May 23rd, 2016

POST HIGHLIGHTS • H.R. 5230 runs directly counter to 40 years of case law on pyramid schemes. • It obliterates the difference between distributor purchases for the business venture versus those for personal use. • The Bill effectively eliminates prosecution of all but the most blatant forms of pyramids.

Throughout American history, free market principles have played, and continue to play, an important and beneficial role. I have been a college economics professor, teaching the free market system, and am actively engaged in assisting the government in prosecuting pyramid schemes. The critical issues surrounding House Bill 5230 (the Bill) are not about enhanced opportunities to be your own boss, and with hard work to become a successful entrepreneur. Emphatically, this Bill fails to enhance entrepreneurship or benefits to American society. All those knowledgeable of the issues, whether inside or outside the industry, know that there are pyramid schemes using the MLM industry as cover. If enacted into law, the Bill will not only enhance this cover but create immeasurable confusion in extant case law, placing pyramid prosecution in a range from very difficult (where it is now) to practically impossible in the future.

The Bill seeks to codify the viewpoint expressed by Mr. Mariano, President of the Direct Selling Association (DSA): “The legal analysis should be: is the product being used by real consumers?” Whether the consumer is a distributor is immaterial.” As shown in detail (Truth and Truthiness; Enduring Primacy of Retail Sales), Mr. Mariano’s position runs directly counter to established and controlling case law. What we need is not a Bill that states, with numerous loopholes, what does not constitute a pyramid scheme. What we need is a federal law clearly stating what does constitute a pyramid scheme — accompanied with an articulation that builds upon, rather than seeking to eviscerate — decades of consistent case law.

Running Counter to Forty Years of Case Law on Pyramid Schemes

In the foundational Koscot decision (1975) the Federal Trade Commission (FTC) distinguished between legitimate MLMs and pyramid schemes that use an MLM structure (the latter also called product-based pyramid schemes). Koscot gave MLMs a green light to pay participant rewards “based upon consummated retail sales” but did not require that all MLM compensation need be structured in the same way. In Amway 1979, the FTC permitted the combined use of Amway’s 70% Rule and its 10 customer retail sales rule to be potential proxies — depending on how the compensation plan operates in practice– for engendering sufficient retail sales that would prevent a pyramid scheme. The important history of this approach and related case law is not repeated here; it is addressed in the Enduring Primacy of Retail Sales in an MLM Context.

The Bill shows reckless disregard for the truth of FTC advice given to the MLM industry 12 years ago and still highly pertinent today (FTC Staff Advisory on Pyramid Scheme Analysis, January 2004):

Modern pyramid schemes generally do not blatantly base commissions on the outright payment of fees, but instead try to disguise these payments to appear as if they are based on the sale of goods or services. The most common means employed to achieve this goal is to require a certain level of monthly purchases to qualify for commissions. While the sale of goods and services nominally generates all commissions in a system primarily funded by such purchases, in fact, those commissions are funded by purchases made to obtain the right to participate in the scheme. Each individual who profits, therefore, does so primarily from the payments of others who are themselves making payments in order to obtain their own profit… Such a plan is little more than a transfer scheme, dooming the vast majority of participants to financial failure.

One exemplar of the importance of this advice comes home in Five Star Auto Club (2000). After trial on the merits, the court ruled that an organization is a prohibited pyramid scheme where participants make payment(s) in order:

to receive the right, license or opportunity to derive income [emphasis added] as a participant primarily from: (1) the recruitment of additional recruits by the participant, program promoter or others; or (2) non-retail sales made to or by such recruits.

Here, as well as other cases, the court addresses the primary funding source for the payment of participant rewards, thus addressing how participants in certain MLMs derive their income from the venture. An MLM can easily avoid recruiting fees and paying associated rewards for just enrolling new people. That stricture is a necessary starting point but it is not sufficient. As highlighted in the Advisory, in order to disguise recruitment rewards as commissions based on product sales, the most common way is to require participants to make a certain monthly level of qualifying purchases; i.e., purchases which qualify a participant to receive commissions. The Five Star decision (2000), fully consistent with the subsequent FTC Advisory in 2004, stands for the proposition that if participant rewards are funded primarily by purchases to meet the qualification for rewards, the organization is a pyramid scheme.

The notion that the appellate court in BurnLounge (2014) renders a different understanding, as some have urged, is strongly erroneous. The appellate court states that when distributors buy product for personal use that was not incentivized to meet qualifications for rewards, those purchases constitute “ultimate use” under Koscot. The court further makes it clear that there remains a critical difference between purchases for the sake of the business/income venture and purchases made for personal use (commonly called “internal consumption”):

BurnLounge is correct that when participants bought packages in part for internal consumption…the participants were the “ultimate users” of the merchandise and that this internal sale alone does not make BurnLounge a pyramid scheme. But it is incorrect to conclude that all rewards paid on these sales were related to the sale of products to ultimate users. Whether the rewards are related to the sale of products depends on how BurnLounge’s bonus structure operated in practice… In practice, the rewards Burn-Lounge paid for package sales were not tied to the consumer demand for the merchandise in the packages; they were paid to Moguls for recruiting new participants. … Rewards for recruiting were “unrelated” to sales to ultimate users because BurnLounge incentivized recruiting participants, not product sales. The FTC and other courts have consistently applied the Omnitrition test in this way.

If enacted into law, the Bill would ensure that such consistent application of case law could not, as a practical matter, continue in the future (below).

Eliminating Prosecution of All But the Most Blatant Pyramids

The burden of proof assumed by the government in prosecuting product-based pyramid schemes is already high. From my experience over a number of such cases, federal prosecution typically involves: (1) an exposition in which the agency argues (each time again beginning with Koscot) for a line of demarcation between a legitimate MLM and a pyramid scheme and that the line has been crossed in the case at hand, (2) for the security of its litigation, presenting an abundance of evidence regarding (a) income misrepresentations, (b) purported company rules that are entirely ineffective in preventing a pyramid scheme, (c) quantification of the losses for the vast majority of participants; (d) extensive analysis of the MLM’s compensation plan showing how it incentivizes recruitment over retail sales; (e) review of all company data, obtainable only under discovery, showing that the primary or sole funding source for the rewards paid to upline participants is the revenue obtained from qualification purchases (discussed earlier).

The Bill exempts certain purchases from constituting any component of a pyramid scheme, namely participant purchases “not made solely for purposes of qualifying for increased compensation.” The exemption is implicit in the Bill’s definition of Ultimate User:

The term ‘ultimate user’ means a non-participant in the plan or operation, or a participant who purchases reasonable amounts of products, goods, services, or intangible property for personal use and whose purchase is not made solely for purposes of qualifying for increased compensation.

One naturally asks who would carry the burden of showing whether participant purchases are made solely for purposes of qualifying for increased compensation? The Bill grants a sweeping exemption affecting a core part of case law but is silent on whether an MLM, the seller of the goods and services (surely with transactional records), has an affirmative duty in ascertaining via its own data or by other means whether participant purchases “are in reasonable amounts … for personal use” and whether participant purchases were (or were not) “made solely for purposes of qualifying for increased compensation.” As the proposed law is silent on these important points, in a prosecution the government is not likely to assume the firm to have an affirmative burden here, and by default would take on the burden of these additional determinations. A separate analysis could be written setting forth the plethora of problems that would be encountered. Suffice it to say, prosecution of product-based pyramid schemes under the terms of the proposed law would surely become resource-prohibitive.

In sum, the Bill would essentially eliminate prosecution of all except the most simplistic and blatant forms of pyramid schemes; the more carefully crafted forms would be left off the hook and thus be permitted to inflict enormous harm on American consumers. As others have also pointed out, the name of HR 5230 (‘‘the Anti-Pyramid Promotional Scheme Act of 2016”) is surely a misnomer. The Bill’s wrong-headed direction in moving against 40 years of established case law is more aptly described as “the Pyramid Permission Act of 2016.”

The views, opinions, and positions expressed in this blog post do not necessarily reflect the views, opinions, and positions of TINA.org.