While entrepreneurs and marketers alike are often aware of the FTC’s involvement in the direct sales space, clients largely remain unaware of the Security and Exchange Commission’s (“SEC”) involvement in network marketing. The SEC oversees the enforcement of federal securities laws. This means the SEC is designed to ensure companies do not offer or sell securities in the absence of proper registration with the SEC.
In Part One of this two-part series, I answer the basic question “What is a Security?” I explain in some detail the elements required for the SEC to conclude the existence of a Security. I also discuss how it all relates to network marketing.
In Part Two, I discuss the SEC’s lawsuits against network marketing companies in violation of securities laws. By providing some fresh examples, I’m confident you’ll find some good takeaways to help you (1) steer clear of a company selling unregistered securities; or (2) make decisions to steer your own business away from this risk.
Under the Securities and Exchange Act, the term “security” means all different kinds of commonly used documents traded for investment or speculation purposes (like notes, stocks, or bonds). However, a security also includes more generic and ambiguously defined terms like “investment contract.” Oftentimes, courts base a security determination on the presence of an “investment contract.” Through case law, courts have generally defined an investment contract in the following plain language:
an investment of money in a common enterprise with the profits to come largely from the efforts of other people.
In sum, an investment contract exists with the presence of three elements.
1. AN INVESTMENT OF MONEY
Self-explanatory. In essence, a person chooses to part ways with something of economic value and expects a financial gain or loss. This could be as simple as someone purchasing product with the hopes of maximizing one’s earning potential in a pay plan.
2. COMMON ENTERPRISE
A venture is a common enterprise when the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment or even a third party.
3. PROFITS LARGELY FROM EFFORTS OF OTHERS
Who is really doing the work that produces an economic return? Is it the investor, the person or company soliciting the original investment, or maybe even a third party? Using a traditional network marketing company as an example, the commissions are static regardless of how the company performs month to month. The numbers go up and down largely based on the distributor’s ability to move product volume. In an unregistered security scenario, the pay is largely influenced by the overall performance of the company, regardless of how the individual distributor performs.
When companies sell securities, they need to register those securities with the Securities and Exchange Commission. The obvious examples of companies that do it properly: stocks publicly traded on the stock exchanges i.e. Apple, Facebook, etc. There are simpler ways of properly selling securities without the company being a publicly traded entity; however, that’s another article for another time.
A SECURITY OFFERING IN NETWORK MARKETING
With a firm understanding of its characteristics, what does the sale of an unregistered security look like in the context of network marketing? Here, it’s not always so black and white. In a network marketing context, companies caught on the wrong side of the law typically argue that (a) real product is being sold (not shares); and (b) the distributors have to invest some energy to maximize their compensation (there’s no passive return). Let me provide an example: Company XYZ sells online training to teach people how to be better internet marketers. The courses vary in price, ranging between $500 to $10,000. In order to be eligible to earn commissions on the $10,000 product, participants are required to buy the product. Company XYZ makes it very clear in their promotional materials, “We make the sales for you, just bring leads to us, we’ll close the sales and write you checks! Just be sure you’re fully qualified and buy your packs now!”
Clearly, Company XYZ is a flaming pyramid scheme. But is it an unregistered security? The short answer: Yes. Courts will likely conclude that the product is a token product designed to conceal the illegal nature of the investment. The product purchase will likely be considered an investment. But since the participants have to theoretically sell the product in order to generate commissions, does that negate the third element of a security i.e. expectation of profit from the efforts of OTHERS? The answer: No. Courts have said, “The fact that an investor contributes some effort, in addition to the initial financial investment, will not negate the existence of an investment contract. When an investor is relatively ignorant regarding the success of the enterprise and turns over money in dependence on the managerial and entrepreneurial expertise of those seeking the investment, the transaction will be considered an investment contract.”
If people are expected to spend money, and those people are promised any sort of return on their purchases / investment, the SEC will likely intervene in an effort to protect consumers. This is where the overall TONE of a program is crucial when it comes to securities analysis. The tone of a program communicates to participants the proper emphasis of the program i.e. legitimate product sales vs. passive investments. As an example, boneheaded statements like “double your money” are sure to draw attention from regulators.
I filmed the compliance video below a few years ago to help educate companies on this topic. While I may have aged since its filming, the advice within the video has not. Towards the end I provide some specific examples of things network marketing companies and their distributors should steer clear of saying. These particular phrases are often synonymous with particular MLM opportunities and represent a huge mistake. Remember, the best way to stay out of trouble is to understand the very things that lead to it.
In part 2 of this series, we’ll provide some specific examples of when the SEC intervened and sued a network marketing company.