Making Sense of the FTC Staff Advisory Letter

How do you measure intent?

In 2004, the FTC attempted to clarify some concerns from the Direct Sales Association with respect to the issue of internal consumption. The letter is short and can be read in its entirety below. There’s one thing that’s noticeably absent from the letter: the basis upon which the FTC distinguishes the good companies from the bad ones. Still, there are some good nuggets to pull from the advisory letter.

Much Ado About Internal Consumption

In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme. The critical question for the FTC is whether the revenues that primarily support the commissions . . . are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture. A multi-level compensation system funded primarily by such non-incidental revenues does not depend on continual recruitment of new participants. . .

Translated in English, I read the above paragraph to mean that the “intent” behind the distributors’ consumption of the product is an important factor. If distributors are purchasing products merely to participate in the pay plan, there’s a serious problem. If distributors are purchasing items for the inherent value, it’s a different story. So how does the FTC measure intent? What’s the appropriate metric to use to read the collective minds of the sales force?

The FTC expresses its disdain for recruitment schemes when it further says, “A multi-level compensation system funded primarily by such non-incidental revenues does not depend on continual recruitment of new participants, and therefore, does not guarantee financial failure for the majority of participants.” Clearly, the FTC understands that programs that require endless recruitment in order for distributors to turn a profit are unsustainable and harmful. How does the FTC determine if a program is an endless chain that requires constant recruitment? In my view, the answer depends on the marketability of the product. If the product is unmarketable, then the only way to advance in the program is to focus on recruitment and exhaustive internal consumption, which brings us to our last and most important part of the letter.

Forced Inventory Requirements…a big no-no

On page 2, the FTC solidifies its position that “intent” is very important when distinguishing good companies from the pyramids when it writes:

The Commissions recent cases, however, demonstrate that the sale of goods and services alone does not necessarily render a multi-level system legitimate. Modern pyramid schemes generally do not blatantly base commissions on the outright payment of fees, but instead try to disguise those 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. As discussed above, such a plan is little more than a transfer scheme, dooming the vast majority of participants to financial failure.

Although it’s not explicitly written above, the word “intent” is there in spirit. If a company has a forced inventory requirement, it’s an immediate red flag because it’s an indicator that the product is serving as a subterfuge of the money transfer scheme. Additionally, it’s an indicator that the product lacks marketability and that the business depends upon constant recruitment of new participants to engage in the inventory requirements. Imagine a company that sold $1,000 bottles of lemonade and required its distributors to purchase a product a month. Clearly, the bottles of lemonade would be considered token products designed to conceal the money transfer scheme. Most companies are not foolish enough to have inventory requirements in order to participate. Additionally, most companies have some type of sales requirement to demonstrate that their products are in fact relevant for nonparticipants.

Measuring Intent…how do regulators do it?

So what are some common sense ways to measure the collective “intent” of the sales force?

  • Is there a prerequisite of selling before the commissions are paid out? This is known as one of the “Amway Safeguards” where the distributors earn commissions from downline volume only after hitting their retail sales quota. It demonstrates that the products are truly marketable because they’re moving to people outside of the compensation plan.
  • Do former distributors continue to buy the products? I know of several people that continue to purchase products from prior MLMs because they love the value of the product. If the answer is “no,” it would indicative that the distributors were purchasing the items largely to participate in the pay plan.

What do you think? What are some ways to measure the “intent” behind internal consumption?

The FTC Advisory Opinion is included below

  • http://tiny.cc/D5oJh Tex

    Here's my take on the above paragraphs, following the —> :

    In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme. The critical question for the FTC is whether the revenues that primarily support the commissions . . . are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture. A multi-level compensation system funded primarily by such non-incidental revenues does not depend on continual recruitment of new participants. . . —> The FTC does not automatically consider lack of outside (non-IBO/distributor) sales a problem. However, the bulk of the bonuses should be based on recurring product sales, not sales from the signup process.

    The Commissions recent cases, however, demonstrate that the sale of goods and services alone does not necessarily render a multi-level system legitimate. Modern pyramid schemes generally do not blatantly base commissions on the outright payment of fees, but instead try to disguise those 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. As discussed above, such a plan is little more than a transfer scheme, dooming the vast majority of participants to financial failure. —> Here, the FTC got sloppy with their terminology of "sales," they seem to be mixing something bought by an IBO/distributor and put into inventory, and a sale to a non-IBO/distributor. Anything that goes into inventory, by definition, is not a real sale to anyone, it is building inventory in anticipation of an inside (downline) or outside customer sale. The 70% inventory rule addresses this issue. There is nothing "modern" about the 70% inventory rule, it has been around for a very long time. However, a required minimum purchase rule can cause both forced consumption and/or violation of the 70% rule.

    I agree the only credible way to measure intent is to have outside sales. It should be noted an MLM with one product can better demonstrate market (customer) demand than an MLM with more products, as the MLM with more products can have a couple of "token" products that have market demand, while the products having more PV/BV are NOT priced to market demand.

  • http://tiny.cc/D5oJh Tex

    Clarification: The recurring sales mentioned in the first paragraph above could be 100% IBO/distributor volume, with ZERO outside sales to non-IBO/distributors.

  • http://www.themlmattorney.com Kevin Thompson

    Good insights, Tex. However, I strongly disagree that a company can get away with 100% distributor volume and I'm confident that the enforcement lawyers at the FTC would disagree as well.

  • http://tiny.cc/D5oJh Tex

    I base my position on the below words from the letter:

    "In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme."

    The FTC appears to be saying the $10,000 pencil issue is okay, as long as the main source of income is from repeat purchases rather than new IBOs/distributors joining. I prefer a retail requirement as well, but this thread was about "Making Sense of the FTC Staff Advisory Letter," not "What Tex and Kevin think about what separates good and bad MLM."

    In addition, the FTC seems to be very supportive of buying clubs, and even MLM designed buying clubs, which is essentially what Amway has been, with negligible outside retail volume. There is a membership fee, and the idea of group buying to reduce price is included in both. The major difference between a traditional buying club and an MLM one is some "save" (and far surpass this concept to making a net profit, if one considers no other overhead costs, and an smaller group even making a net profit when the other overhead costs are considered) more than others, and the FTC appears to have no concerns with this issue.

    I view the FTC's position that "$10,000 pencils with no outside sales are okay, as long as most of the profit is from repeat purchases, not new IBO/distributors" as a "rough cut" to an MLM being acceptable, and the "outside retail sales are required" a much more "fined tuned, refined, and better measure of real market demand" measure of an MLM, and one much less subject to abuse.

  • http://www.themlmattorney.com Kevin Thompson

    Tex, the key is "motive." Clearly, the distributors would be buying the $10K pencils to participate in the scheme, not for the inherent value. And motive is determined by outside sales. Stay tuned on this issue.

  • http://tiny.cc/D5oJh Tex

    I agree, and I've already said the ONLY reasonable way to measure motive is to have outside sales.

    Distributors also wouldn't (couldn't afford to) CONTINUE to buy $10,000 pencils. This is the logic behind the FTC logic of internal consumption being the major source of profit rather than the new recruits. However, retail sales are needed as well, as churn could skew the analysis.

    The $10,000 pencils is obviously the extreme case. The scenario becomes increasingly murky when the pencils are $5,000, $1,000, $10, $1, etc. This is where Amway has had problems, trying to say the product QUALITY makes the high priced products a good VALUE, and the recent price reductions have significantly lessened this concern. You can only ride the quality horse so far, it eventually gets bogged down.

  • http://[email protected] David Steadson

    Kevin,
    Motive *isn't* soley determined by outside sales. If a network was selling iphones and mobile contract, 100% internally, and the network price (even after expenses) was less than street price, then a motive can be discerned – getting a cheap iphone!

    Same with any product really, and that's where some discernment is necessary. Really, the real value of the product in the marketplace is what is important. "Outside sales" just make it much, much easier to determine that value, but they're not necessary and there's no particular reason there should be.

    A smart company of course would want to avoid inspection on this issue so mandate at least some retail sales so that they have evidence their product has real demand at whatever price they've set.

    Of more concern to me, and you allude to this in your post, is the many, many MLMs that have mandatory personal volume via autoship programs – even worse is when that mandatory personal volume *explictly excludes* volume from non-distributor "preferred customers" who order direct from the company.

    That kind of setup is clearly inviting illegitimate demand as well of course as predictable ending up with distributors with garages full of stock and a long-term dislike of the industry.

  • http://tiny.cc/D5oJh Tex

    As usual, poor analogy.

    An iphone and mobile telephone service can easily be compared in the marketplace. Most products offered by most MLMs cannot be easily compared, and many MLM companies misuse this fact to their advantage, the Amway price reductions last year are an indication of this fact. IBOs/distributors will ALWAYS have legitimate additional incentives to buy the products, including the bonus involved, the learning process to better market the products to customers and downline, and to exhibit a desired self-consumption example.

    Please withdraw your point. Thank you.

    Of much more concern to the Amway business model is the bill in Tennessee which outlaws the ATS (Amway Tool Scam). There is FAR greater money involved in this issue than all the others combined.

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  • John Diosiu

    As usual the FTC has added confusion as well as fuel to the fire of opponents while trying to ‘clarify’ the situation. i.e On the one hand it now increases the requirement to sell outside the network and then contrasts with buyers clubs. Network marketing is a useful tool to promote an unusual or unique product for an innovative company without massive initial resources (EG Kleeneze or Wikaniko) or a service company trying to get products to individuals at better prices (Most Telcos, Gold and Silver coin buying clubs etc) in both cases when millions of people buy telecom, gas electric and gold and silver anyway this is obviously the primary motivation to join but does this reclassify them as buying clubs? Of course not and because they have a multi level structure they become tarred with the potential pyramid brush. Most experienced networkers know a pyramid when they see one why dont the FTC use the common sense approach instead of convoluted definitions that catch legitimate companies in the net?