By Stephen O’Regan

Senior Associate, International Business Advisory

Dezan Shira & Associates, Guangzhou

The Chinese government has launched a three-month campaign to crack down on pyramid schemes. The campaign follows a series of frauds that recently led to four deaths, and associated protests that erupted in downtown Beijing this summer.

The campaign, which will last until November 15, 2017, aims to eliminate gangs and scammers that lure and mislead job seekers into participating in pyramid schemes. The government’s announcement of the crackdown sent stocks of Multi-Level Marketing (MLM) companies – such as Herbalife and Nu Skin – tumbling, due to fears that the campaign could disrupt their operations.

Businesses in China with organizations similar to MLM structures should scrutinize their internal practices and study relevant regulations to avoid non-compliance with government regulators.

RELATED: Gaining Direction: Navigating China’s Direct Sales Industry

MLM organizations

MLM, a type of direct selling system, is a marketing strategy where the company’s sales force is highly dependent on the salespersons they have hired in different tiers of selling. The sales force is compensated not only for sales they generate, but also for the sales of the other salespeople that they recruit in this marketing strategy.

This recruited sales force is referred to as the participant’s “down-line”, and can provide multiple levels of compensation. This type of organizational structure can be quite enticing as it has the opportunity to build up a big networking distribution without investing a considerable and consistent amount of money.

The key features followed by MLM organizations are:

Organizers, or operators, who take in new members calculate and pay salaries to a member on a different level according to the number of new members they have introduced either directly or indirectly, as well as the sales performance of the member;

Organizers request new members to hand in a sum of money as a precondition to joining;

The organizers, or the operators, encourage members to invite more people join, forming a multi-level relationship;

The salaries of members at a certain level are based on the sales of members at a lower level.

The main factors that need to be taken into account before setting up any networking and marketing plan for an enterprise are the size of the market, high quality products to sell, and efficient internal training. The base concept of these activities is that the salesperson’s gain is in proportion to the quantity and quality of the products that he or she is able to sell to potential clients.

However, with the MLM pyramidal structure, the highest position always gets a percentage of the sales from those who are in the bottom positions. Some companies that wish to set up this type of structure want to incorporate a five or more level system.

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MLM and direct sales in China

From our experience, a large number of foreign companies have expressed interest in entering into the Chinese market through this MLM structure. However, they are going to be disappointed.

In 2005, Chinese government enacted a law called Regulation of Direct Sales and Regulation on Prohibition of Chuanxiao (Chuanxiao stands for MLM). With this regulation, China makes clear that while Direct Sales is permitted in the mainland, MLM is not.

Even if allowed, Direct Sales must follow several rules. The company is required to:

have a business license;

only pay out one level of commission;

offer an advanced training course to sellers, where they have to get a license by the end of the course; and,

direct sellers must wear a badge to prove their status.

In addition, the personal seller’s commission it set at 30 percent of the sales, including bonuses, commission, and other benefits. According to regulations, MLM organizers, and the members at top level, obtain interest illegally, and according to the Chinese government, disturb normal economic order, thereby affecting social stability.

Contrarily, MLM is legal in in Taiwan and Hong Kong. It is common to see salespeople from these regions selling in the mainland using Taiwanese or Hong Kong addresses and banks to become sales representatives in these jurisdictions, while at all times living and working in China. The legality of this is questionable.

Even after the application of Regulation of Direct Sales and Regulation on Prohibition of Chuanxiao, many companies are still operating under the MLM structure, and this does not seem to be changing. Nu Skin Enterprise, for example, was under investigation for an illegal pyramid scheme. Regulators accused them of relying more on signing up new salespeople than actually selling products to customers. Nonetheless, they still play an important role in China’s marketplace.

They are not the only company who are following this sales model; many other such enterprises act within the Chinese market with MLM structures. With the new crackdown on pyramid schemes, however, companies with MLM structures will find themselves under even harsher scrutiny from the authorities should they fail to adopt compliant structures.

This article was originally published on July 16, 2015 and has been updated with the latest regulatory changes.



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