Emory Corporate Governance and Accountability Review

The Multilevel Marketing Misnomer: How the Federal Trade Commission May Change Network Marketing
Jeremy Pineres Emory University School of Law, J.D. Candidate, 2017; Vice President, Student Animal Legal Defense Fund; House Coordinator, Emory Law Houses Program; Mentor, Emory Law Mentor-Mentee Program; B.A. Legal Studies, University of Central Florida. I would like to thank Heidi Hegewald, Liu Chen, and Nicole Fukuoka for helping refine my work, and Kelsey Spillers and Laura Beth Jackson for their encouragement and support throughout the writing process.

Multilevel marketing, also known as network marketing, is a business model in which distributors typically earn money through: (1) commissions on products or services they sell to the public, (2) a percentage of the capital new recruits invest to join the company (under the original distributor, known as one’s “downline”), and (3) a percentage of the sales made by the distributor’s “downline.” 1Multilevel Marketing, Fed. Trade Comm’n (Aug. 2012), . This structure shares characteristics with the problematic pyramid scheme, in which there is also a product or service sold. 2Common Fraud Schemes, Fed. Bureau of Investigation, (last visited Sept. 20, 2015). However, in a pyramid scheme, the focus of sales and actual profit is earned by the introduction of new “downlines,” not sales of products or services. 3 Id. Promoters promise rapid returns to prospective investors, claiming that they will earn easy money by simply getting others to make the same investment. 4Id. This business structure is not only fraudulent, but unsustainable, because eventually the supply of prospective investors is depleted and the pyramid collapses. 5Id.

While the distinction between the two models may seem clear, the Federal Trade Commission (the “FTC’) recently investigated Vemma Nutrition Co., a leading multilevel marketing energy drink company, and argued that the manner in which these companies implement compensation plans can result in blurred lines. 6Samantha Masunaga, Court Halts Vemma Temporarily on FTC Claim That It’s a Pyramid Scheme, L.A. Times (Aug. 27, 2015), . The FTC alleged that the company operated much like a pyramid scheme by focusing on the “recruitment of distributors over bona fide retail sales, while also misleading distributors, mostly young adults, on their ability to earn income by selling its products.” 7Antoine Gara, Federal Trade Commission Calls Vemma a Pyramid Scheme That Preys on Young Adults, Forbes (Aug. 26, 2015), . On September 18, 2015, a federal judge granted in part and denied in part the FTC’s Motion for a Preliminary Injunction, enjoining Vemma from recruiting new sales members. 8Judge Bars Vemma Nutrition from Resuming Full Business Operations, Cronkite News (Sept. 18, 2015), . This is a monumental step in the direction of reforming a business practice that currently induces the destitute, hopeful, and unaware into becoming part of a pyramid scheme called by a different name. 9 Id. This article will explain how many multilevel marketing companies operate similar to a pyramid scheme, as well as the impact the ruling in the Vemma case may have on the future of the multilevel marketing business structure.

I. How the Transition to Illegal Practices Occurs

While there are many different types of compensation plans offered by multilevel marketing companies, 10Ronald Kimmons, Examples of Compensation in Multilevel Marketing Plans, Houston Chronicle, (last visited Oct. 2, 2015). the oldest type, which is used by popular multilevel marketing companies such as Herbalife and Amway, is the breakaway compensation plan. 11Rod Nichols, Which Compensation Plan Is the Best?, Better Networker (Sept. 24, 2010), . In this plan, an initial distributor may only recruit people directly under them. 12Id. The initial distributor experiences downline (vertical) growth when its new recruits further recruit people under them. 13Id. Visually, the compensation plan looks like a staircase: as the initial distributor’s sales volume increases through each additional tier of distributors, the initial distributor earns commissions based on the sales of each lower tier. 14Id.

Oftentimes multilevel marketing companies will claim to sell legitimate products or services. 15Beware of Pyramid Schemes Posing as Multi-Level Marketing Programs, Secs. & Exch. Comm’n. (Oct. 1, 2013), . This has the effect of hiding the truth about revenue generation under their compensation plan to avoid being labeled as a pyramid scheme. 16Secs. & Exch. Comm’n, supra note 15. The problem with this claim, however, is that the products or services offered by these companies are priced too high to compete with standard markets that sell comparable shelf products. 17Jon M. Taylor, The Case (for and) against Multi-level Marketing 8-1,8-19 (2011), available at . The price of these products or services are inflated in order to satisfy: (1) costs of production, (2) costs of infrastructure, (3) substantial individual commissions for promoters at the top of the chain of distributors, (4) aggregate commissions for downline participants, and (5) a percentage of sales skimmed by the founders. 18Id.

The problematic transition from legitimate multilevel marketing sales to illegal pyramid scheme occurs when a largely unsellable product or service is combined with a compensation plan supposedly based on the sales made by distributors. 19Id. at 18–19, 29–30. At first glance, such a business model would seem to generate no revenue and inevitably fail. The industry’s solution to this problem, however, is achieved by rewarding distributors via commissions based on the start-up and inventory fees paid by new recruits. 20Aditi Jhaveri, The Telltale Signs of a Pyramid Scheme, Consumer Info. (May 23, 2014), . According to the FTC’s complaint against Vemma:

The defendants allegedly claim that affiliates’ earning potential is limited only by their own efforts and that Vemma provides young adults an opportunity to bypass college and student loan debt. Vemma urges customers to make an initial investment of $500-$600 for an “Affiliate Pack” of products and business tools, buy $150 in Vemma products each month to remain eligible for bonuses, and enroll others to do the same. 21FTC Acts to Halt Vemma as Alleged Pyramid Scheme, Fed. Trade Comm’n (Aug. 26, 2015), .

This shifts the source of revenue generation away from legitimate sales of products (by distributors to the public) to income based on recruitment of new distributors. 22Jhaveri, supra note 19. This point is further emphasized when one considers that a company as large and well-known as Herbalife does not track or distinguish between sales made to end customers and distributors. 23Herb Greenberg & Karina Frayter, Why Spotting a Pyramid Scheme Isn’t So Easy, CNBC (Jan. 9, 2013), .

II. How the Ruling Will Impact the Multilevel Marketing Model

U.S. District Court Judge John Tuchi’s ruling, which granted in part and denied in part the FTC’s Motion for Preliminary Injunction, has the effect of prohibiting Vemma from “paying commissions, recruiting new members, offering rewards for purchases[,] and tying sales to multi-level marketing.” 24Robert Anglen, Judge Forbids Vemma to Resume Normal Operations; Company to Be Supervised by Federal Monitor, AZCentral (Sept. 22, 2015, 1:09 PM), . The court-appointed receiver concluded that in 2015, seventy-eight percent of product sales were to affiliates, while only twenty-two percent of product sales were to customers. 25Robert Anglen, Court Keeps Controversial Vemma Energy-Drink Firm under Receiver, Cincinnati (Sept. 18, 2015, 8:11 PM), . An analysis of past years resulted in roughly the same numbers: eighty-six percent of product sales were to distributors in 2013, and seventy-one percent of product sales were to distributors in 2014. 26Anglen, supra note 24.

The ultimate decision in this case may affect the future of the multilevel marketing business structure in several ways. Assuming the court decides that commissions based on start-up fees are not allowable because such payouts encourage the recruitment tactics of a pyramid scheme, the business model would necessarily shift back to commissions based primarily on the sales of products or services. To shift a larger percentage of retail sales away from distributors to end-consumers, the court may find that multilevel marketing businesses may not bundle eligibility of bonuses with the purchases of product. Therefore, if a distributor is not able to sell his or her full inventory, the distributor would not be under undue pressure to buy unnecessary inventory in order to stay eligible for bonuses. This would have the effect of requiring the products or services to be competitive in the market through adjustments in quality, price, or a combination of both quality and price. The ruling, assuming the preceding changes occur, should bring network marketing back to its roots—direct sales made through networking with individuals.

Footnotes

1Multilevel Marketing, Fed. Trade Comm’n (Aug. 2012), .

2Common Fraud Schemes, Fed. Bureau of Investigation, (last visited Sept. 20, 2015).

3 Id.

4Id.

5Id.

6Samantha Masunaga, Court Halts Vemma Temporarily on FTC Claim That It’s a Pyramid Scheme, L.A. Times (Aug. 27, 2015), .

7Antoine Gara, Federal Trade Commission Calls Vemma a Pyramid Scheme That Preys on Young Adults, Forbes (Aug. 26, 2015), .

8Judge Bars Vemma Nutrition from Resuming Full Business Operations, Cronkite News (Sept. 18, 2015), .

9 Id.

10Ronald Kimmons, Examples of Compensation in Multilevel Marketing Plans, Houston Chronicle, (last visited Oct. 2, 2015).

11Rod Nichols, Which Compensation Plan Is the Best?, Better Networker (Sept. 24, 2010), .

12Id.

13Id.

14Id.

15Beware of Pyramid Schemes Posing as Multi-Level Marketing Programs, Secs. & Exch. Comm’n. (Oct. 1, 2013), .

16Secs. & Exch. Comm’n, supra note 15.

17Jon M. Taylor, The Case (for and) against Multi-level Marketing 8-1,8-19 (2011), available at .

18Id.

19Id. at 18–19, 29–30.

20Aditi Jhaveri, The Telltale Signs of a Pyramid Scheme, Consumer Info. (May 23, 2014), .

21FTC Acts to Halt Vemma as Alleged Pyramid Scheme, Fed. Trade Comm’n (Aug. 26, 2015), .

22Jhaveri, supra note 19.

23Herb Greenberg & Karina Frayter, Why Spotting a Pyramid Scheme Isn’t So Easy, CNBC (Jan. 9, 2013), .

24Robert Anglen, Judge Forbids Vemma to Resume Normal Operations; Company to Be Supervised by Federal Monitor, AZCentral (Sept. 22, 2015, 1:09 PM), .

25Robert Anglen, Court Keeps Controversial Vemma Energy-Drink Firm under Receiver, Cincinnati (Sept. 18, 2015, 8:11 PM), .

26Anglen, supra note 24.

Emory University School of Law, J.D. Candidate, 2017; Vice President, Student Animal Legal Defense Fund; House Coordinator, Emory Law Houses Program; Mentor, Emory Law Mentor-Mentee Program; B.A. Legal Studies, University of Central Florida. I would like to thank Heidi Hegewald, Liu Chen, and Nicole Fukuoka for helping refine my work, and Kelsey Spillers and Laura Beth Jackson for their encouragement and support throughout the writing process.