customers.

If, from the start, all of the points made above are addressed in the initial design and are monitored in the implementation, regulatory scrutiny is unlikely. When inadequate or no attention has been paid to A1, A2, and C1, the states with proactive consumer protection agencies are likely to start an investigation rather quickly. I advocate correct initial design and company-monitored, correct implementation. However, some companies getting off on the wrong foot can recover.

Fixing a flawed plan can be as easy as changing language in corporate literature, or as difficult as rolling out totally new and substantially restructured products, services, and methods of compensation, accompanied by massive nationwide retraining. Some companies have made these transitions, and others have died in the process. When the alternative is a cease and desist order in a key state, with more states to follow, hard choices must be made. The bottom line will be affected. Fickle representatives will jump ship. Some representatives seek out and work flawed plans for the quick monetary gain and are prepared to move on to the next one at a moment's notice.

Patching up C1 and C2 is inadequate, without a corporate resolve to address A1 and A2. It starts with the company's product or service. Long before MLM, around the turn of the century, someone said, "Build a better mousetrap, and the world will beat a path to your door." The "making legitimate," or "legalizing," of an MLM plan under regulatory scrutiny can only be accomplished by going to the core. The core is the product or service being brought to the general public marketplace by the company, and, of course, how it is brought to the marketplace. The core is not the bells and whistles of the compensation plan.

If a flawed MLM plan is under attack, it must be taken most seriously. State and federal regulators are too savvy to accept wordsmithing patches without substantive changes to the way business is done. Often, distributor "leaders" want the simple formula of "get two who get two, et cetera, and cash those commission checks." If, in the analysis above, A1, A2, and C1 are flawed, either in the design or the implementation, significant changes to the way business is done must be made. If few or no one will buy the company's products or services, except to play the game, then the MLM plan will be attacked as an endless chain money game. The state or federal agencies will eventually hound the company out of business. What is often required to close or settle an investigation is a corporate marketing shift to a retailing focus, followed by field retraining. Corporate monitoring and verification that the changes are being implemented in the field are often required.

Since retailing is the legal answer to MLM longevity, finding the right products or services is critically important. But I am digressing from the legal perspective. To wrap up, I have looked for other paths through the jungle of laws and regulations regarding MLM. E-commerce increases the many variations of selling, but does not bring with it exemptions from anti-pyramid statutes. If another path exists that does not include or require these legal ABCs, I have not found it.
About the Author
Gerald P. Nehra is an MLM-specialist, private practice attorney. He is one of only a few attorneys nationwide whose practice is devoted exclusively to direct selling and multilevel marketing issues. His 33 years of legal experience includes nine years at Amway Corporation, where he was Director of the Legal Division. He can be reached at 1710 Beach Street, Muskegon, Michigan 49441-1008, 231-755-3800, 231-755-4700 fax. His e-mail address is GNehra@mlmatty.com.
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