Required Purchases: The MLM Pay to Play Dilemma

    Thomas Ritter is an associate attorney at Thompson Burton PLLC. His practice area focuses primarily on cybersecurity law, which includes an assortment of data protection and privacy-related matters, and a wide-variety of business transactions. He assists diverse businesses from well-established companies to early stage start-ups.

    moneyWhen I sense a gap in the industry’s understanding on an issue, I see it as an opportunity to learn more and write content that sets the record straight. I’ve been fielding a lot of questions lately on the subject of whether a company can require monthly product purchases as a condition for pay plan qualification. When I give the answer, I’m sometimes met with surprise. They’ll often say, “They’re doing it over here and over there…..are you telling me they’re a pyramid schemes!?” Here’s the truth: multilevel marketing companies cannot require their participants to buy inventory as a condition to participation. This is black letter law, meaning it’s a rule not subject to any dispute. Whether this principle comes as a surprise or makes no difference, an understanding of why it exists and where it comes from is crucial to the avoidance of regulatory trouble.

    The best definition for what constitutes a pyramid scheme arises out of the 1975 FTC case, In re Koscot Interplanetary, Inc. What separates a legitimate MLM from an illegal scheme boils down to two basic elements:

    (1) a participant’s payment of money in return for the right to sell a product/service; and

    (2) the right to receive rewards unrelated to the sale of product to ultimate users.

    For companies, any sort of required purchase invokes the pay to play / quid pro quo (“this for that”) dilemma. By requiring a distributor to buy this (inventory) for that (right to participate), Companies mistakenly believe they’ve created a surefire way to push product and generate commissions. In the two most recent and high-profile FTC cases in which MLM companies were accused of running a pyramid scheme (BurnLounge and Vemma), courts found fault with the companies’ endorsement of the pay to play model. With BurnLounge, participants (called “Moguls”) were explicitly “required to purchase a package” to have the “ability to sell music, merchandise, and packages.” The Court held that “the sale of packages thus conveyed the right to sell a product,” satisfying the first Koscot element. In the action against Vemma, however, the Company didn’t directly require an Affiliate to make a purchase or pay a fee in order to participate.  Nonetheless, the Court found the Company was designed and marketed in such a way that the purchase of inventory, for all intents and purposes, wasn’t optional (as per the court). “Vemma’s bonus structure and training materials are designed to make new Affiliates buy a $600 Affiliate pack, which makes payment for the right to sell a Vemma product if not a written requirement, a practical one.” The Vemma case is a clear illustration that courts and regulators alike look beyond a Company’s policies on paper. The true crux of the matter lies within the Company’s operational realities, i.e., how the Company really operates in practice.

    While BurnLounge and Vemma represent real world examples of the pay to play dilemma, a 2004 FTC Advisory Opinion provides the best basis for understanding the regulatory aim behind its prevention.

    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.

    Essentially, the FTC is saying the implementation of pay to play requirements inevitably leads to pyramiding — bonuses based on recruitment as opposed to legitimate product sales.

    Under a value driven paradigm, no restrictions exist so as to dictate a participant’s intent behind his/her underlying consumption of a product. In stark contrast, the opportunity driven paradigm features the pay to play element: without payment, one cannot participate and if one cannot participate, one cannot earn commissions. Pay to play requirements produce ambiguity behind why a participant buys. Is it because he/she really wants the product? Or is because he/she just wants to participate in the income opportunity? In our view, if there’s ANY sort of requirement, courts will easily find that the motivation driving consumption is the opportunity (not the value). If you don’t believe me, look at how the Court handled Vemma.

    Under the current bonus system there is no way to unbundle the intent to consume products as ultimate users from their desire to remain qualified for bonuses.

    THE ANSWER TO COMPANIES’ PAY TO PLAY DILEMMA

    Having forced you to read why inventory purchases cannot be a requirement to participation, I’ll answer the question you’ve been repeatedly asking yourself: what choice do I have? For me, it’s rather simple. Three choices clearly exist and are the same choices we’ve written about in the past regarding the post-vemma world.

    For the sake of brevity I will quickly summarize:

    1. Stand pat, do nothing, and hope you don’t get caught. Just excuse me when I politely say, “told you so,” when the FTC suddenly receives unilateral control over your company; or,
    2. Require that at least half of the required inventory purchase come from legitimate and verifiable customers; or,
    3. Eliminate required inventory purchases altogether. What better way to see if your product really does, in fact, have intrinsic market value than by no longer requiring volume goals. I call this the Kevlar approach, because a company choosing to eliminate PV (personal volume) has made a regulator’s job of shooting it down as a pyramid scheme A LOT more difficult.

    To conclude, one of the first things I notice when I evaluate an MLM’s business model is whether or not it charges participants for the right to participate. As I’ve studied regulators arguments, the companies they’ve pursued, and how the court proceedings have shaken out, there’s no way around it — quid pro quo / pay to play is the logical starting point to the pyramid scheme determination. If companies really want to stay on the right side of the law, the quid pro quo dilemma isn’t a dilemma at all. The choice is easy — it’s just not worth the risk.

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      Thomas Ritter is an associate attorney at Thompson Burton PLLC. His practice area focuses primarily on cybersecurity law, which includes an assortment of data protection and privacy-related matters, and a wide-variety of business transactions. He assists diverse businesses from well-established companies to early stage start-ups.

      • Monte Bertrand

        Thomas – if a company runs a temporary promotion like “Buy this bigger pack when you sign up and we’ll give you extra bucks when you hit some kind of qualification” but it’s only for a certain period, does this also run into this type of risk?

        Also, what if you only get paid to certain levels for having a certain number of customers/reps? Can this run afoul also? ex) “You have to have 4 active legs in order to get paid down to the 4th level” type incentives in the comp plan?

        • Thomas Ritter

          @Montebertrand, thanks for the questions.

          In regards to the first one on promotional packs, the concern there would be the buy to qualify I wrote about above. Even though it’s a promotional deal for a limited time, regulators would still look at that and try to determine the motive behind why people are buying. It could easily be argued that people are buying the promotional pack solely because of the financial incentives. Kevin and I always pound the customer sales drum. If the only people taking advantage of this promotion are distributors, there’s a serious problem. With your example, it would be important to have legitimate customer sales that reflect people are taking advantage of it other than the sales organization. If not, regulators will jump all over that and say distributors are only buying to qualify.

          In regards to your second question, it’s a very fine line. Having some recruitment requirements in an effort to establish ranks is one thing, but having a comp plan where the majority of distributors are unlikely to achieve higher levels because of the need to heavily recruit is another. With the latter, regulators will argue that a recruitment bias exists. With matrix plans, regulators in the recent and not so distant past have heavily targeted companies utilizing such a plan. Matrix plans are not illegal per se, but they tend to lead to heavy recruitment and attract aggressive networkers.

          Hope this answers your questions.

          • Monte Bertrand

            Yes, perfect explanation!

          • It’s so nice to have your SANITY here, Thomas. Thank you!

      • QuarksBar

        Great article Thomas. So many companies appear to be like this and it seems a lot of companies are sprouting up with “virtual” products. Seems like a lot of these travel and shopping companies fall right into the categories you are talking about.

      • foobeca

        This article reads a lot like what the MLM critics have been saying all along. The glaring example that stands out in my mind here is Herbalife with its Supervisor program.

        The fact that there would be qualification levels to receive *ANY* commission at all strikes me as a scam in and of itself. In what other industry do people pay money for the right to participate, then purchase required inventory to meaningfully participate, then have to meet qualification levels to even get any compensation whatsoever?

        In other industries, you sell a widget you get some % as commission. If I’m selling cars, I wouldn’t have to buy or sell 10 cars first before receiving a cent in commission. In fact, sales people would balk at the notion of it. The only time where a straight commission isn’t paid out and there’s qualification levels is if there’s a base salary.

      • Nancy Drew

        I’ve never been involved in MLM company before now except for a brief foray into Amway and Arbonne(was not enthused about the products, signed up to help a friend and became inactive shortly after)…. and know almost nothing about how MLM marketing works . After reading this article and a few more, I think I’ve come upon a “doozie” of a conundrum.

        About 5 months ago I found a product that I absolutely love, want to share with others, and don’t mind making a little $$ . The company does require a minimal monthly purchase to be a distributor. I was already purchasing the product so when my sponsor asked if I wanted to distribute I jumped right in. Again, I emphasize, I love the product, the wholesale prices I get and do not want this product to go away. The product is legit. However, AFTER signing up and immediately making about 15-20 sales, I discovered some disturbing facts that I have since just been working around because I want to get and sell the product at the lowest possible prices.

        On to the disturbing facts….The person who sponsored me, along with her spouse, are old hands at MLM marketing, and have been successful in other companies before getting involved in the one they are in now. They claim the company came to them and asked them for marketing strategies and negotiated a special contract with this couple (what I know so far: lowest wholesale prices, and right sell at those prices, immediate commission checks to distributors, subsidized by said couple, and the disturbing part: permission (blind eye turned) to said couple sending their own marketing materials and contact info to their distributors’ customers (to siphon future customers back to themselves), When I have accidentally messed up email info of a customer on my order form, I was issued a veiled “threat” that I would not receive my full commission for the sale, if the info was not complete and correct. Sales director of main company said, very tactfully in legal speak, so I’m paraphrasing, “work around it, deal with it”.

        I recently discovered they also are allowed to place any of their own personally sponsored distributors anywhere in their downline structure, even without the knowledge or permission of those distributors. That adds to my volume but the people I had in mind to fill my two “legs” must now be put on the other side, instead of one on each, Unless a phone call to the sales director changes that. I was told by the husband in this company not to worry about where people are placed, “Why should you care? You’re getting volume?”

        In essence, they are a “para-company” within the main company. They bring in lots of sales, are subsidizing the commissions checks sent out by the main company (which they recently reduced without notifying their distributors. Had to find out on your own…When I asked about it, I was told the original commission was a “trial” with a time limit.) So they are greasing palms and allowed to break the rules.

        Again, I love the product, love the lowest prices but resent the customer poaching, and downline interference, as well as required monthly purchases for any in my downline who might not want to buy monthly, but do want to consume the product on their own schedule and still be able to sell to others. I don’t mind buying monthly because I would be doing so anyway, but not everyone will want to do that.

        I am trying to build a legitimate business with an effective product that I love. I’m trying to “put out the fires” but this most recent transgression of blocking one of my “legs” (unless it can be corrected with a phone call) has really gotten to me. Besides being told not to worry etc. I was told to just add about 75 more customers and then come back to talk about how to build my team. I was originally told “Don’t worry about team building. Just build your customer base to about 30 people then form your teams”, which I was about to do, when I discovered someone else was already in my downline that I hadn’t put there. Unless I can put my own people directly above this person, it looks like an attempt to put someone in the structure to start receiving checks from my down line.

        How can I address these things without destroying my own fledgling business? There are good parts in this(low wholesale prices), but this couple are not helping their downline, but rather using them to build their own volume and increase their own bonus checks from the main company. I’m at loss as to what my next step should be (besides make another, probably useless phone call, and work around it.)