What is a Pyramid Scheme?

This is a simple question which should have a simple answer, but it does not. The Federal Trade Commission has at least two conflicting definitions, and additional definitions have been developed under the federal and state securities laws as well as state laws prohibiting pyramid schemes or chain distributor schemes. Some state laws have been amended as a result of lobbying by the Direct Selling Association; these laws legalize plans that would be considered pyramid schemes under other definitions.

Here I will focus on the FTC’s definition, which has evolved in a series of cases it brought against MLM firms beginning in the 1970’s.  The most frequently quoted definition is from In re Koscot Interplanetary, Inc., in which the FTC ruled that:

Such schemes are characterized by the payment by participants of money to the company in return for which they receive (1) the right to sell a product and (2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of the product to ultimate users.[1]

Critically, the final injunction in Koscot provided that (a) compensation could only be paid on “actually consummated” sales, and (b) compensation could only be paid on sales to persons who were not participants in the MLM plan. 86 F.T.C. at 1186.

Unfortunately, however, just a few years later the FTC ignored these provisions in a case it brought against Amway. In re Amway, 93 F.T.C. 618, 630-31 (1979).  Even though Amway paid commissions based on purchases by distributors rather than sales to bona fide consumers, violating the Koscot rules, the FTC ruled that Amway was not a pyramid scheme because it had three rules that supposedly encouraged retail sales: the 10 customer rule, the 70% rule and the buyback rule. More details about the serious problems caused by the endorsement of these rules in the Amway decision are available here. In a nutshell, the Amway decision immediately and dramatically changed the legal landscape of the MLM world.   MLM firms were provided with an attractive alternative to complying with the onerous definition of “retail sales” in the Koscot injunction.  Instead of limiting compensation to consummated retail sales, MLM firms could pay compensation on purchases by downline participants, provided that they followed the “Amway rules.”   Every sophisticated MLM firm promptly adopted some variant of the Amway rules.  The MLM industry expanded like wildfire after the Amway ruling.

In Webster v. Omnitrition, the Ninth Circuit held that the second element of the Koscot test – recruitment with rewards unrelated to product sales – is the sine qua non of a pyramid scheme.[2]  In FTC v. Burnlounge, the Ninth Circuit clarified that the rewards do not have to be “completely” unrelated to retail sales; an MLM is a pyramid if the rewards are paid “primarily” for recruiting.[3]   MLM proponents often make statements to the effect that “we aren’t a pyramid scheme because we are selling a real product.”   But the sale of a product is a red herring; the occurrence of some retail sales does not preclude the finding that an MLM is a pyramid scheme.

There is considerable controversy over whether “ultimate users” can include MLM distributors who are supposedly purchasing for their own use.   In Omnitrition the Ninth Circuit appeared to hold that participants in the MLM plan cannot be considered “ultimate users”.   In Burnlounge, however, the Ninth Circuit appeared to back off this position.   The problem of considering MLM participants to be ultimate users – what the MLM industry refers to as “self-consumption” – is that in order to assess whether an MLM is a pyramid scheme it is necessary to determine whether the distributor’s purchase is motivated by a bona fide desire to consume or use the products, or whether the purchase is motivated by the desire to qualify for rewards under the MLM compensation plan.  As explained by Edith Ramirez, the former Chairwoman of the FTC:

Simply put, products sold by a legitimate MLM should be principally sold to consumers who are not pursuing a business opportunity. For good reason, the law has always taken a skeptical view of paying compensation to someone based on the presumed “internal consumption” or “personal consumption” of recruits who are pursuing a business opportunity.  When a product is tied to a business opportunity, experience teaches that the people buying it may well be motivated by reasons other than actual product demand.[4]

The fact that MLM distributors may have mixed motives for purchasing products complicates the determination of whether a given MLM plan is a pyramid scheme.   It requires the FTC (or private plaintiff) to undertake a lengthy, time-consuming and expensive investigation into the actual purchases and sales of products by the MLM’s distributors.   Such investigations are made more burdensome due to the fact that MLM firms typically do not collect records of their distributors’ retail sales.

The complexities inherent in assessing the motivations of MLM distributors in purchasing products reached its acme in the FTC’s recent settlement with Herbalife. The FTC’s complaint alleged that Herbalife distributors “experience difficulty in selling product to customers outside the network,” while Herbalife’s “compensation structure puts pressure on Distributors to purchase large quantities of product in order to qualify for greater wholesale discounts and recruiting-based rewards.”[5]  The FTC then alleged that Herbalife distributors disposed of excess products by giving or throwing it away, or by gradually consuming it themselves.[6]  Significantly, the complaint alleged that “[s]uch self-consumption is not driven by genuine demand for the product, but is the easiest and most convenient way for a Distributor to get some benefit from product that the Distributor would not have bought absent his or her participation in the business opportunity.”[7]  In the consent order, which also imposed $200 million in restitution and a seven-year monitoring regime by an independent compliance monitor, Herbalife was required to implement a comprehensive set of changes to its compensation plan, including retail sales verification and record-keeping, much of which was designed to preclude the payment of rewards to distributors based on purchases by other distributors unless those purchases were undoubtedly motivated by bona fide retail demand.[8]

Notably, the FTC did not use the term “pyramid scheme” in its complaint against Herbalife.   On the other hand, at the press conference announcing the settlement, the chairman of the FTC made the most famous double negatives in MLM history, stating that “they were not determined not to have been a pyramid.”[9]  Rather than use the term “pyramid scheme”, the FTC characterized Herbalife’s compensation plan as an “unfair practice.” As discussed here, the FTC’s mandate is to protect consumers from “unfair and deceptive practices;” pyramid schemes are not mentioned in the FTC Act. The FTC’s complaint against Herbalife reads exactly like its complaints against other MLM companies accused of being pyramid schemes. The only thing missing is the term, “pyramid scheme.” Undoubtedly, the avoidance of the term pyramid scheme was bargained for as part of the settlement negotiations between the FTC and Herbalife.

So, even if you only consider the FTC’s definition of pyramid scheme, you can get bogged down in the morass of determining such questions as what is or is not a retail sale, who is a consumer, and whether a distributor’s purchases of inventory are motivated by consumer demand or the desire to qualify to earn commissions, rise in the ranks, or maintain their position in the MLM compensation plan. To make matters worse, just about every state has a statute prohibiting pyramid or chain distributor schemes, or otherwise governing MLM offerings, and the definitions in many of those statutes are inconsistent with the FTC’s definition. For instance, many of the state anti-pyramid statutes follow a format drafted by the Direct Selling Association, under which MLM programs that have some form of repurchase agreement are excluded from the definition of pyramid scheme.

In my opinion any compensation plan that permits unlimited recruitment and imposes inventory purchase requirements on the right to earn commissions should be considered a pyramid scheme, regardless of whether anyone is making retail sales. This is not the law, just my point of view. If, however, you are considering an MLM “business opportunity,” I would urge you to apply my definition when you study the compensation plan. If the plan is a pyramid scheme under my definition, I would urge you to avoid it. There is a better than 99% chance this will save you a lot of money and heartache.

[1] In re Koscot Interplanetary, Inc., 86 F.T.C. 1106, 1180 (1975), aff’d mem. sub nom., Turner v. FTC, 580 F.2d 701 (D.C. Cir. 1978).  

[2] Webster v. Omnitrition, 79 F.3d 776 (9th Cir. 1996).

[3] Burnlounge, supra, 753 F.3d at 885-86.

[4] Keynote Remarks of FTC Chairwoman Ramirez, Direct Selling Association Business & Policy Conference, Washington, DC (October 25, 2016), page 6, available at  https://www.ftc.gov/system/files/documents/public_statements/993473/ramirez_-_dsa_speech_10-25-16.pdf (hereinafter “Keynote Remarks”).

[5] FTC v. Herbalife, Complaint for Permanent Injunction and Other Equitable Relief, ¶72, available at https://www.ftc.gov/system/files/documents/cases/160715herbalifecmpt.pdf (hereinafter Herbalife Complaint).

[6] Herbalife Complaint,  ¶74.

[7] Herbalife Complaint, ¶74.

[8] See generally, Keynote Remarks, pages 7-10.   The consent order in FTC v. Herbalife International of America, Inc. is available at https://www.ftc.gov/system/files/documents/cases/160715herbalife-stip.pdf

[9] See FTC Press Conference: Herbalife (July 15, 2016), available at  https://www.ftc.gov/media/71151