He has lectured and published extensively on direct selling. Jeff is a graduate of the University of Southern California Law School. He is an active member of the State Bars of California and Oregon.

Guest Post by Jeff Babener
FTC vs. AdvoCare: A Teachable Moment for Direct Selling 

History is Written by the Victor

Ring the bells that still can ring
Forget your perfect offering
There is a crack, a crack in everything 
That’s how the light gets in
– Anthem, Leonard Cohen

Quiet Uncertainty

It was like the calm of quiet uncertainty before the storm. In May, 2019, 26-year-old leading direct selling company, AdvoCare, announced that it would exit MLM in favor of a one level direct sales model. It indicated that it was doing so, and “had no choice,” after confidential talks with the FTC. That was it. No other explanation. And the industry asked: What is this all about? It may be true, as T.S. Elliot said, “the world will end in a whimper, not a bang.” For a detailed article on the May withdrawal and ramifications, see AdvoCare Abandons MLM: Uncertainty Returns to Direct Selling.

A Jarring Dissonance

The FTC Speaks

And then, in October 2019, a cacophony, as the other shoe dropped. The FTC announced a stipulated judgment in which AdvoCare was proclaimed online and in newspapers across the country as a pernicious pyramid scheme that had swindled hundreds of thousands.

The settlement came with a $150m fine, life time MLM bans for AdvoCare’s CEO and top distributors, and the FTC spiked the ball in the end zone, noting at its press conference, “It is significant that we have a large and well known multilevel marketing company that is admitting that it operated as a pyramid… “

Sending an underlined message across the bow of the direct selling industry, the FTC online blog labeled the case as “the landmark settlement.”

Buyer’s Remorse

“Foul!,” called AdvoCare in an immediate responsive press release:

“The FTC incorrectly stated in a press conference that AdvoCare had admitted to operating as a pyramid. This is categorically false. AdvoCare forcefully rebutted this charge in its discussions with the FTC. To this day, AdvoCare denies it operated as a pyramid.”

Actually, AdvoCare was technically right… No such admission had been given (although it had stipulated to the veracity of the factual allegations in the Complaint), prompting the Director of the FTC Bureau of Consumer Protection to later apologize at the Washington, D.C. DSA Legal and Regulatory Conference.

A pyrrhic victory for AdvoCare, whose marketing program and opportunity for thousands of distributors was totally gutted. “Elvis had left the building.”

FTC Has Non-Legal Leverage. What Now?

This was the third major DSA member company hit by the FTC in less than 5 years. And the FTC accomplished its goals, without litigation, but rather the sheer leverage it had over the companies and individuals based on their unique factual situation. For Vemma, an asset freeze. For Herbalife, the overriding need to address its position as a publicly traded company. For AdvoCare, industry speculation about the unstated jeopardy of owners and board members, as well as existential threat to the business. For better or worse, the FTC accomplished its objectives in all three cases without taking the matter to formal adjudication. Therefore, the new quasi legal standards were set by FTC leverage, without firing a litigation shot, rather than by actual case law. Case law did not change.

Serious? To paraphrase a general counsel of one of the industry’s largest MLM companies: “Our first priority is not to prepare for a FTC confrontation, but rather to use our best efforts to stay off their radar in the first place.”

More to come? Could well be. The industry was left with a choice. It could wring its hands or treat this as a teachable moment for its future. As they say, a new reality, and “it is what it is.”

From the industry’s perspective, were the penalties draconian? Absolutely. Might it have been more appropriate to adopt a remedial solution rather than ban the entire MLM model? Absolutely. But that is another issue for another day.

The initial instinct of the industry was to recoil from a near death blow to a 26-year-old industry leader and longtime DSA member, complaining of a new era of FTC bullying. But, as the facts unraveled, some real concerns arise as “the crack in the bell lets the light in.” Maybe, it was not about bullying after all. The industry needs to pay serious attention and self- reflection about guidance it provides to its own companies.

Fact Checking the FTC and AdvoCare

What were the facts in issue from the standpoint of the FTC and AdvoCare? Well, as far as AdvoCare, we will never know. The company capitulated, without even filing one defensive document. And so, all we really can discern is what the FTC alleged. And from a legal standpoint, their version “stands” because, notwithstanding a preamble that states that AdvoCare neither admits nor denies any of the allegations in the Complaint, the stipulated order for permanent injunction and monetary judgment, recites:

VI.(D) The facts alleged in the Complaint will be taken as true, without further proof, in any subsequent civil litigation by or on behalf of the Commission against Settling Defendants…”

And so, we won’t really hear AdvoCare’s explanation. All we have is the uncontested FTC Complaint allegations. And history suggests that this “neither admit nor deny” stipulated order will morph into a “de facto” FTC guidance in the future.

The big picture said the FTC is that the facts support that AdvoCare crossed the line from operating a legitimate MLM program to a program that was instead an illegal pyramid scheme.

For the uncertainty created by no clear adjudication of such important issues, the industry owes “no thanks” to AdvoCare for its decision to merely “roll over,” despite contending after the settlement order that it had forcefully rebutted the pyramid charge in pre-settlement discussions with the FTC. Unfortunately, the “game over buzzer” had already sounded.

History Repeats Itself: Omnitrition Déjà Vu…

Other than ramped up aggressive enforcement and penalties (life time MLM bans for the CEO and lead distributors and forcing AdvoCare to abandon the MLM model), those looking for new insight in the AdvoCare prosecution, will not find it.

This was the opinion of the FTC and its Director of the Bureau of Consumer Protection, Andrew Smith, and a historical legal perspective would come to the same conclusion.

The AdvoCare prosecution can be summed up in a few words:

1. Inventory Loading. In other words, “pay to play,” “buy in to active qualification for “active” rank commissions and rank advancement commissions; purchasing far more product than realistically needed for either personal use or to meet resale demand to customers, focusing on recruiting business builders who buy inventory and encourage others to do the same.

2. Exaggerated Earnings Claims. It is eerie, but this is a “history repeats itself” moment. In 1996, in Webster v. Omnitrition, (79 F.3d 776) the U.S. Court of Appeals for the 9^th Circuit, held Omnitrition to be a pyramid scheme based on the company recruitment of business builders qualified with  inventory loading, who in turn, did the same. Omnitrition was co-founded by Charlie Ragus. In 1993, Ragus founded AdvoCare. It is a sad irony that 26 years later, the Ragus founded AdvoCare MLM program would be shuttered by similar inventory loading accusations as in Omnitrition.

The Omnitrition Court held that the well venerated Amway safeguards meant nothing if not enforced and if, in the presence of inventory loading:

The promise of lucrative rewards for recruiting others tends to induce participants to focus on the recruitment side of the business at the expense of their retail marketing efforts, making it unlikely that meaningful opportunities for retail sales will occur. Koscot, 86 F.T.C. at 1181. The danger of such “recruitment focus” is present in Omnitrition’s program. For example, Webster testified that Omnitrition encouraged him to “get to supervisor as quick as [he] could.” Ligon states:

[T]he product sales are driven by enrolling people. In other words, the people buy exorbitant amounts of products that normally would not be sold in an average market by virtue of the fact that they enroll, get caught up in the process, in the enthusiasm, the words of people like Charlie Ragus, president, by buying exorbitant amounts of products, giving products away and get[ting] involved in their proven plan of success, their marketing plan. It has nothing to do with the normal supply and demand in this world. It has to do with getting people enrolled, enrolling people, getting them on the bandwagon and getting them to sell product…

FN3… First, Omnitrition produced evidence of enforcement only for its ten customer rule. Even assuming that Omnitrition’s enforcement measures are effective, it is not clear that these measures serve to tie the amount of “Royalty Overrides” to retail sales. The overrides are paid based on purchases by supervisors. In order to be a supervisor, one must purchase several thousand dollars’ worth of product each month. That some amount of product was sold by each supervisor to only ten consumers each month does not insure that overrides are being paid as a result of actual retail sales.

Fast Forward 23 years and it all sounds the same. Said the FTC in its Press Release and Blog about AdvoCare:

Press Release:

AdvoCare operated an illegal pyramid scheme that pushed distributors to focus on recruiting new distributors rather than retail sales to customers. The compensation structure also incentivized distributors to purchase large quantities of AdvoCare products to participate in the business and to recruit a downline of other participants with the same incentives. The clear directive of this structure was, as one AdvoCare distributor explained during the company’s Success School training, to “recruit business builders who recruit business builders who recruit business builders…”

The FTC alleged that under the AdvoCare compensation plan, participants were charged $59 to become a distributor, making them eligible to receive discounts on products, and to sell products to the public. To earn all possible forms of compensation, however, participants had to become “advisors,” which typically required them to spend between $1,200 and $2,400 purchasing AdvoCare products and accumulate thousands of dollars of product purchase volume each year, according to the complaint. The FTC alleged that the income of AdvoCare advisors was based on their success at recruiting, with the highest rewards going to those who recruited the most advisors and generated the most purchase volume from their downline.

To recruit people, the FTC alleged, AdvoCare and the other defendants told distributors to make exaggerated claims about how much money average people could make—as much as hundreds of thousands or millions of dollars a year. The FTC alleged that distributors were told to create emotional narratives in which they struggled financially before they joined AdvoCare, but obtained financial success through AdvoCare. Distributors were also allegedly told to instill fears in potential recruits that they would suffer from regrets later if they declined to invest in AdvoCare.

The FTC alleged that the defendants told consumers that they could realize large incomes by promoting AdvoCare and that their earning capacity was limited only by their effort. For example, AdvoCare promoter Diane McDaniel told consumers that “the sky is the limit. I’m the variable. I get to decide what I truly want according to the effort I put forth” and that “there is incredible profit that can be made through infinity.”

In reality, the FTC alleged, AdvoCare did not offer consumers a viable path to financial freedom. In 2016, 72.3 percent of distributors did not earn any compensation from AdvoCare; another 18 percent earned between one cent and $250; and another 6 percent earned between $250 and $1,000. The annual earnings distribution was nearly identical for 2012 through 2015.

FTC Blog:

… people paid AdvoCare thousands of dollars to become “distributors,” buy inventory, and become eligible for cash bonuses and other rewards. But, the FTC says, AdvoCare rewarded distributors not for selling product but for recruiting other distributors to spend large sums of money pursuing the business opportunity. That push to recruit is a classic sign of a pyramid scheme.

On the earnings front, the FTC also alleged that AdvoCare earnings disclosures played fast and loose with earnings averages by extrapolating data of one month’s earnings into an annual earnings average, when in fact, the month chosen might not be a recurring event.

Legal observers are perplexed how it could happen after Omnitrition litigation that the same “front loading” fact pattern might occur again in a related successor company. Probably, the answer is that, unless one is extremely careful, these things just “creep up on you.

Unfortunately, the cultural problem was not new and was a bit of a “tiger by the tail.” The focus on recruiting and duplicating “front loading” business builders was suggested by a legal expert, who was also a former insider knowledgeable observer, to predate the FTC Order by more than a dozen years:

AdvoCare leaders encouraged new distributors to “buy their Advisor order” ($2,000) so they could begin earning commissions sooner. This was ingrained in the distributor culture… there were efforts made to discourage this and ensure that products purchased through “advisor orders” were sold to retail customers. …AdvoCare was a victim of its own success and it was unable to reign in leaders… Existing problems only become magnified when you go through a period of hyper-growth similar to what AdvoCare experienced.

Based on the “uncontested” alleged facts set forth by the FTC, serious pyramiding issues are raised. And that is all we have. Without a vigorous defense by AdvoCare, or, in fact, any defense at all, and based on the FTC Settlement Order providing that “facts alleged will be deemed to be true,” it is far more than a challenge for industry supporters to come to the support of AdvoCare in this dispute. This is a true loss for the direct selling industry. The silence of AdvoCare left the industry in an awkward uninformed position with no arrows in its quiver, akin to a performer on stage pleading, “Throw me a bone, I’m dying up here.”

State of the Law

The FTC and the direct selling Industry are totally in sync on one point:

Nothing about the FTC/AdvoCare settlement changes the existing legal standards for pyramid vs. legitimate direct selling. Those case law standards weave their way in FTC cases from the Koscot case through Amway through Burnlounge:

Koscot: Multilevel commissions must be based on sales to ultimate users.

Amway: Multilevel companies must adopt procedures that encourage retail selling.

Omnitrition: (9^th Circuit Class Action): In the presence of front-loading and lack of enforcement of the Amway standards, companies can expect pyramid challenges.

Burnlounge: The primary incentive to distributor purchases or payments should be a genuine need, whether for resale or personal use, as opposed to qualification in the compensation plan. Are distributor payments and commissions driven by recruitment and qualification in the plan, on the one hand, or sales to ultimate users?

Andrew Smith, FTC Director of the Bureau of Consumer Protection, was in total agreement, in his presentation to the October, 2019 Washington D.C. DSA Legal and Regulatory Conference.

In a well-received presentation, and to the surprise of many attendees, he emphasized multiple times that the FTC is supportive of the MLM model. He went out of his way to express his opinion that, in some ways, MLM is a superior business model because:

1. It provides flexibility and opportunity to individuals to earn extra income.

2. It provides a warm and attentive experience, and qualify products, to retail consumers.

He stated that the FTC welcomes compliant MLM companies. And his standards were not measurably different than existing case law.

The FTC seems to have retreated from its all-out assault on recognition of personal use, as argued and rejected by the BurnLounge court. Its attention is now turned to the basic question of whether a MLM program is placing its focus on sales to ultimate users, which includes personal use purchases in reasonable amounts and wholesale purchases for resale, in amounts reasonably calculated to fulfill retail consumer demand and for which the company can track the flow of product to ultimate users such that compensation reasonable relates to sales to ultimate users. (As an aside, the Director played slightly “fast and loose” in describing the Koscot test as paying compensation “unrelated to product sales,” omitting three key words of Koscot, “to ultimate users,” thus leaving the erroneous impression that only product sales to non-participant retail customers should count. Such a position would be a misrepresentation by omission of the Koscot/BurnLounge standard.

But overall, Director Smith’s description of the state of the law seemed consistent with case law. He suggested this analysis:

1. Does the scheme emphasize recruiting over sales to consumers? Are compensation results driven by recruiting others? Are distributors focused on recruitment and duplication rewards arising from recruiting other distributors to “buy?” Does that plan have a qualifier relating to recruitment?

2. Does the program have incentives to buy goods that are not based on satisfying a distributor’s own personal needs or reasonable inventory to supply retail customers? A telltale pattern would be monthly purchases just enough to meet compensation qualification activity requirements. Another would be front-loading which Director Smith indicated as an attribute of pyramid schemes. His observation of AdvoCare was that distributors were encouraged to buy and did buy for more than they reasonably needed or could use.

 He stated that the FTC key questions are:

1. How do distributors really make money in the plan?

2. Does the company have incentives that promote recruiting and purchasing over sales?

3. Is the company gathering data to track product sales to end consumers?

Director Smith stressed:

1. At the FTC, we want you to be successful as a MLM.

2. However, we also want you to be in compliance as an MLM.

3. Effectively, he said, “we are not looking for a fight, and we want you to stay off our radar,” and he implored companies to examine and reexamine their programs to remove any practices that would put a company on the FTC radar.

4. He stated the FTC position, which no one in the industry disputes, is that a pyramid headhunting inventory loading recruitment scheme is unsustainable as a business model.

Unless completely cynical, given the tenor of his presentation, it seems fair to take Director Smith at his word. Refreshing! The industry can live with this going forward.

Guidance for Radar Avoidance in a Post-AdvoCare World

Every breath you take
Every move you make…
I’ll be watching you
– Every Breath You Take, Sting, The Police

If you are looking for life in a post-FTC vs. AdvoCare/Herbalife/Vemma world, here are some common sense guidelines to create the strongest defense to your MLM program and for promoting anti-pyramid practices aimed at staying off the FTC radar:

1. Overriding Goal… The Big Picture.

The compliant MLM “acid test” will be a mandate and demonstration of significant sales to non-participant retail customers. Bottom line analysis by FTC and state AGs:

A product or service with real retail customers and a good ratio of retail customers to distributors to demonstrate that people buy the product because they want it, and not just to qualify in the marketing plan.

Upline commissions must derive from sale of product to ultimate end users.

With a high retail customer to distributor ratio, experience suggests that most other legal issues (assuming no outrageous earnings or product claims) tend to recede into the background.

2. Track. Track… Flow of Product to and Use by the Ultimate User.

After Vemma, Herbalife and AdvoCare, few priorities are as important as tracking and verifying the flow of product to and use by the ultimate user, whether it be a nonparticipant retail customer or distributor for personal/family use. The short answer: Track the flow and use of product to both nonparticipant retail customers and distributor personal/family use. In fact every company and the DSA should launch a joint initiative with leading direct selling software companies to develop software which accurately tracks the flow of product such that a company can demonstrate that distributor purchases are, in fact, in reasonable amounts for distributor personal use and reasonable inventory quantities for resale, calculated to meet the ordering needs of retail customers. And software should track that every product sold is used by the ultimate user, whether for personal use by distributors or use by non-participant retail customers.

3. Promote Non-Participant Retail Sales and a Preferred Customer Program.

It is in everyone’s interest, the company, distributors, the industry and regulators, to place an emphasis on retail sales to non-participant customers. After all, the business is called “direct selling,” and not “direct consumption.” The promotion of retailing should find a thread through every piece of company literature and advertising.

In addition the gold standard of retailing is the presence of non-participant preferred customers, i.e., those retail customers that are provided incentives and discounts to commit to monthly or orderly product purchases. From a legal standpoint, a robust preferred customer program makes the statement that there is a real market for the product and purchasers are purchasing because they want the product as opposed to being motivated by qualifying in the business opportunity.

4. Time to Rethink Personal/Group Volume Qualification Requirements for Active Status, Rank Status, Rank Advancement Commission Payout if the Volume is Based on Distributor Purchases that are Not Clearly Documented as End User Personal Use of Distributors or Retail Customers.

In fact, some leading direct selling companies have already initiated elimination of volume requirements for active status, fast start commissions, rank status, rank advancement and payment of enhanced commissions. The FTC has long expressed a deep concern for volume requirements that tend to trigger inventory loading or distributor purchases that are not driven by consumer demand, but instead for purposes of qualification.

Said Former FTC Commissioner Edith Ramirez in her remarks at the DSA Business and Policy Conference in September, 2016: “Any requirements or incentives that participants purchase product for reasons other than satisfying genuine consumer demand – such as to join the business opportunity, maintain or advance their status, or qualify for compensation payments—are problematic.”

In Vemma and Herbalife, companies were restricted on credit that could be accorded to distributor purchases, whether for personal use or resale. Many companies are reconsidering volume requirements that are documented as reasonable personal use or retail sales. Unless a company is prepared to track end destination of product, it should reconsider volume requirements that cause suspicion that the products are purchased to qualify and not driven by consumer need.

Above all, rewards should reasonably relate to sales to end users (personal use plus retail customers.

There are multiple approaches to compensation for multilevel payments on downline purchases.

(a)      The Herbalife settlement limited credit to downline distributor purchases (only about one-third of distributor purchases qualified for credit for MLM commissions.)

(b)      Pay MLM commissions only after verification of personal use or sale.

(c)      Pay MLM commissions at time of purchase, but absolutely track and verify personal use and sale of product purchased for resale.

5. Rethink Distributor Ordering Methods that Produce “Inventory Loading” Accusations. Use a Ramp-Up Authorization Approach that Authorizes Increasing Wholesale Orders Based on Demonstration of Retail Sales.

Above all: Do not allow distributors to purchase more than they can use for reasonable personal use and/or quantities for there is a realistic resale to retail consumer need.

Actually, in today’s world of next day UPS and FedEx, online ordering and direct to consumer shipping, there really is no need any more for large inventory purchases or stocking distributors.

Approaches for Avoiding Inventory Loading:

(a)      Eliminate or reduce volume requirements for active, rank, rank advancement.

(b)      Allow volume, but track and pay only on personal use level of volume or wholesale for resale volume that is verified sold to retail customers.

(c)      Limit amount of inventory or, at least, install a ramp-up authorization based on demonstrated sale and/or personal use.

6. Bulletproof Yourself on Earnings Claims. Don’t be the Nail that Sticks Up and Gets Hammered Down.

Avoid earnings hype in advertising, testimonials and lifestyle presentations. Scuttle the Maserati and the Tuscan villa images. Be realistic… this is the anomaly and not the norm. Take the bullseye off your forehead. In almost every FTC case, the first invitation to regulators is unrealistic earnings claims. The hype “opens” the door or lifts the canopy of the tent. And, as they say, “Once the camel has his nose in the tent, you can be assured that his ‘body’ will soon follow.”

In other words, don’t be the low-lying fruit. Don’t effectively, and unintentionally, “bait” the FTC to initiate an enforcement action by over-aggressive hype and promises.

Absolutely do not make claims of wealth, fast wealth, easy money or sure-fire systems, nor effectively invite the FTC to inquire into a program based on earnings hype and systems based on distributor “purchasing” rather than distributor “selling” and “using.”

And whether legal or not, now is the time to “ditch” the pictures and videos of distributor mansions and luxury cars. Since such MLM-driven lifestyles are clearly the exception to the rule, why wear a red flag in front of a “bull.”

7. Post a Transparent Earnings Disclosure.

As a general matter, the FTC is all about disclosure so that consumers can make informed decisions. Once you have a track record, post a simple and transparent average earnings disclosure. At a minimum, you should disclose:

(a)      What percentage of distributors who have signed up are active, i.e., earning any income?

(b)      Of those that are active, what is the average earnings?

(c)      If any example, testimonial or illustration of a particular income, bonus or lifestyle award is presented, what percentage of active distributors earn at least that amount or above?

(d)      Unless the company surveys average costs of doing business by distributors, earnings averages should be represented as “gross earnings” and that they are not “net earnings.”

(e)      Absolutely disclaim that any earnings illustrations are representations of an expectation of earnings.

(f)       “Pepper” promotional material with average earnings disclosures and disclaimers at every instance that an illustration/testimonial of earnings potential is
provided.

(g)      Either calculate average business costs to disclose net earnings or specifically disclose that average earnings are presented as “gross,” as opposed to “net” and do not take into account distributor business costs.

Irrespective of the depth of the earnings disclosure, do not ever play fast and loose with earnings disclosures, nor “parse” to exaggerate the opportunity.

During his presentation to the DSA Legal and Regulatory Conference, FTC Director raised a new “ask” by the FTC. He suggested that companies should not only present gross earnings, but should also present net earnings which take into account costs of doing business by distributors. Upon questioning, he recognized that this may be a daunting task. At the very least, he suggested that companies should disclose that their typical average earnings disclosures are “gross earnings” and, not net earnings, i.e., they do not take into account distributor costs of doing business. Look for more of this “ask” in the future.

8. Adopt, Follow and Enforce the Amway Safeguards.

The Amway safeguards have been the gold standard and been honored in case after case going on 40 years. Although the FTC may wish to pivot away from the Amway safeguards, the courts have not done so.

(a)      70% rule to avoid inventory loading… no ordering unless 70% of previous orders have been sold or used for personal/family use. Place lids on initial orders and allow a ramp up of size of order over time. Never mandate monthly autoship to qualify for commissions. And avoid front-loading. In the famous Omnitrition case, the court noted that the Amway safeguards are rendered ineffectual as a defense to pyramiding if a company encourages or allows front-loading of product because it becomes clear that commissions are not related to sales to ultimate users when distributors are incentivized to buy huge amounts of inventory that are out of proportion to needs for resale or the needs of personal and family use.

(b)      Adopt and enforce an actual nonparticipant retail sales mandate to qualify to receive commissions. Over the years, that number has been expressed in numbers from five to ten or in sales volume … often with an allowable ramp up over time.

(c)      Honor a buyback policy on inventory and sales support materials for terminating distributors… no less than 90% for 12 months.

9. Consider a Reclassification Program to Convert Non-Earning Distributors to Preferred Customers.

In a new FTC enforcement era, the “name of the game” is demonstrating high ratios of non-participant retail customers to active distributors. In the retailing analysis, non-participant retail customers, who are provided discounts or other incentives in exchange for signing up as “preferred customers,” are like “gold” in “upping” the ratios. Watch for direct selling companies to use major initiatives to convert to preferred customers distributors who are loyal product purchasers, but who are not really “working the opportunity,” i.e., low or no earning in the direct selling opportunity.

The conversion can be voluntary or non-voluntary.

1. Voluntary.

For instance, in the Herbalife settlement, Herbalife was given nine months to work on a reclassification of brand loyal, but low earning distributors, to preferred customers so that the non-participant retailing ratios would be increased for personal use purchases. Other leading companies, such as USANA, followed suit, substantially increasing retailing ratios.

2. Involuntary.

Another path that companies may wish to consider is automatic involuntary conversion. Under this approach a company would adopt an automatic reclassification program that automatically reclassifies non-earning independent representatives to preferred retail customers, all the while providing superb discount pricing, special customer benefits, generous customer appreciation referral rewards. If the converted preferred customer later decides to reactivate, the company might even consider providing an option for the right, after a waiting period or based on customer referral activity, to re-sign up as an active independent representative in a reserved genealogical downline position.

10. Promote Industry Guidance on Compliant Compensation Plans.

Similar to the DSA initiative on earnings claims compliance of the Direct Selling Self-Regulatory Council (DSSRC), support the launch of a DSA task force to develop best practices compensation plan guidelines and to continuously audit and constructively advise member DSA companies for avoiding pyramiding accusations of the sort raised by the FTC in Vemma, Herbalife and AdvoCare.

11. Support Clear Federal Legislation on Direct Selling.

Companies should actively support DSA federal legislative action to set forth clear anti-pyramiding guidelines so that the FTC, states and companies are playing on the same field with the same rules and goalpost settings.

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The post FTC vs. AdvoCare: A Teachable Moment for Direct Selling appeared first on The World of Direct Selling.

He has lectured and published extensively on direct selling. Jeff is a graduate of the University of Southern California Law School. He is an active member of the State Bars of California and Oregon.

Guest Post by Jeff Babener
AdvoCare Abandons MLM: Uncertainty Returns to Direct Selling   

The Answers are in the Shadows

In a legendary exchange about the genius of his music, Mozart noted that, if you are looking for the real music, you will find it in the silence between the notes.

On May 17, 2019, out of the blue, a 26-year-old Texas-based MLM/direct selling company, AdvoCare, respected in the industry for its business and products, announced, after “confidential talks with the FTC,” its only “viable choice” was closure of the MLM aspect of its business, with its attendant negative impact on the livelihood of all those distributors who worked hard to build downline sales organizations.

The Internet lit up.

MLM distributors decried betrayal, and they also may have wondered if this was merely step one to go directly into retail stores or online as Slick50 and Metabolife did after their MLM sales force created a market and brand.

Other leading direct selling companies were stunned. And distributors of those companies wondered, “Are we next?”

What happened? We may never know. Should the $30 billion MLM/direct selling industry be worried? With the power and leverage of the FTC over the fate of any one company it is important to understand as “best as possible” what happened here.

We only know one thing after the AdvoCare MLM abandonment: that uncertainty has surfaced again in the direct selling industry about the MLM model. And because this issue is existential for MLM/direct selling, it should be a priority for leaders in the direct selling industry.



AdvoCare Announces MLM Closure

In its May 17, 2019 Press Release, 26 year old AdvoCare upended its business model and, at least momentarily, caused the industry to ask if there was something afoot that could upend the entire industry direct selling/MLM model. This follows a similar momentary concern after the 2016 FTC Herbalife settlement.

AdvoCare Press Release

AdvoCare to Revise Business Model

New Compensation Plan to Focus on Direct-to-Consumer Sales

PLANO, Texas (May 17, 2019) – Today, AdvoCare International announces a revision of its business model from multi-level marketing to a direct-to-consumer and single-level marketing compensation plan. AdvoCare has been in confidential talks with the Federal Trade Commission about the AdvoCare business model and how AdvoCare compensates its Distributors. The planned change will impact Distributors who have participated in the multi-level aspect of the business. Those who currently sell only to customers will not be impacted and there will be no impact on Preferred Customers or retail customers’ ability to purchase products.

“Over the years, we have made many changes to the AdvoCare policies as the regulatory environment has shifted. Based on recent discussions, it became clear that this change is the only viable option,” says Patrick Wright, AdvoCare’s Chief Executive Officer… The company gave notice to its more than 100,000 Distributors on May 17 that, effective July 17, 2019, AdvoCare will revise the business model to a single-level distribution model, paying compensation based solely on sales to direct customers. The Retail and Preferred Customer programs will remain intact…

For the Industry: A Roller Coaster of Certainty and Uncertainty

Did the industry place too much reliance on its recent quiet period with the FTC? It is hard to say.

There has always been a cordial tension between the FTC and the direct selling industry. Each has had its view of an acceptable business model, and from time to time, they clash. The result has been a roller coaster of certainty and uncertainty for the direct selling industry.

In 1975, the FTC decided that the MLM model of Amway was a pyramid and pursued litigation against Amway for four years, ultimately resulting, in 1979, in the validation of the Amway model as a legitimate business opportunity rather than a pyramid. The favorable attributes of the Amway model, buyback policy, 70% rule and retail customer mandate, were then referenced for the next four decades by courts as the “Amway safeguards.”

After a nearly 20 year quiet period, the FTC and the industry were again at odds in the late 90’s and beyond regarding how they view the legitimacy of “personal use” by distributors as a legitimate sale to an end user per the universally recognized legal standard set forth in the seminal Koscot case. The uncertainty caused the industry to secure legislation in many states recognizing “personal use” as legitimate. To this date, the industry has failed to secure federal legislation on this point, although the U.S. Court of Appeals for the Ninth Circuit, in BurnLounge, rejected the FTC argument that personal use purchases should not count and gave a minor win to the industry.

The uncertainty continued, and, in 2016, the FTC successfully caused Herbalife to change its MLM model to give limited credit for personal use purchases. Other companies did not follow the Herbalife model and the tension continued. Riding high on the Herbalife settlement, the then FTC Commissioner Ramirez announced that there was a new “sheriff in town” and the tensions and uncertainty surfaced again as the industry felt that it was about to be upended.

(1)      She renounced use of the famous Amway safeguards standard, adopted in the landmark FTC case, In re Amway, 1979 as being irrelevant, overrated and not really relied on by courts in pyramid cases. (An unfortunate misinterpretation of case law).

(2)      She redefined the famous Koscot standard to require compensation to upline to be based on sales to nonparticipant retail customers rather than based upon Koscot’s language which specified that commissions must be based on sales to “ultimate users,” effectively reclassifying distributor users as “second class ultimate users.”

(3)      She pivoted away from a legal analysis in the most recent BurnLounge case, which demanded, in pyramid cases, a factual analysis of the “primary motivation” test in which a court asks “what is the primary motivation for distributors when they make purchases…” instead migrating to a punch list of inflexible operating restrictions imposed on Herbalife in its recent settlement.

(4)      She essentially attempted to create a new legal standard, the “percentages test,” an arbitrary new rule in which upline distributors would be limited to receive commission credit for only one-third of sales volume attributed to personal use by downline distributors, whether or not such purchases were reasonable in quantity and for actual use by the distributor “ultimate user.”

(5)      She announced that a long-time practice of almost all leading direct selling companies, autoship to distributors, should, effectively, be prohibited.

(6)      She pivoted away from a well-established component of leading direct selling programs, stating that monthly activity volume requirements may not include any purchases by distributors.

(7)      She asserted that the long-time practice of established direct selling companies, tracking of performance activity, connected to wholesale purchasing, should be banned.

Following the 2016 Presidential Election, a new anti-regulatory climate set in and the tension and uncertainty subsided with the subsequent Acting Chairperson asking the industry to come to the table with the FTC as stakeholders, again accepting a “going  forward” FTC policy based on long established case authority and principles of government/industry collaboration rather than top down directives.

And then, out of the blue, comes the May 17, 2019 Press Release of AdvoCare abandoning its multilevel program, based on confidential discussions with the FTC and deciding that abandonment was its only “viable choice.”

And it is here that the roller coaster is again on the on again/off again track of uncertainty.

What next?



An Enigma Wrapped in a Mystery Wrapped in a Riddle

Why did AdvoCare capitulate and abandon its core business and its MLM distributors?

Doing the Right Things

Actually, it seemed like one of the least likely candidates. In fact, it seemed to be a poster child for adopting major consumer safeguards found in case authority and the DSA Code of Ethics.

1. It adopted the classic legal safeguards called out in case after case, all patterned after the famous Amway “safe harbor” rules, first noted in Amway’s successful litigation with the FTC in 1979 and heralded over and over in case authority.***

a. A complete inventory refund for terminating distributors for product purchased within 12 months of termination.

b. A prohibition on inventory loading and the adopting of the classic Amway 70% rule, prohibiting new purchases in the absence of use or sale of 70% of previously purchased product.

c. A five retail customer rule which conditioned payout of downline commissions unless distributors made at least five non-participant retail customer sales per pay period.

d. It followed FTC and DSA initiatives that encouraged and incentivized retail selling by adopting a preferred retail non-participant customer program that was subscribed to by thousands and thousands of preferred customers.

e. It published average earnings disclosures that exceeded most state and FTC standards.

***Of course, the assumption here is that AdvoCare lived up to those consumer safeguards. If the FTC had cogent information that the above promised consumer safeguards were not enforced or implemented, it would be a new game, and a new strong explanation for any pressure felt by AdvoCare management to make a statement like “we had no other viable choice”. On this point, since the discussions were “confidential”, the answer is unknown unless either the FTC or AdvoCare elaborates further.

f. Even one of the MLM industry’s harshest watchdog critics, BehindMLM.com, seemed favorably impressed in its 2015 AdvoCare review, a rare happening:

AdvoCare has one of the strongest retail focuses I’ve seen in MLM yet.

Affiliates are required to submit retail customer details to the company, with fixed numbers of retail orders required on an ongoing basis…. (“made at least five (5) retail sales to at least five (5) different customers (other than yourself) in each pay period”)

From time to time, AdvoCare may contact the customers listed on your Retail Sales Compliance form to verify that the sale took place as reported.

If you provide false or inaccurate information, your Distributorship may be suspended or terminated, at the sole discretion of AdvoCare.

Do note that I couldn’t find any information on how frequently or widespread AdvoCare verify submitted retail customer information.

Theoretically an affiliate could rig the retail requirement, but the hassle of setting up five bogus customers just to qualify for commissions seems hardly worth it.

You’d be far better off actually retailing AdvoCare’s products, failing which you probably should instead find a company whose products interest you.

AdvoCare’s product lineup is in the health and wellness niche and is quite robust. Price wise you’re going to have to compare with what’s available locally.

Given the retail commission requirements and years AdvoCare has been around, there’s a good chance you’ll find them to be competitive.

AdvoCare’s compensation plan as a whole seems pretty well balanced, offering upfront retail commissions, a three-level unilevel and expansion based on a rank generation and 0.75% infinitely at the Platinum, Double and Triple Diamond ranks.

Note that recruitment is required to advance in AdvoCare’s ranks from Gold 3 Star, however chain-recruitment is not an issue due to no mandatory purchase of product and/or incentives for recruiting affiliates who purchase product.

Any recruited affiliate orders do count volume wise, but at the end of the day an affiliate’s own PV requirements must be satisfied in order to qualify for commissions.

$500 PV to qualify as an advisor is far easier achieved through retail sales over the ongoing self-purchase of product.

Furthermore, AdvoCare employ a 70% rule on top of the retail customer requirements already in place:

Overrides, Leadership Bonuses and the 70% Rule AdvoCare pays Overrides and Leadership Bonuses, and other bonuses and incentives based on your representation that you have sold or consumed 70 percent of all products purchased by you.

If AdvoCare later discovers that you did not sell or consume 70 percent of such products, AdvoCare may deduct the amount of the Override, Leadership Bonus or other bonus or incentive previously paid from compensation due to you in subsequent pay periods, or AdvoCare may deny payment of any Override, Leadership Bonus or other bonus or incentive in addition to any disciplinary action that may be taken, including suspension or termination.

How strictly the above rule is adhered to is unclear, but at least on paper AdvoCare work to prevent inventory loading.

I’ll point out again that an affiliate purchasing $500 of product each pay period is hardly going to be viable for most affiliates. Ditto having a recruited affiliate purchase the same.

Nonetheless, I would encourage a prospective affiliate to ask their potential upline for a copy of their last few Retail Sales Compliance forms.

Check the details don’t look suss (I’d advise against calling any of the customers due to privacy reasons), and ask the upline what the customers ordered, how long they’ve been customers and perhaps how they became customers in the first place.

That should eliminate any suspicion of shenanigans with regards to the details on the form being fudged.

All in all with AdvoCare you’re looking at a stable company that’s been around for twenty-two years, a large product lineup to market and a retail-orientated compensation plan that pays deeply at the upper tiers.

If you’re interested in the products, have checked out their viability against what’s available locally and think you can carve out a customer-base to market to, AdvoCare might be the MLM opportunity for you.

2. It is true that it faced criticism by watchdog organization, TINA, a perennial industry critic, and in a Texas class action, that, like most MLM companies, a very small percentage of active distributors made significant income. However, the FTC standard for deceptive or unfair practices is disclosure, as opposed to the amounts of earnings by distributors. And, in the case of AdvoCare, the company annually published one of the most robust and transparent earnings disclosure charts. (And it should be noted that, if the negative litmus test for a direct selling company is the fact that few distributors earn substantial income, then virtually every major direct selling company for 60 years has been illegal. The fact is that this industry, like others, offers an opportunity as opposed to a guarantee.)

 3. It was praised in the U.S. and abroad for its fine line of products and its branding of sporting events and personages was outstanding.

So What Happened? Who’s to Blame? Who Knows?

Victory has a thousand fathers, but defeat is an orphan.

John F. Kennedy

The answers are completely speculative, but to the extent that they may be based on non-legal factors, then, the entire industry should be worried.

And the primary answer lies in becoming a target of the FTC and its position of leverage.

1. AdvoCare was carrying on, under pressure on two fronts: the FTC and class action litigation. Since 2017, AdvoCare has attempted to fend off a class action in Texas which accused it of a myriad of offenses, from pyramid to fraudulent behavior. This sort of litigation is extraordinarily expensive, terrible public relations and always speculative as to outcome.

Might the litigation have been averted? Perhaps. If the company’s arbitration clause in its distributor agreement had been ruled enforceable, the class action might have been averted. However, the request to enforce arbitration was denied and the matter thrust back into federal court.

One industry legal advisor with knowledge of AdvoCare offers this opinion:

AdvoCare did not help itself by not updating its distributor agreement to prevent the class action lawsuit that has contributed to its current state of affairs.

The arbitration provision in AdvoCare’s lawsuit was unenforceable because it let AdvoCare amend at any time with no prior notice and was not limited to prospective conduct. This allowed the plaintiff to successfully argue that the arbitration provision is illusory.

This analysis appears to reference the landmark Texas decision by the U.S. Court of Appeals for the Fifth Circuit, which struck down the “mandatory arbitration” clause for direct seller, Stream Energy, as unenforceable and illusory:

Under Texas law, a stand-alone arbitration agreement requires binding promises on both sides as consideration for the contract. “But when an arbitration clause is part of an underlying contract, the rest of the parties’ agreement provides the consideration.” Still, an arbitration agreement may be illusory if a party can unilaterally avoid the agreement to arbitrate. Here, Torres and Robison assert that the arbitration clause is illusory because Ignite could amend the clause “in its sole discretion” ….

It does appear that AdvoCare did ultimately update its arbitration clause, but post class action filing.

This prompted the same industry legal observer to opine:

It is a travesty what’s happened with AdvoCare. Almost all of its wounds appear to be self-inflicted.

Score one arrow in the quiver for FTC leverage.

2. Second non-legal arrow in the FTC quiver. One cannot underestimate the pressure on individual managers or owners when the FTC has the ability to threaten naming the individuals as well the company. Although entirely speculative, the above industry legal advisor offered a speculative opinion:

If you take AdvoCare’s public statement at face value then it is saying that any MLM comp plan is not a viable option. I think this was a fear-based decision in an attempt to ensure to the maximum extent possible that AdvoCare’s owners are immune from any potential fine from FTC as part of any potential settlement.

 Again, at best, this is speculative opinion. However, such a scenario is plausible in difficult legal circumstances.

3. Third FTC arrow in its quiver. The direct selling industry has long been critical of the FTC’s use of a temporary restraining order as its first litigation volley. It has sometimes been referred to as “trial by ambush.” In this scenario, the FTC walks into federal court ex parte (without the presence of other counsel) with a brief and motion that have been months in the preparation, requesting the court to temporarily shut the company down and to freeze the assets of both the company and its owner/managers. At once, the company finds itself out of business and also lacks access to its own funds to defend itself. Under such pressure, many MLM/direct selling companies have capitulated and entered into stipulated injunctions. This unique potential and historically employed leverage hangs like a “sword of Damocles” over every direct selling company, including AdvoCare. This makes negotiation very difficult.

4. Fourth FTC arrow in its negotiating quiver. The impact of an FTC suit on the branding, sales, marketing or public reputation of any company cannot be overstated. The recent FTC Herbalife settlement illustrates the pressure to achieve resolution by target companies. And, although AdvoCare is not at the same risk of exposure as that which may impact the stock price of a publicly traded company, the adverse publicity may easily be destructive of its brand and sales in the marketplace, i.e., need to move on.

5. We don’t know what we don’t know.

A Fifth speculative arrow for the FTC quiver:

This is new territory. Nothing like this has ever happened before to a 26 year old well established direct selling company. As they say in international intelligence circles, “We don’t know what “kompromat” (compromising materials)” the FTC has on AdvoCare. But when a company announces that scrapping its core marketing system is “the only viable choice,” eyebrows raise. What does that mean?

In the Absence of Clear Legislation, The Only Certainty is Uncertainty. What Next?

 The AdvoCare announcement of MLM abandonment has shocked the industry. Its public explanation of “after confidential discussion with the FTC, there was no other viable choice” raises a million speculative questions to which we may never know the answer.

We’re just dancing in the dark… Bruce Springsteen

 We can only know what we know and act on it. And this we know:

1. Nothing about the announcement changes the existing legal standards for pyramid vs. legitimate direct selling. Those standards weave their way from the Koscot case through Amway through Burnlounge. And the acid test is: Are distributor payments and commissions driven by recruitment and qualification in the plan, on the one hand, or sales to ultimate users.

2. Now is the time to support DSA dialogue with the FTC and also to support DSA sponsored federal legislation to provide clear explanation of the ground rules for legitimate direct selling, including recognition of the legitimacy of personal use by distributors as an end destination for product sales.

And if you are looking for life in a post FTC/Herbalife world, and in the absence of either capping credit for personal use (Herbalife) or abandoning your MLM altogether (AdvoCare), here are some common sense guidelines to create the strongest defense to your MLM program by clearly promoting anti-pyramid practices:

 1. Bulletproof yourself on earnings claims. Don’t be the nail that sticks up and gets hammered down.

Avoid earnings hype in advertising, testimonials and lifestyle presentations. Scuttle the Maserati and the Tuscan villa images. Be realistic… this is the anomaly and not the norm. Take the bullseye off your forehead. In almost every FTC case, the first invitation to regulators is unrealistic earnings claims. The hype “opens” the door or lifts the canopy of the tent. And, as they say, “Once the camel has his nose in the tent, you can be assured that his ‘body’ will soon follow.”

In other words, don’t be the low-lying fruit. Don’t effectively, and unintentionally, “bait” the FTC to initiate an enforcement action by over-aggressive hype and promises. 

Absolutely do not make claims of wealth, fast wealth, easy money or sure-fire systems, nor effectively invite the FTC to inquire into a program based on earnings hype and systems based on distributor “purchasing” rather than distributor “selling” and “using.”

And whether legal or not, now is the time to “ditch” the pictures and videos of distributor mansions and luxury cars. Since such MLM driven lifestyles are clearly the exception to the rule, why wear a red flag in front of a “bull.”

2. Post a transparent earnings disclosure.

 As a general matter, the FTC is all about disclosure so that consumers can make informed decisions. Once you have a track record, post a simple and transparent average earnings disclosure. At a minimum, you should disclose:

(a)      What percentage of distributors who have signed up are active, i.e., earning any income?

(b)      Of those that are active, what is the average earnings?

(c)      If any example, testimonial or illustration of a particular income, bonus or lifestyle award is presented, what percentage of active distributors earn at least that amount or above?

Irrespective of the depth of the earnings disclosure, do not ever play fast and loose with earnings disclosures, nor “parse” to exaggerate the opportunity.

3. Adopt, follow and enforce the Amway safeguards.

The Amway safeguards have been the gold standard and been honored in case after case going on 40 years. Although the FTC may wish to pivot away from the Amway safeguards, the courts have not done so.

(a)      70% rule to avoid inventory loading … no ordering unless 70% of previous orders have been sold or used for personal/family use. Place lids on initial orders and allow a ramp up of size of order over time. Never mandate monthly autoship to qualify for commissions. And avoid front-loading. In the famous Omnitrition case, the court noted that the Amway safeguards are rendered ineffectual as a defense to pyramiding if a company encourages or allows front-loading of product because it becomes clear that commissions are not related to sales to ultimate users when distributors are incentivized to buy huge amounts of inventory that are out of proportion to needs for resale or the needs of personal and family use.

(b)      Adopt and enforce an actual nonparticipant retail sales mandate to qualify to receive commissions. Over the years, that number has been expressed in numbers from five to ten or in sales volume … often with an allowable ramp up over time.

(c)      Honor a buyback policy on inventory and sales support materials for terminating distributors…no less than 90% for 12 months.

4. Promote non-participant retail sales and a preferred customer program.

 It is in everyone’s interest, the company, distributors, the industry and regulators, to place an emphasis on retail sales to non-participant customers. After all, the business is called “direct selling,” and not “direct consumption.” The promotion of retailing should find a thread through every piece of company literature and advertising.

In addition, the gold standard of retailing is the presence of non-participant preferred customers, i.e., those retail customers that are provided incentives and discounts to commit to monthly or orderly product purchases. From a legal standpoint, a robust preferred customer program makes the statement that there is a real market for the product and purchasers are purchasing because they want the product as opposed to being motivated by qualifying in the business opportunity.

5. Track. Track. Track… flow of product to and use by the ultimate user.

After FTC v. Herbalife, few priorities are as important as tracking and verifying the flow of product to and use by the ultimate user, whether it be a nonparticipant retail customer or distributor for personal/family use. Although the FTC may wish to assert that the legal standard requires tracking to the nonparticipant retail customer, that assertion does not accurately state the case law in Koscot or BurnLounge, which speak in terms of compensation related to the sale of product to the ultimate user. The short answer: Track the flow and use of product to both nonparticipant retail customers and distributor personal/family use. If the FTC is desirous of a new legal standard, it will not achieve it by merely stating its position, but rather through case law, federal legislation or federal rule adoption. It is also worthy to note that more than a dozen states have adopted legislation recognizing personal use.

Either way, the time to start tracking is “yesterday.”

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The post AdvoCare Abandons MLM: Uncertainty Returns to Direct Selling appeared first on The World of Direct Selling.

Jeffrey A. Babener, of Portland, Oregon, is the principal attorney in the law firm of Babener & Associates. For more than 30 years, he has advised leading U.S. and foreign companies in the direct selling industry, including many members of the U.S. Direct Selling Association. He has served as legal advisor to various major direct selling companies, including Avon, Amway, Herbalife, USANA, and Nu Skin.

He has lectured and published extensively on direct selling. Jeff is a graduate of the University of Southern California Law School. He is an active member of the State Bars of California and Oregon.

Guest Post by Jeff Babener
DSA Launches Independent Contractor Initiative   

“As Gregor Samsa awoke one morning from uneasy dreams he found himself transformed in his bed into a gigantic insect…”
Metamorphosis, Franz Kafka

A Kafka Experience 1996:

Dateline Maine 1996 for one of America’s leading direct selling companies:

One day you have no presence; the next day you are the largest employer in the state… at least until the state amends its unemployment statute, in 1996, to follow the federal tax definition of independent contractor exemption for direct sellers:

Service performed by a direct seller as defined in 26 United States Code, Section 3508(b)(2).  Maine 26 M.R.S.A. 13 sec. 1043(11)(F)(28) (Amendment 1996)

Groundhog Day 2018: Deja Vu All Over Again

One day, leading direct selling telecom company, ACN, had virtually no employee presence in Oregon. A day after a seminal Oregon Supreme Court ruling, ACN found itself held to be an Oregon employer, with the accompanying challenges. Future? Uncertain. A similar case is playing itself out for Kirby of Norwich in Connecticut.

And So, the DSA Initiative…

In July, 2018, the Direct Selling Association announced an industry-wide initiative to update state unemployment legislation to be in sync with federal standards, in place since 1982, which call out direct sellers as independent contractors.

Most observers agree that, for the vast majority of 16 million individual U.S. direct sellers, many with incremental average monthly income, often a $100 or less, the compliance costs and taxes of income tax withholding or unemployment taxes, could be devastating to direct selling companies.

With state challenges, already happening in Oregon and Connecticut, which threaten the viability of the direct selling model, the DSA undertaking could not be more timely. The initiative is the legacy of a multiyear effort in which, says the DSA, 38 states have already adopted a similar umbrella exemption that follows the historic achievement of the DSA in the 1982 amendment of the U.S. Internal Revenue Code (TEFRA… Tax Equity Fairness Responsibility Act) recognizing independent contractor status of direct sellers for federal tax purposes. 26 U.S Code § 3508. The most recent DSA accomplishment: North Carolina, effective July 1, 2018.

And the update initiative is reflective of the forward looking wisdom of the 2018 U.S. Supreme Court Wayfair decision (upholding state sales tax collection on interstate online sellers) that, to paraphrase the Court, it is imperative for courts and legislatures to recognize the changing economic realities of how interstate companies do business in the various states. In light of recent state employment direct selling decisions in Oregon and Connecticut, accommodating changing business model paradigms to economic reality is quite important.

Historic Legislation

Prior to 1982, the direct selling industry suffered a cloud over its head, i.e., the potential that the distributors of  direct selling companies might be classified as employees for federal tax purposes, with all the onerous challenges of withholding, record keeping, payment of employee taxes, etc. Such burdens threatened the economics of the direct selling model. The industry needed relief and certainty for its channel of distribution.

Led by former 40 year DSA President, Neil Offen, in 1982, Congress amended the Internal Revenue Code to recognize “direct sellers” as independent contractors for federal tax purposes. In 1995, Congress, recognizing the industry diversification (or as Wayfair might put it: changing economic reality) into sale of telecom and other services, specifically added “sale of services” to its “sale of products” exemption.

TITLE 26-INTERNAL REVENUE CODE

Subtitle C-Employment Taxes

CHAPTER 25-GENERAL PROVISIONS RELATING TO EMPLOYMENT TAXES

Sec. 3508

For purposes of this title, in the case of services performed as a direct seller—

(1) the individual performing such services shall not be treated as an employee, and

(2) the person for whom such services are performed shall not be treated as an employer.

(b) Definitions

(2) Direct seller

The term “direct seller” means any person if—

(A) such person—

(i) is engaged in the trade or business of selling (or soliciting the sale of) consumer products to any buyer on a buy-sell basis, a deposit-commission basis, or any similar basis which the Secretary prescribes by regulations, for resale (by the buyer or any other person) in the home or otherwise than in a permanent retail establishment,

(ii) is engaged in the trade or business of selling (or soliciting the sale of) consumer products in the home or otherwise than in a permanent retail establishment, or

(iii) is engaged in the trade or business of the delivering or distribution of newspapers or shopping news (including any services directly related to such trade or business),

(B) substantially all the remuneration (whether or not paid in cash) for the performance of the services described in subparagraph (A) is directly related to sales or other output

(including the performance of services) rather than to the number of hours worked, and (C) the services performed by the person are performed pursuant to a written contract between such person and the person for whom the services are performed and such contract provides that the person will not be treated as an employee with respect to such services for Federal tax purposes.

A Multidimensional Issue

First, it must be recognized that the perennial question of employee vs. independent contractor is not a one dimensional issue. There are many legitimate competing constituencies with a stake: small businesses, entrepreneurs, taxpayers, workers, channels of distribution such as direct selling, etc. The quest for solutions is not a zero sum game.

Said the California Supreme Court in its recent Dynamex decision (4 Cal. 5th 903,  2018) holding package/document delivery drivers to be “employees” rather than “independent contractors,” and sending a shot across the bow against the entire “gig” economy of Ubers, Lyfts, etc., and maybe even precipitating a future second guessing of the existing California statutory exemption for direct selling:

Under both California and federal law, the question whether an individual worker should properly be classified as an employee or, instead, as an independent contractor has considerable significance for workers, businesses, and the public generally. On the one hand, if a worker should properly be classified as an employee, the hiring business bears the responsibility of paying federal Social Security and payroll taxes, unemployment insurance taxes and state employment taxes, providing worker’s compensation insurance, and, most relevant for the present case, complying with numerous state and federal statutes and regulations governing the wages, hours, and working conditions of employees. The worker then obtains the protection of the applicable labor laws and regulations. On the other hand, if a worker should properly be classified as an independent contractor, the business does not bear any of those costs or responsibilities, the worker obtains none of the numerous labor law benefits, and the public may be required under applicable laws to assume additional financial burdens with respect to such workers and their families.

And the Court correctly noted, sometimes the decider is a veritable Solomon who must make difficult and compromising choices that will certainly not please everyone:

The difficulty that courts in all jurisdictions have experienced in devising an acceptable general test or standard that properly distinguishes employees from independent contractors is well documented. As the United States Supreme Court observed in Board v. Hearst Publications (1944) 322 U.S. 111, 121, 64 S. Ct. 851, 88 L. Ed. 1170: “Few problems in the law have given greater variety of application and conflict in results than the cases arising in the borderland between what is clearly an employer-employee relationship and what is clearly one of independent, entrepreneurial dealing.

Dark Clouds for Direct Selling

For better or worse, over the last few decades, various leading direct selling companies have become ensnared in state unemployment cases, finding themselves judicially transformed to leading employers in a state, with all the attendant regulatory and financial burdens.

The thrust of the uncertainty is played out in;

1- States that earlier adopted exemptions, but unfortunately with evolving business models, the statutory exemption might no longer deliver the intended protection.

Example Oregon: A hostile work environment for direct selling.

Oregon is a good example where confusion reigns for direct selling companies in the aftermath of ACN Opportunity, LLC v. Employment Department, 362 Or. 824 (2018).

Actually, many years before Congress sought to protect direct sellers, in 1982, the state of Oregon had already done so in 1977. ORS 657.087(2) provides:

“Employment” does not include service performed by individuals to the extent that the compensation consists of commissions, overrides or a share of the profit realized on orders solicited or sales resulting from the in-person solicitation of orders for and making sales of consumer goods in the home.

However, in ACN Opportunity, LLC vs. Employment Department, the state of Oregon asserted that independent distributors of telecom direct seller, ACN, were in fact employees because, in general, their solicitation was not in the home. The Oregon Supreme Court agreed.

If the court really wanted to effectuate the 1977 intent to protect direct sellers, it could have done so.  It could have interpreted that either:

1. The products/services marketed by ACN distributors were for use “in the home;”

2. Or, that distributors used a business based in their home to market products/services.

3. In fact, the Court was thrown a softball that it completely “whiffed” when it was pointed out that, in 1983, the Oregon legislature updated, for tax purposes, the exemption of a “direct seller” to be consistent with the federal statute 3508. It could have interpreted the definition in the 1977 legislation to be consistent with 1983 tax definitional updates.

  
It did not.

ACN also observes that the Oregon legislature adopted that same language in 1983 in ORS 316.209, which defines “direct seller” for tax purposes. See ORS 316.209(3)(a)(B) (defining a direct seller as a person who is “[e]ngaged in the trade or business of selling, or soliciting the sale of, consumer products in the home or otherwise than in a permanent retail establishment”).

ACN argues that it makes no sense for direct sellers like its IBOs to be treated as employees in some contexts (unemployment taxes) but as exempt from the definition of employment in other contexts (income taxes).

The problem, although the State of Oregon in 1977 intended to protect direct sellers, times change and in 2018 it is rare for a direct seller to solicit/sell in the home. And the long story short message from the Court was, effectively “we don’t care…if the direct selling industry thinks it should still be protected, the legislature is the place to go.”

ACN argues that that result will create an “impractical burden for workers and a regulatory nightmare for the state officials tasked with administering Oregon’s employment laws,” jeopardizing the future viability of the direct selling industry in Oregon. If that is true, then it is a policy issue that ACN can present to the legislature to address. (Footnote 6 to Decision)

Having ruled that time had passed by direct selling for its 1977 “home free” ticket, the Oregon court searched for other traditional bases for exemption, but ruled that ACN came up short. Apart from the policy issue, the Court’s legal analysis was subject to legitimate criticism by legal observers that the Court’s analysis was somewhat myopic and tunnel visioned.

1. Said the Court, the company failed to demonstrate that owners maintained business location separate from the company, as grounds for classifying owners as independent contractors, citing that direct sellers were not paying for rent or repairs on separate business facilities. This misses modern economic reality.

 
Try telling 400,000 U.S. Uber drivers that they “really” don’t have their own business because they don’t pay for rent or repairs on a building separate from Uber.

2. The company failed to demonstrate that owners had a right to hire and fire, as ground for classifying owners as independent contractors rather than employees. Its analysis was totally off-base, citing a non-circumvention/non-solicitation paragraph in ACN policies, common to all direct selling companies that has nothing to do with hiring and firing. Again, try telling 400,000 Uber drivers that they are not really operating their own business because Uber insists that the contracted Uber driver is the only one authorized to drive Uber passengers on his/her account in his/her car.

 
The Chief Justice penned a concurring opinion, agreeing with the decision, but imploring the legislature to bring the tracking of direct seller employee/independent contractor status current with “economic reality.” But, in a closer look might suggest that the concurring opinion might easily be construed as opining that the decision was not “bold” enough in addressing and protecting the modern practices and “economic reality” of direct selling and other businesses:

Of course, 1977 was before cell phones, internet (no Facebook, Craigslist, or eBay), and ubiquitous coffee shops (with wi fi) holding themselves out as remote offices where a seller of goods or services might conduct business online or meet with a customer or client. The requirements the legislature used to identify exempt direct sales in 1977—in-person solicitation and sales “in the home”—may no longer be appropriate to delineate some of the kinds of direct sales that the legislature intended to reach when it enacted that exemption. In any event, different models of direct sales have emerged because of technological, social, and economic changes, while the direct sales statute remains unchanged.

… Again, given new technology, a person’s “business” may exist entirely on his or her laptop, tablet, or smart phone. And individuals may view their “business location” as wherever they and their device are located—the aforementioned coffee shop, the city library, or a shared work space such as WeWork—or, if working at their residence, entirely from a deck chair on the porch. The existing statutes often can be useful in determining when a person is an employee or an independent contractor; however, because of the substantial changes in many sectors of the economy—in how work is done, where, by whom and under what compensation arrangements—the results courts reach in those cases may not be those that the legislature intended.

… Whatever direction such legislative or administrative changes might take, it is apparent that existing statutes and regulations do not address the realities of important parts of today’s work environment. If that legal framework can be updated to align contemporary workplace realities with the state’s policy objectives, individual workers and employers—as well as the regulators and courts who apply the laws—will benefit.

Bottom line: Right or wrong, the high court has spoken; the only remedy is legislative.

2- States that have not adopted Section 3508 type exemptions, applying a common law test and/or statutory test referred to as the three prong ABC test, to which direct selling companies typically struggle to fulfill prong C:

The ABC Test:

A) The worker is free from the employer’s control or direction in performing the work.

B) The work takes place outside the usual course of the business of the company and off the site of the business.

C) Customarily, the worker is engaged in an independent trade, occupation, profession, or business.

Connecticut Is a Second Prime Example of the Need for Legislative Update

In 2018, the Connecticut Supreme Court, noting that the legislature had abandoned use of a favorable common law employment/independent contractor analysis with a statutory ABC Test, held that there was a challenge with Kirby of Norwich and prong C of the ABC test, and therefor its sales representatives, in that case, were now reclassified as employees rather than independent contractors, with all the attendant obligations. Kirby of Norwich v. Administrator, Unemployment Compensation Act, 328 Conn. 38 (2018)

And again, the message to the direct selling industry is a polite “too bad.” Times may be changing and you should look for relief in the legislature and not the courts:

Although we recognize the appeal of the plaintiff’s arguments, we are not persuaded that we should overrule JSF Promotions, Inc. We acknowledge that a narrow interpretation of part C of the ABC test imposes significant burdens on businesses, like the plaintiff…

We will not interpret the ABC test in such a manner.¹⁴ Although we are sympathetic to the plaintiff’s claim that part C creates certain, undesirable practical consequences as applied to the specific facts and circumstances of this case, any decision to alter or modify part C on the basis of a determination that, under such facts and circumstances, its costs outweigh its benefits must be made by the legislature, not this court.¹⁵

Even after acknowledging the DSA’s amicus brief that identify 31 states that have gone so far as to statutorily exempt direct sellers as independent contractors rather than employees, the Connecticut Supreme Court punted to its statutory ABC test. In essence said the Connecticut Court, “good luck…you are on your own.”

The amicus curiae contends that, in states without such statutes, direct sellers have been recognized as independent contractors under the common law “for decades.” The only case addressing that question in Connecticut, however, is Electrolux Corp. v. Danaher, supra, 128 Conn. at 342, 23 A.2d 135, which, as we have explained, was decided before the legislature amended the act to include the ABC test. Other jurisdictions are split on the issue of whether a putative employee must actually be engaged in an independently established occupation to satisfy part C of the ABC test. It may well be that exempting direct sellers from the act, regardless of whether they are actually engaged in an independently established occupation, is the better public policy. As we have indicated, however, that policy judgment is one to be made by the legislature, not us. (emphasis added)

The DSA Initiative Is Timely

Over the decades, the DSA has done a stellar job in protecting the direct selling industry from the challenges of “employer designation.” Its success approaches 40 states. However, the recent adverse cases in Oregon and Connecticut, suggest that its new initiative is timely. In addition the Dynamex California case is a shot across the bow of the “gig” economy, and the direct selling industry should be vigilant that it is not caught in a new legislative Dynamex tsunami. The DSA has indicated that its upcoming initiative will focus on Connecticut, Oregon, and Indiana.

If the industry is looking for simple clarity and guidance, citation to the federal independent contractor tax standard, it is suggested that the model exists in the most recent DSA-sponsored legislation from North Carolina:

North Carolina
H 931/S 717
Effective July, 2018
Employment:
Exclusions. – The term excludes all of the following:
… Service performed by a direct seller, as defined in section 24 3508(b)(2) of the Code.

This approach is clean, direct and sends a clear message to protect the viability of the direct selling model.

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The post DSA Launches Independent Contractor Initiative appeared first on The World of Direct Selling.

Jeffrey A. Babener, of Portland, Oregon, is the principal attorney in the law firm of Babener & Associates. For more than 30 years, he has advised leading U.S. and foreign companies in the direct selling industry, including many members of the U.S. Direct Selling Association. He has served as legal advisor to various major direct selling companies, including Avon, Amway, Herbalife, USANA, and Nu Skin.

He has lectured and published extensively on direct selling. Jeff is a graduate of the University of Southern California Law School. He is an active member of the State Bars of California and Oregon.

Guest Post by Jeff Babener
U.S. Supreme Court Sales Tax Reversal… Where to from Here?  

The future ain’t what it used to be.
Yogi Berra

Or maybe it is. In ancient Egypt the pharaohs placed a general tax on the sale of all commodities at the rate of 5% of sale price. The Romans obviously thought this was a good idea and, after their conquest of Egypt, the rate rose to 10%. For the next 2,000 years, to this day, bureaucrats have found sales tax a favorite revenue raiser.

The Bombshell… Deja Vu, All Over Again 

South Dakota v. Wayfair, Inc. June 21, 2018. Slip Opinion 17-494, 585 U.S. ____ (2018): The U.S. Supreme Court overturned a 50-year-old precedent on how states can tax sales by out-of-state retailers, holding that its earlier 1967 and 1992 decisions were wrong, and that it needed to rectify its mistake to reflect the economic reality of today’s interstate commerce to prevent discrimination against local brick and mortar retailers that favored online out-of-state retailers.

Effectively, it abandoned a decades-old bright line analysis that the “physical presence” nexus that justified states to impair interstate commerce, in violation of the Commerce clause of the Constitution was being replaced by a more “amorphous” standard of an “economic reality” impact of out-of-state sellers in states that sought to impose sales and use taxes.

Impact and Response to This “Missile” on Contact

For most online sellers: A thermonuclear explosion… life will never be the same. Keep in mind that one of the largest online sellers, Amazon, recognized the future, and had already undertaken to collect sales tax in the 45 states that impose sales/use taxes, although most of its third party vendors have not.

For direct sellers, who sell both online and offline: More like momentary eclipse of the sun… back to business; they have already been collecting and paying sales/use tax for decades. Actually, says direct selling, “Thank you for leveling the playing field!”

And, as to all online sellers, whether direct sellers or not, “no thank you” long term for an expected flood of creative new state taxes that will develop over the next 20 years in our “virtual and gig” economy. This is just the beginning.

First, What Just Happened?

As summarized by the Court in its syllabus and majority and dissenting opinions:

Wayfair is a major online retailer of home furnishings. Although it has substantial sales into South Dakota, it has no physical presence in South Dakota. Until the Wayfair case, 50 years of court precedent prevented states from impairing interstate commerce, in violation of Commerce Clause, U.S. Const. art. I, § 8, cl. 3, by imposing a duty on out-of-state retailers who had no “nexus” with the state. And for the Supreme Court, “nexus” required physical presence. Two famous cases set the bright line mandate of physical presence: National Bellas Hess, Inc. v. Department of Revenue of Ill., 386 U.S. 753 (1967), and Quill Corp. v. North Dakota, 504 U.S. 298 (1992). Both National Bellas Hess and Quill involved interstate shipment from products ordered from catalogs.

It is estimated that these two cases caused South Dakota to miss out on $48 million to $58 million annually. And so, like many states, South Dakota sought to test the issue again, claiming that the Internet had changed things, i.e., we had a new economic reality of “nexus” that went beyond physical presence. Based on this half century standard, Wayfair refused to collect sales tax imposed by a relatively new South Dakota sales tax law that sought to impose sales tax responsibilities on out-of-state sellers who sold more than $100,000 in goods and services into the state or carried out more than 200 sales transactions.

Litigation followed, led by South Dakota requesting a declaratory judgment that its new tax was valid. Wayfair raised the long time defense of lack of “nexus” via physical presence. South Dakota lost at the trial court and State Supreme Court and requested review by the U.S. Supreme Court.

The states hit the jackpot. And it was the lucky day for the forty-one states, two Territories and the District of Columbia, all hungry for new taxes, who joined South Dakota to ask the U.S. Supreme Court to reject the test formulated in Quill. In 2017, the U.S. Government Accountability Office pegged the prospective increase to the states, if South Dakota won the Wayfair case, as being between $8 billion and $13 billion per year.

In a 5-4 decision, in an opinion written by Justice Kennedy, the Court sided with South Dakota, changing e-commerce forever. The reasoning:

1. The Quill “physical presence” decision was not flexible enough to apply the changing economic realities of how out-of-state businesses can, in fact, have meaningful connections with states… even with no presence.

Said the Court:

“The Quill Court did not have before it the present realities of the interstate marketplace.  In 1992, less than 2 percent of Americans had Internet access… Today that number is about 89 percent… When it decided Quill, the Court could not have envisioned a world in which the world’s largest retailer would be a remote seller… ” (Amazon)

2. As such, the National Bellas Hess/Quill decisions were wrongly decided.

The physical presence rule has “been the target of criticism over many years from many quarters.” Each year, the physical presence rule becomes further removed from economic reality and results in significant revenue losses to the States. These critiques underscore that the physical presence rule, both as first formulated and as applied today, is an incorrect interpretation of the Commerce Clause.

The physical presence rule is not a necessary interpretation of the requirement that a state tax must be “applied to an activity with a substantial nexus with the taxing State.”

Although physical presence “frequently will enhance” a business’ connection with a State, “it is an inescapable fact of modern commercial life that a substantial amount of business is transacted…[with no] need for physical presence within a State in which business is conducted.”

Having abandoned the necessity of physical presence for “nexus,” the Wayfair Court reasserted its accepted framework for state taxation as set forth in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).

The Court explained the four required factors in Complete Auto Transit:

The Court held that a State “may tax exclusively interstate commerce so long as the tax does not create any effect forbidden by the Commerce Clause.” After all, “interstate commerce may be required to pay its fair share of state taxes.” The Court will sustain a tax so long as it (1) applies to an activity with a substantial nexus with the taxing State, (2) is fairly apportioned, (3) does not discriminate against interstate commerce, and (4) is fairly related to the services the State provides. (emphasis added by the author)

The Court held that, in this case, taxing Wayfair met the tests… again, even without physical presence.

3. In the current legal framework, the prohibition on taxation discriminated against in-state sellers in favor of out-of-state sellers.

The current tax approach that shields online retailers unfairly discriminates against local brick and mortar retailers.

The physical presence rule has long been criticized as giving out-of-state sellers an advantage. Each year, it becomes further removed from economic reality and results in significant revenue losses to the States.  These critiques underscore that the rule, both as first formulated and as applied today, is an incorrect interpretation of the Commerce Clause.

In effect, it (Quill) is a judicially created tax shelter for businesses that limit their physical presence in a State but sell their goods and services to the State’s consumers, something that has become easier and more prevalent as technology has advanced.

By giving some online retailers an arbitrary advantage over their competitors who collect state sales taxes, Quill’s physical presence rule has limited States’ ability to seek long-term prosperity and has prevented market participants from competing on an even playing field.

4. States are unfairly losing vast needed revenue.

It is estimated that National Bellas Hess and Quill cause the States to lose between $8 and $33 billion every year.

5. Congress had taken no action to remedy the situation.

Of course, when Congress exercises its power to regulate commerce by enacting legislation, the legislation controls… But this Court has observed that “in general Congress has left it to the courts to formulate the rules” to preserve “the free flow of interstate commerce.”

A Faint Hearted Dissent

Interestingly, after letting the physical presence legal standard stand, the dissenting Justices, as led by conservative Chief Justice Roberts, did not disagree on the merits of the issue, but rather on whether it was the proper role of the Court to enter the controversy when Congress should decide what state action does or does not interfere with interstate commerce, i.e., our job is to interpret the law and not legislate the law.

In National Bellas Hess, Inc. v. Department of Revenue of Ill., this Court held that, under the dormant Commerce Clause, a State could not require retailers without a physical presence in that State to collect taxes on the sale of goods to its residents. A quarter century later, in Quill Corp. v. North Dakota, this Court was invited to overrule Bellas Hess but declined to do so. Another quarter century has passed, and another State now asks us to abandon the physical presence rule.  I would decline that invitation as well. I agree that Bellas Hess was wrongly decided, for many of the reasons given by the Court.

The Court should not act on this important question of current economic policy, solely to expiate a mistake it made over 50 years ago.

Said Justice Roberts, this is a decision for Congress to make, and not the Court: 

“A good reason to leave these matters to Congress is that legislators may more directly consider the competing interests at stake. Unlike this Court, Congress has the flexibility to address these questions in a wide variety of ways.  As we have said in other dormant Commerce Clause cases, Congress “has the capacity to investigate and analyze facts beyond anything the Judiciary could match.” Here, after investigation, Congress could reasonably decide that current trends might sufficiently expand tax revenues, obviating the need for an abrupt policy shift with potentially adverse consequences for e-commerce. Or Congress might decide that the benefits of allowing States to secure additional tax revenue outweigh any foreseeable harm to e-commerce. Or Congress might elect to accommodate these competing interests, by, for example, allowing States to tax Internet sales by remote retailers only if revenue from such sales exceeds some set amount per year.  In any event, Congress can focus directly on current policy concerns rather than past legal mistakes. Congress can also provide a nuanced answer to the troubling question whether any change will have retroactive effect.”

On a non-economic note, Wayfair may pave the way for new alliances on the court. The 5-4 decision found conservatives and liberals aligning together on each side of the issue.

Strange Bedfellows

Majority: Kennedy, Gorsuch, Thomas, Ginsberg, Alito
Dissent: Roberts, Sotomayor, Breyer, Kagan

The Impact or Non-Impact on Direct Selling

Although marveling at the enormity of the Wayfair decision on American commerce, the direct selling industry may merely “yawn” at its impact on direct selling.

Why? Well, most direct selling companies, although out-of-state sellers just about everywhere but their home state, have routinely collected sales tax for both online and offline sales for decades. Blame the U.S. Supreme Court for this one. In 1960, in Scripto v. Carson, 362 U.S. 207 (1960),  the Court recognized “physical presence” and “nexus” arising from activity of an out-of-state seller through independent contractor sales reps who solicited purchase orders in Florida, imposing a duty to collect Florida “use” tax, the flip side of the coin to its first cousin, sales tax.

In fact, direct sellers manifested their contacts further in so many ways. “In-state” independent contractor reps sell, recruit, promote products, conduct opportunity meetings, organize training and drive “in-state” customers to the website of out-of-state direct selling companies.

It would have been difficult to deny “nexus,” and so virtually every leading direct selling company collected and remitted sales tax for in-person and online sales.

And so, as important as Wayfair is to the futures of online retailers, for direct sellers it was “much ado about nothing.” In fact, at a direct selling tax conference in the early 2000’s, the U.S. Sales Tax Administrator for one of the industry’s largest companies, revealed that the company had collected sales tax since 1971, and was undertaking to do the same for its sales in a relatively new channel, the Internet.

Actually, if there is any immediate Wayfair impact for direct sellers, it is positive. The decision levels the playing field. Now that online sellers of vitamins, skin care and other consumer products are headed for sales tax accountability, it makes direct sellers, who already are forced to collect sales tax, more competitive.

A Few Lessons Learned from Wayfair

Let me tell you how it will be
There’s one for you, nineteen for me
‘Cause I’m the taxman, yeah, I’m the taxman
Should five percent appear too small
Be thankful I don’t take it all
‘Cause I’m the taxman, yeah I’m the taxman
If you drive a car, I’ll tax the street,
If you try to sit, I’ll tax your seat.
If you get too cold I’ll tax the heat,
If you take a walk, I’ll tax your feet.
Taxman, The Beatles

Agree or disagree, sales tax responsibilities will be a new fact of life for online commerce. It is a sea change, albeit a short-term positive one for direct sellers.

Long term may be a different story for all out of state sellers, including direct selling. The U.S. Supreme Court opened the state taxation equivalent of a Pandora’s box.

To credit Louis XV, “Après moi, le deluge.” To put it in more modern colloquial terms, “Once the camel’s head is in the tent, his butt is sure to follow.” State tax administrators are salivating everywhere. First look for a tidal wave of state sales tax initiatives aimed at out-of-state sellers. And then things will get creative… and costly. Think click tax for Google. Think virtual property tax for cloud-based players. Just follow the yellow brick road into the ”cloud” and tax whoever is there.

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The post U.S. Supreme Court Sales Tax Reversal… Where to from Here? appeared first on The World of Direct Selling.

Jeffrey A. Babener, of Portland, Oregon, is the principal attorney in the law firm of Babener & Associates. For more than 30 years, he has advised leading U.S. and foreign companies in the direct selling industry, including many members of the U.S. Direct Selling Association. He has served as legal advisor to various major direct selling companies, including Avon, Amway, Herbalife, USANA, and Nu Skin.

He has lectured and published extensively on direct selling. Jeff is a graduate of the University of Southern California Law School. He is an active member of the State Bars of California and Oregon.

Guest Post by Jeff Babener
MLM Cryptocurrency Scams: Stopping the Brand Killer and Protecting the Direct Selling Channel

I got a coin in my palm
I can make it disappear
I got a card up my sleeve
Name it and I’ll pull it out your ear
I got a rabbit in my hat
If you wanna come and see
This is what will be
This is what will be
Magic, Bruce Springsteen

In March 2018, Google followed Facebook in banning cryptocurrency ads. Why? It was too hard to identify the legitimate from the illegitimate advertiser and that out of control speculation and fraudulent financial schemes were creating confusion for the consumer experience. Given that more than 80 percent of Google revenue derives from ads, Google was rightfully concerned that rampant fraud buried in its signature product, online advertising, could dilute its “brand” and poison the receptive market of its readers and product consumers, its advertisers.

The Google/Facebook actions follow alarms going off at all levels of government. Almost simultaneously, the FTC took one of its first major actions against a cryptocurrency pyramid scheme, upon the heels of a yearlong demonstration of similar actions by the SEC, states and foreign governments against fraudulent cryptocurrency Ponzi/pyramid cloud mining investment schemes.

Just as Google and Facebook realized that cryptocurrency scams could be a “brand killer,” the direct selling industry may have awakened to the prospect that the cryptocurrency scheme species is mutating into various MLM offerings that threaten the “brand” of direct selling itself, poisoning pools of potential customers and sales people. Time for direct selling to join the war on these “brand killers?” Absolutely.

Tulip Mania Redux

From January, 2017 to December, 2017 to March, 2018, the price of one Bitcoin, the acknowledged leader and prototype of various cryptocurrencies, gyrated from $1,000 to $20,000 to $6,000. The recent experience hearkened back to the Dutch Tulip Mania “financial bubble” collapse in the 1600’s in which the value of a newly introduced flower bulb skyrocketed from a mere flower price to a point where one tulip bulb sold for the equivalent of 10-15 times the average annual salary of a skilled craftsman, and then plummeted 99.99 percent back to mere flower pricing.

Will this be the fate of Bitcoin and other blockchain cryptocurrencies? The jury is out. Many financial analysts describe Bitcoin as a fraudulent financial device. Some argue that the majority of cryptocurrencies will crash to zero and disappear in the next few years. At the same time, many, in the financial community, grudgingly acknowledge that Bitcoin is increasingly recognized as a valid storage of value for which financial markets have established its place. Only time will tell.

Cryptocurrency: A “Front” for Ponzi and Pyramid Schemes

Although the ultimate future of cryptocurrency is not clear, the hype and rampant speculation has brought out the “get rich quick” con artists to promote a variety of Ponzi and pyramid schemes, many of which are spread via a MLM-type salesforce. Actually, to call the MLM cryptocurrency salespeople a sales force is a gross misbranding. As a general matter, those spreading the word are over-zealous investors who intentionally or unintentionally “suck” in their friends and contacts into a future collapsing pyramid. All of the MLM schemes have flashed the “New Age” technical terms, “cryptocurrency,” “digital currency,” “cloud mining” as if these were “magic” terms that bestowed some sort of legitimacy on what was, in reality, a scam, trying to defy the proverbial Texas wisdom, “you can put lipstick on a pig, but it’s still a pig.”

The criticism from the direct selling community is not so much about cryptocurrency, itself, as it is that cryptocurrencies such as Bitcoin or others, are the “shiny object” that deflects the viewer from the reality of many MLM cryptocurrency programs, ie., that the presence of cryptocurrency is merely an excuse to cause investors to part with their money in exchange for promises of passive income from appreciation of cryptocurrency, and to cause others to do the same. And the ugly truth is that the source of the stream of passive income/appreciation to early adopters derives from funds contributed by later investors. In short, one is describing a Ponzi and/or pyramid scheme, or both.

One website that tracks the emergence of MLM cryptocurrency Ponzi/pyramid schemes, BehindMLM.com, has unearthed more than a score of such scams already, revealing one or two new ones per week globally, a virulent scourge growing in number and intensity.



MLM cryptocurrency scams come in many iterations. A few approaches pop up with regularity.

1. Out-and-out pyramid. In a classic “airplane” scheme, participants buy into positions in a “cryptocycler” with either cash or Bitcoin, and are rewarded for getting others to do the same.

2. Disguised pyramid. Investors contribute to the support of a pseudo cryptocurrency trading platform or trading services, and are rewarded for recruiting others to do the same. Sometimes, a passive “return on investment” (ROI) is promised to traders from appreciation of purchased cryptocurrency. The source for commissions comes from funds invested by new investor/consumer/distributors, and the only reason “consumers” pay money is to buy into payoffs in the MLM opportunity.

3. Ponzi/pyramid cloud mining investment scheme. Investors purchase shares or memberships in a company which claims to mine cryptocurrency with thousands of computers that are programmed with algorithms to yield “digital coins” and are promised outrageous passive returns on their investment. Investors find others to do the same. In fact rewards and returns merely come from investments by new investors.

This scheme is obviously a pyramid.  It is also a Ponzi scheme. Says the SEC, the investment in cloud mining ventures is also the sale of an unregistered security.

4. Ponzi/pyramid ICO or Cryptocurrency purchase scheme. Investors are urged to buy coins in an ICO (Initial Coin Offering), or buy existing cryptocurrency coins, in which they are promised substantial returns on their investment, sometimes guaranteed returns. Investors make money by finding new investors. The return on investment invariably comes from new investor money.

In short, MLM cryptocurrency offerings represent:

1. Sale of unregistered securities.
2. Ponzi Schemes.
3. Pyramid Schemes.
4. Fraudulent financial schemes.

Regulators Speak Out in Action and Words

The SEC was sufficiently concerned about the proliferation of ICOs that in December 2017, it issued an SEC alert on the dangers of this new phenomenon. It also clarified its position to announce that the SEC regards an Initial Coin Offering (ICO) a securities offering that must be registered with the SEC. Of course, in the context of sales people, this would prohibit sales persons, whether compensated through an MLM format or not, to be licensed sellers of securities, a virtually impossible task for 99.99 percent of MLM businesses.

Similarly, on March 13, 2018 IMF (International Monetary Fund) Managing Director, Christine Lagarde noted the global promise and peril of cryptocurrency, including rank speculation, financial fraud and use in criminal money laundering:

Whether Bitcoin’s value goes up or Bitcoin’s value goes down, people around the world are asking the same question: What exactly is the potential of crypto-assets?

The technology behind these assets—including blockchain—is an exciting advancement that could help revolutionize fields beyond finance. It could, for example, power financial inclusion by providing new, low-cost payment methods to those who lack bank accounts and in the process empower millions in low-income countries.

The possible benefits have even led some central banks to consider the idea of issuing central bank digital currencies. Before we get there, however, we should take a step back and understand the peril that comes along with the promise.

The peril of crypto-assets

The same reason crypto-assets—or what some people call crypto-currencies—are so appealing is also what makes them dangerous. These digital offerings are typically built in a decentralized way and without the need for a central bank. This gives crypto-asset transactions an element of anonymity, much like cash transactions.

The result is a potentially major new vehicle for money laundering and the financing of terrorism.

And in February, 2018, China unveiled a new set of regulations to ban cryptocurrency by blocking access to exchanges that trade cryptocurrency. Sooner or later blockchain technology will be recognized in China, but, for now, the government, like so many others, is trying to catch up with a phenomenon that also carries great risk of “out of control” speculation and financial fraud.

MLM Cryptocurrency Scams

Among potentially dozens of MLM cryptocurrency scams is the poster child, One Coin, which originated from Belize and Bulgaria, issuing its own “coin” which was promoted globally from 2015 using a MLM compensation plan. Ostensibly, purchasers did not buy One Coins, but instead purchased educational packages that explained trading in One Coin which were accompanied by “mining contracts” that created One Coins.

Through a stormy history One Coin was prosecuted, shuttered or placed on observation and warning lists as a Ponzi/pyramid in many jurisdictions, including India, Vietnam, Croatia, Norway, Finland, Sweden, Latvia, Thailand and other countries.

U.S. states are also in motion.  While the typical MLM cryptocurrency program is based in, or emanates from, foreign jurisdictions that may include Hong Kong, Dubai and European countries, these programs are often active in the U.S. with distributors and management of contacts occurring in America.

On March 2, 2018 the North Carolina Securities Division issued a cease and desist against a MLM cryptocurrency scheme originating from web hosting in France, Power Mining. Power Mining collected funds from investor/MLM distributors who were promised a return on investment from “cloud mining” of various crypto currencies.

The state cases are piling up. On December 20, 2017, the Texas State Securities Board shut down USI-Tech, another MLM cryptocurrency cloud mining firm.

And the same sort of cease and desist issued from the South Carolina Securities Commissioner, on March 9, 2018 for MLM cryptocurrency scheme Genesis Mining and Swiss Gold Global.

Onn March 7, 2018, the New Jersey Bureau of Securities joined other states with a cease and desist order against Bitcoiin, another MLM cryptocurrency program for which famed actor, Steven Seagal, is the official global brand ambassador.

And so on and so on… and Into the Fray Stepped the U.S. FTC…

In February, 2018, the FTC followed MLM cryptocurrency scam concerns by the SEC, states and foreign governments, in its first prosecution, FTC vs. Bitcoin Funding Team/My7Network/Jetcoin.

Said the FTC:

The defendants claimed that Bitcoin Funding Team could turn a payment of the equivalent of just over $100 into $80,000 in monthly income…

According to the FTC, Bitcoin Funding Team and My7Network participants could only generate revenue by recruiting new participants and convincing them to also pay cryptocurrency. For example, Bitcoin Funding Team participants were required to make an initial Bitcoin payment to an earlier participant and pay a (platform) fee to Bitcoin Funding Team. With these payments, participants were eligible to recruit new members and receive payments from them. Promoters claimed participants could earn bigger rewards if they paid additional Bitcoins...

The FTC alleges that a fourth defendant, Scott Chandler, promoted Bitcoin Funding Team and another deceptive cryptocurrency scheme, Jetcoin. Jetcoin also promoted a recruitment scheme and additionally promised investors a fixed rate of return on their initial Bitcoin investments as a result of Bitcoin trading. In a series of promotional calls, Chandler claimed Jetcoin participants could double their investment in 50 days.

In fact, notes the FTC, few investors made money and the revenue for payment just came from recruiting new investors. The Bitcoin Funding and My7Network models were alleged to be out and out cash pyramids. Said the FTC, the Jetcoin model, which promised substantial guaranteed returns on purchase of Bitcoins, was both a headhunting recruitment pyramid and a Ponzi scheme, in which guaranteed returns would come to early investors from later investors.

Enough Said… We’ve Reached the Tipping Point of “Brand Dilution”

Everyone understands that the emergence of blockchain digital currency may be a serious positive development in the world of finance. But, in such a short time, the number of scams, financial frauds, unregistered securities offerings, crazy speculation, Ponzi schemes, pyramids and money laundering may taint and poison any legitimate activity with which it becomes associated. Hence Google and Facebook ban cryptocurrency ads on their platforms. And similarly, the brand of “direct selling/MLM” is endangered if MLM cryptocurrency scams are viewed as somehow being part of legitimate direct selling and MLM.

Time for Direct Selling Industry Involvement

The direct selling industry needs to step up to the plate. Google sees the brand dilution. Facebook abhors the brand dilution. The SEC, the FTC, the IMF, U.S. state and foreign governments abhor the fraud. It is time for the direct selling industry to protect the livelihood of its sales persons and the financial security of its consumers before the public begins to mistake these MLM cryptocurrency scams as belonging to the same gene pool as legitimate Direct Selling/MLM.

This should be done in a unified manner with an industry voice. One viable starting point is for the U.S. Direct Selling Association (DSA) and the World Federation of Direct Selling Associations (WFDSA: Membership of direct selling associations of approximately 60 countries) to each establish and fund a Cryptocurrency Task Force.

Among other goals to protect the integrity of the direct selling “brand,” this and other industry task forces should monitor, study, analyze, educate, inform and thwart financial fraud. They should become one of the “go to” sources for the public on these issues.

And One More Thing… Time to Join with Government

In November, 2017, Acting FTC Chair, Maureen Ohlhausen, presented to the U.S. DSA, and graciously invited the DSA and all its members to be “stakeholders at the table” to forge a new cooperation to help ensure the dual goals of success of the direct selling industry and protection of its sales force and consumers. Simultaneously, the industry invited the FTC to be a stakeholder in proposed federal anti-pyramid legislation, H.R. 3409.

It is time for the industry to return the hospitality, and offer all its U.S. and global resources, expertise and full-throated support to every governmental agency that is combatting cryptocurrency pseudo-MLM/direct selling financial fraud. The task forces, set up by the industry, could become tremendous and valuable partners to the SEC, FTC, IMF, and U.S. state and foreign consumer protection agencies. It is time for the industry to step up.



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Jeff is a graduate of the University of Southern California Law School. He is an active member of the State Bars of California and Oregon.

Guest Post by Jeff Babener
The New FTC Direct Selling Guidance… Imperfect, But a Good Start

Ring the bells that still can ring
Forget your perfect offering
There is a crack in everything 
That’s how the light gets in
Leonard Cohen… Anthem

The new FTC Direct Selling Guidance arrived in January, 2018. It built on the goodwill dialogue between the FTC and the direct selling industry that was ushered in by a well-received DSA presentation of acting Chairperson Maureen Ohlhausen in November, 2017.

Was it helpful to the conversation on “personal use” and “pyramid?” Yes. Was it perfect? No. There are two major ambiguity flaws (likely inadvertent) in the Guidance that must be discussed. Are these “cracks” in this Faberge Egg? Yes, but, that’s how the light gets in.

1. Did the FTC recognize that this area should be governed by 40 years of case authority rather than FTC administrative fiat? Absolutely. Did it miss a major characteristic of this well established industry? Yes. Even in this friendly guidance, the FTC was tone deaf to the reward tracking model used by leading direct selling companies (including Amway, Mary Kay, Shaklee, Tupperware) for more than 50 years, and never questioned by the courts, that follows wholesale movement of product with an underlying assumption that companies are capable of mandating, incentivizing and encouraging that product is accounted for: resold to ultimate users, personally used by distributors as ultimate users or returned under liberal one year buyback/refund programs. Should a successful half century model be upended…if the idea is to support an established industry, probably not.

2. The Guidance employs the term “driven by consumer demand” multiple times. The inadvertent implication is “driven by retail sales.” This semantic term is at odds with actual detailed Guidance discussion that concurs with the industry position that the pyramid test is “driven by sales to the ultimate user,” meaning that sales to distributors in reasonable amounts, for either personal use or resale, should be placed in the category of “sales to the ultimate user.” Perhaps the simple fix is a document global search and replace of “driven by consumer demand” with “driven by ultimate user demand.”

Is more FTC/Industry dialogue and adoption of H.R. 3409 (anti-pyramid bill) a good next step? For sure.

How we arrived at this dialogue…

The direct selling industry search for certainty in proposed H.R. 3409 has some real basis in the vacillating positions of the FTC. After the initial success of a MLM structure, by Amway, Mary Kay and Shaklee, in the 1950’s and 1960’s, the appearance of a true pyramid in Koscot and Dare to be Great, prompted the FTC to challenge the entire MLM concept, and specifically Amway, as being a pyramid. In 1979, an FTC administrative law judge rebuked the FTC, holding that Amway was a legitimate business opportunity, principally because it adopted what has come to be known, in all subsequent cases, as the Amway Safeguards:

1. A retail customer mandate that demanded distributors to enroll retail customers.

2. A 70% rule that demanded that product reordering was prohibited unless a distributor had sold or personally used 70% of product purchases.

3. A buyback policy for terminating distributors that offered a repurchase of product from terminating distributors.

4. Following up on Koscot’s requirement that MLM commissions should relate to sales to ultimate users, the Amway case also recognized that personal use in reasonable amounts constituted “sales to ultimate users.”

Little substantive legal precedent occurred for the next 20 years, after which the FTC started urging courts, ultimately unsuccessfully, that distributor personal use should not be viewed as a sale to the “ultimate user.”

Sufficient concern, in the industry, caused the industry to seek the 2004 FTC Advisory that seemed to guardedly recognize personal use.

However, the FTC drumbeat against personal use continued in court arguments and consent judgments. A reading of oral argument transcripts in the BurnLounge and Vemma cases demonstrates this animosity to personal use. In what some industry observers view as an opportunistic moment, in the Herbalife settlement, the FTC took advantage of the company’s need to achieve stability in financial markets, to achieve, what many industry observers viewed as a draconian settlement, shifting the test to a “percentages test,” effectively calling out “personal use” as a “second class” sale to “ultimate users” which did not deserve full recognition.

In what many viewed as an intimidating (but well-articulated) 2016 presentation to the DSA, Chairperson Edith Ramirez, effectively stated that there was a new “sheriff in town,” and that the FTC regarded the Herbalife settlement as the new FTC guidance.

Under the new proposed paradigm, “ultimate user” was to be viewed as “non-participant retail customer” and the Amway Safeguards, so often cited in 40 years of case authority, was thrown “under the bus.” Long established and accepted industry practices, autoship and wholesale tracking, were deemed persona non grata.

See: Fact Checking the FTC and also see: Searching for Certainty: H.R. 3409

Again this vacillation and, upending of case authority, caused great uncertainty in the industry. So much so, that the industry sought a bi-partisan introduction of H.R. 3409 to return the pendulum to the middle.

And then came the 2016 presidential election, the drive for less regulation, likely change of FTC commissioners, and suddenly, the FTC vacillated once again, walking back the Ramirez doctrine. In an extremely well-received November 2017 DSA presentation, Acting Chairperson, Maureen Ohlhausen, perhaps, in response to new proposed federal legislation (H.R. 3409) and a new anti-regulatory climate, pivoted away from a “take it or leave it” policy to one of cooperation, and one that recognized that case authority ruled the day as opposed to FTC guidance, which can change from staff to staff and commissioner to commissioner.

“There are a lot of nuances” packed in the Koscot Standard and analysis of legitimacy vs. pyramid, Chairperson Ohlhausen, importantly, noted, “I have instructed the FTC staff to meet with the various stakeholders, including the DSA, to discuss those nuances. We anticipate applying the information we’ve gained to issue future guidance, as well as to guide future law enforcement decisions.”

See: Stakeholders Come to the Table: H.R. 3409 

Old Common Ground; New Common Ground

And true to the Ohlhausen presentation, within two months, in January, 2018, the FTC announced its new formal Guidance, leaving Ramirez in the rearview mirror and culminating months of productive dialogue between the DSA and the FTC. Importantly, the FTC went on record as recognizing that case law trumps all, that every case is to be “fact driven,” that an “ultimate user” means “a real user” and recognizing the validity of personal use purchases so long as they are driven by “actual need” for product as opposed to driven by desire to qualify in the MLM compensation plan.

Old Common Ground

First, it is worthwhile to note those items in the new FTC Guidance for which the FTC and direct selling industry have long been on the same wavelength, and for which industry trade organizations, such as the DSA, have undertaken self-regulation.

1. Inventory loading is totally unacceptable. Its existence, even in the presence of a buyback policy or other consumer safeguards, will likely render a program to be a pyramid.

2. Unsupported earning representations, hypotheticals, potentials and lifestyle representations, in the absence of average earnings disclosures, are deceptive.

3. Industry self-regulation and regulatory cooperation is always welcomed.

4. Deceptive activity is never acceptable.

5. Individual company consumer safeguard compliance programs serve a very salutary purpose.

New Common Ground

Appreciated by the industry is the FTC Guidance published clarification on multiple points:

1. FTC Guidance is “non-binding.” The only authoritative guidance must come from case authority. And also, FTC Guidance is “staff guidance” and does not bind the FTC or its commissioners or the direct selling industry in any way.

2. FTC settlements and enforcement orders are not binding, they are not “guidance,” but rather they are examples of the FTC position in various cases.

3. Koscot’s “based on sales to ultimate users” is the prevailing authority on pyramid analysis. “Ultimate user” does not mean “non-participant retail customer” (as promoted by Ramirez), but rather sales to “real users.” This is very helpful to the dialogue. “Real users:” an interesting new turn of phrase by the FTC.

4. BurnLounge is the most current explanation of Koscot, providing:

a. Analysis in all pyramid cases is “case by case” and “fact driven” in which the overall program is examined by “the economic reality” of the offering.

b. Purchases for personal use by distributors are deserving of recognition as a sale to “ultimate users,” with the caveat that predominant intent of the purchase is to satisfy their own real product demand, for example, for resale or personal use, as opposed to a purchase made with the predominant intent to merely qualify in the compensation plan for rewards.

5. It is reasonable to expect a company to develop mechanisms to encourage retailing and to adopt a compliance policy that demonstrates that distributors buy product for their own real product demand, either for resale or personal use in reasonable amounts. And there is no right “one way” to accomplish demonstration of product purchase for the “right reasons.”

On the new common ground, it is probably best to hear from the FTC in its own words:

“Under Section 5 of the FTC Act, what is an MLM with an unlawful compensation structure, which is sometimes called a pyramid scheme?”

The most widely-cited description of an unlawful MLM structure appears in the FTC’s Koscot decision, which observed that such enterprises 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 the sale of the product to ultimate users.” In re Koscot Interplanetary, Inc., 86 F.T.C. 1106, 1181 (1975).

“How do MLMs with unfair or deceptive compensation structures harm consumers?”

An MLM compensation structure that incentivizes participants to buy product, and to recruit additional participants to buy product, to advance in the marketing program rather than in response to consumer demand in the marketplace, poses particular risks of injury. Where such an unlawful compensation structure exists, a participant is unlikely to be able to earn money or recover his or her costs through selling product to the public. In such circumstances, participants will often attempt to recruit new participants who will buy product, and pressure existing recruits to buy product, with little concern for consumer demand. Where an MLM has a compensation structure in which participants’ purchases are driven by the aspiration to earn compensation based on other participants’ purchases rather than demand by ultimate users, a substantial percentage of participants will lose money.

“How does the FTC distinguish between MLMs with lawful and unlawful compensation structures?”

At the most basic level, the law requires that an MLM pay compensation that is based on actual sales to real customers, rather than based on mere wholesale purchases or other payments by its participants. In evaluating MLM practices, the FTC, in accord with established case law, focuses on how the structure as a whole operates in practice, and considers factors including marketing representations, participant experiences, the compensation plan, and the incentives that the compensation structure creates. The assessment of an MLM’s compensation structure is a fact-specific determination that the FTC makes after careful investigation.

“How does the FTC treat personal (or internal) consumption by participants in determining if an MLM’s compensation structure is unfair or deceptive?”

Product that is purchased and consumed by participants to satisfy their own genuine product demand – as distinct from all product purchased by participants that is not resold – is not in itself indicative of a problematic MLM compensation structure. For example, the final order entered in FTC v. Herbalife permits the payment of compensation based on personal consumption, subject to specific limitations and verification requirements. However, the FTC’s law enforcement experience has shown that MLM participants may buy product – and recruit or pressure other participants to buy product – for reasons other than their own or other consumers’ actual demand, such as to advance in the marketing program.

This issue, like all issues concerning the evaluation of an MLM’s compensation structure, is fact-specific and usually involves a comprehensive analysis of a variety of factors. It is worthwhile, however, to highlight two topics that the FTC is likely to consider when evaluating an MLM’s payment of compensation that is premised, in part, on participants buying product that is not resold. First, the FTC staff is likely to consider whether features of the MLM’s compensation structure incentivize or encourage participants to purchase product for reasons other than satisfying their own personal demand or actual consumer demand in the marketplace. Second, the FTC staff is likely to consider information bearing on whether particular wholesale purchases by business opportunity participants were made to satisfy personal demand. The persuasiveness of this information in any particular case will depend on its reliability.

The FTC’s case against BurnLounge provides an example. BurnLounge argued that its participants bought product packages consisting of sales websites and music-related merchandise because they wanted to use the merchandise. When BurnLounge’s product packages were untied from the business opportunity, however, monthly sales of these packages plummeted by almost 98 percent. At most, actual demand was responsible for only a small minority of package sales, and BurnLounge was found to have an unfair or deceptive compensation structure.

“Is it still correct, as stated in the 2004 “FTC Staff Advisory Opinion – Pyramid Scheme Analysis,” that “the amount of internal consumption in any multi-level compensation business does not determine” whether the FTC will consider the MLM’s compensation structure unlawful?”

Yes. Personal or internal consumption – meaning product participants purchase and consume to satisfy their own genuine product demand – does not determine whether the FTC will consider an MLM’s compensation structure unlawful. As noted in the answer to question 5, when evaluating the issue of participants’ internal consumption, the FTC staff is likely to consider, among other factors, both (i) whether features of the MLM’s compensation structure incentivize or encourage participants to purchase product for reasons other than satisfying genuine demand; and (ii) information bearing on whether purchases were in fact made to satisfy personal demand to consume the product. When evaluating MLMs, the FTC focuses on how the structure as a whole operates in practice and considers factors including marketing representations, participant experiences, the compensation plan, and the incentives that the compensation structure creates.

The 2004 letter should not be misconstrued as suggesting that an MLM can lawfully pay compensation on wholesale purchases that are not based on actual consumer demand by characterizing such purchases as “internal consumption.” The 2004 letter itself does not support such a construction, nor do subsequent judicial decisions. For example, the court in BurnLounge held that, notwithstanding the defendants’ characterization that participants bought packages for “internal consumption,” the compensation paid on such purchases was not tied to consumer demand for the merchandise in the packages; instead, the opportunity to advance in the marketing program was the major driver of package purchases. Similarly, in granting a preliminary injunction against Vemma Nutrition Company, the court rejected the argument that individuals who had joined as business opportunity “Affiliates” only wished to purchase product for their own consumption, finding that this claim was “not based in fact.”

“Does the FTC Act require MLMs to retain sales receipts?”

No, there is no such requirement. However, as discussed above, to comply with the FTC Act, the compensation structure of an MLM must be based on actual sales to real customers. Thus, documentation of actual sales to real customers provides relevant information concerning an MLM’s compensation structure.

There is no single method for creating and retaining such documentation. Different MLMs employ a variety of approaches to demonstrate that their product is sold to retail customers, including collecting retail sales receipts created by participants; having retail customers buy product directly from the company, rather than from a participant’s inventory; and having product users sign up with the company as customers who are not participating in a business opportunity. Other MLMs use other approaches or a combination of approaches.

The most persuasive documentation is obtained through direct methods and used to verify that retail sales are made to real customers. Documentation obtained through indirect methods – such as policies requiring participants to attest they have sold a certain amount of product to qualify to receive reward payments – are less likely to be persuasive, with unsupported assertions being even less persuasive.

Ambiguities to Discuss

There are two major ambiguity flaws (likely inadvertent) in the Guidance that must be discussed.

1. Wholesale Tracking

Former Commission Chairperson Ramirez was quite clear that, even with use of consumer safeguards, the 50 year practice of leading companies to base qualification and reward structure, tied to tracking of wholesale product, was “out the window” and would be viewed as evidence of “pyramiding.” In the future, autoship and wholesale tracking would be prohibited. And she threw the famous In re Amway FTC decision on the “ash heap” of history as antiquated, out of date and no longer useful to the pyramid analysis. Her analysis was not supported by 40 years of case authority. And, in the absence of inventory loading and enforcement of the Amway safeguards, no court has ever rejected MLM programs that measure activity based on wholesale tracking. Such a model has existed for 50 years, starting with, and continued, with multibillion dollar direct selling companies such as Amway, Mary Kay and Shaklee.

Although the new FTC Guidance does not attack the Amway Safeguards decision, the standard and decision is conspicuously absent from the Guidance. One wonders why? And a real ambiguity is presented on the use of wholesale tracking:

Par. 14… “In addition, an MLM’s compliance program should ensure that compensation paid by the MLM is based on actual sales to real customers, rather than based on wholesale purchases or other payments by its participants.”

In fact, this statement is internally inconsistent with other discussion in the guidance. Did the FTC Guidance really intend to upend a 50 year model as argued by former FTC Chairperson Ramirez? Is this intentional or an oversight that deserves more dialogue between the industry and the FTC?

As to the buy-sell dealer arrangement, direct selling industry practices reflect virtually every other buy-sell dealer arrangement across many industries. Whether it be for incentives, volume pricing, discounting, rebates, rewards, measures of the relationships are almost always tracked with wholesale movement of product, with the underlying assumption that reordering occurs because product does, in fact, reach the ultimate user, whether it is resold, used for personal use, and if not, subject to buyback.

2. Semantics: Replace “Consumer Demand” with “Ultimate User Demand”

 As noted, the guidance employs the term “driven by consumer demand” multiple times. The inadvertent implication is that this means “driven by retail sales.” This semantic term is at odds with actual detailed guidance discussion that concurs with the industry position that the pyramid test is “driven by sales to the ultimate user,” meaning that sales to distributors in reasonable amounts, for either personal use or resale, should be placed in the category of “sales to the ultimate user.”

How did this term, “consumer demand,” come to be used? Although speculative, it is probably a throwback to the DSA presentation of former Chairperson Ramirez in which she effectively rejected personal use as a legitimate part of the ultimate user analysis and equated the term “driven by sales to the ultimate user” as meaning driven by “sales to retail customers.”

Said Ramirez:

I will start by explaining what we mean by “real customers.” Simply put, products sold by a legitimate MLM should be principally sold to consumers who are not pursuing a business opportunity… So, what does an MLM organized around real customers look like? You can see one approach laid out in the recent consent order we obtained in the Herbalife case. The order identifies two classes of people who are not pursuing the business opportunity: “retail customers” who simply buy product from Herbalife distributors and do not have any direct connection to the company; and “preferred customers,” who have registered with Herbalife as customers and do not participate in the Herbalife business opportunity.

In so doing, she rejected 40 years of case law and even the FTC’s own 2004 Advisory Opinion. As late as the BurnLounge case, the FTC actually argued this position, and it was rejected by the court.

Acting Commissioner Ohlhausen and the FTC Guidance repudiated that analysis and returned to definitions in case law, in the substantive discussion, that would include in “sales to the ultimate user” sales in reasonable amounts for personal use or resale. In fact, the FTC Guidance backs off the Ramirez’s use of the term, “real customer,” and, at times, replaces it with “real user,” which encompasses both personal use users and resale users.

Unfortunately, the semantic term of “consumer demand,, chosen in the guidance muddies the water and really should be changed to reflect the intent of the guidance, and also to be consistent with case law. As noted, a possible fix is a document global “search and replace” of “driven by consumer demand” with “driven by ultimate user demand.”

Where Does This Leave Us?

As said in NY/NJ, if you are looking for a simple answer: “Fuhgedaboudit.” (Forget about it.)

As Acting Chairperson Ohlhausen noted, this entire area of interpretation is “nuanced.” Since the FTC Guidance is non-binding staff guidance, it is useful, but the case authority remains (in absence of passage of legislation such as H.R. 3409) as the real guidance:

Koscot: Pyramid is triggered by payment of consideration and a reward that is not based on “sales to the ultimate user.”

Amway: Adoption of Amway Safeguards, including a retailing mandate, a 70% rule and a buyback policy, if enforced, tilts to legitimacy.

Omnitrition: In the presence of inventory loading (in that case, $5,000) and inadequate enforcement of the

Amway Safeguards, a presumptive pyramid is present.

BurnLounge: This is a synthesis of earlier cases and represents the state of the law today.  Added to case law is recognition of personal use, by a distributor, as a legitimate ultimate user, but an analysis must be made as to whether distributor purchases are driven by real demand of the distributor, for resale or personal use, or whether the predominant/primary motivation for purchases is to qualify in the compensation plan. And the analysis is one that is “fact driven,” “case by case” and should take into account a factual investigation of the basis of distributor purchasing and the “economic reality” of the overall program. The analysis will be a nuanced balancing test of “good factors” and “bad factors.”

A good summary of the balance of “nuanced factors” appears in an earlier discussion of BurnLounge: Analyzing BurnLounge

 BurnLounge Establishes a “Fact Driven” Balancing Standard: Recruitment v. Sales. 

The BurnLounge Ninth Circuit Appeals Court established a going forward pyramid test that is fact driven, and which balances whether distributor payments and commissions are driven by recruitment, on the one hand, or sales to ultimate users on the other hand, i.e.

Are distributor product/service purchases incidental to the business opportunity? Or rephrased: Is the focus in promoting the program, rather than selling products to ultimate users?

If one reads the trial court decision, listens to the oral argument before the Ninth Circuit or reads the Ninth Circuit opinion, the words “primarily” or “predominant” are frequently used to discuss the motivation of distributor purchasing, in order to determine if they should be included in the category of ultimate users. 

The central inquiry will always be: What do they pay, and why do they pay it?

And the ultimate standard of inquiry going forward in pyramid cases will be: What is the predominant or primary motive of distributors in making purchases? Is the primary motivation for purposes of resale or personal use or, as a gateway purchase to qualify for rewards in the MLM opportunity and compensation plan?

What is clear after the BurnLounge case is that “personal use” purchases become somewhat “neutral,” i.e., such purchases, which are not incidental to the opportunity, are not to be excluded in the analysis of sales to ultimate users. And, on the other hand, the mere presence of some personal use purchases or even some sales to retail customers, will not, in itself, be determinative of legitimacy. With that in mind, many other factors will need examination.

How will this work in future cases? It is fairly simple. Get out a piece of paper and make two columns for the “good facts” and the “bad facts.” In a simplistic sense, the winner of pyramid v. legitimate or recruitment v. sales, will be the dominant list. Well, actually, it is not all that simple, because a court will likely choose to ascribe more weight to designated items on each list.

Clearly, the “bad” list will include, but is not limited to, such factors as:

Front-end loading or inventory loading,

Large upfront fees,

Mandated purchases to qualify for commissions or rank advancement,

Bogus product or service,

Inflated prices,

No buyback policy,

No mandate for retail sales by distributors,

No restrictions on “over” ordering,

Unsubstantiated earnings representations,

No evidence of product consumption by ultimate users, either by outside      customers or distributors,

Payment of commissions for training or sales tools as opposed to being based on product sales to ultimate users,

Evidence of unsold product in the marketplace characterized by “garage loading,”

Actual headhunting or recruitment fees,

Mandatory purchases of peripheral or accessory products or services,

And the list will continue with any abusive practice that does not focus rewards primarily driven by sales to ultimate users,

And the “good list”…  again, some, but certainly not all the important factors:

High quality goods and services,

Demonstration of a “real world” marketplace for the product or service,

Goods and services that are fairly priced,

No upfront mandated investment or payment other than a modestly priced “at cost” sales kit,

No inventory requirements,

Demonstration that product/service is used by consumers, whether they be retail customers or distributors,

Sales commissions and rank advancement strictly based on sales of product or service to ultimate users,

Emphasis on sales and use to ultimate users, including retail customers and personal use by distributors,

Amway Safeguard: Buyback policy for terminating distributors,

Amway Safeguard: Anti-inventory loading rule, such as 70% rule, prohibiting purchases unless distributors have sold or used a specified amount of previously purchased product,

Amway Safeguard: Mandate of some specified level of retail sales to outside customers as a condition for qualifying for commissions and rank advancement,

Avoidance of Earnings Representations/Potentials/Hypotheticals/Testimonials unless a transparent average earnings disclosure is provided to potential distributors,

Above all, emphasis on rewards on sales of product/service to ultimate users (retail customers or distributor personal use in reasonable amounts) rather than rewards arising from recruitment of other distributors,

Requirement that any personal use purchases by distributors be in reasonable amounts,

Requirement that any product purchases for resale be in commercially reasonable amounts and subject to buy back policy for terminating distributors,

Quality training to distributors that emphasizes both product sales as well as recruit development.

In the end, any court will be required to conduct this balancing test. And it will seek assistance not only from the parties and the evidence, but, as noted in the BurnLounge Ninth Circuit decision, from qualified direct selling experts. Those experts will assist in fact finding, but they will not be the fact finder nor the author of the legal standard…this role is for the trial court.

Next Steps: Dialogue and Adoption of H.R. 3409

Kevin Lomax: Are we negotiating?
John Milton: Always.
Film, Devil’s Advocate

Two next steps are in order:

1. First, the industry and FTC are well served by continuing dialogue.

2. Second, given the vacillation of the FTC that has occurred over 40 years, this industry is deserving of some legislative certainty, so that it is not held hostage to the ever changing staff, commissioners and positions of the FTC.

The stated purpose of H.R. 3409:

To amend the Federal Trade Commission Act to prohibit pyramid promotional schemes and to ensure that compensation is not based upon recruitment of participants into a plan or operation, but on sales to individuals who use and consume the products or services sold, and for other purposes.

It is the first of its kind at the federal level. Interestingly, anti-pyramid statutes have been enacted in almost all states for half a century. And, anti-pyramid laws, similar to the current federal bill, have been adopted in more than 20 states, with almost identical legislation adopted in more than a dozen states.

H.R. 3409 is the “real thing” and it slams abusive pyramid scams. The core of the legislation, is rooted in a 40 year line of cases that emanate from Koscot, that Chairperson Ohlhausen describes as the backbone of “going forward” FTC policy, a rule that commissions paid to distributors must be based on sales to “ultimate users.”

Bottom line: The bill would finally give the industry certainty that is found in the line of cases from Koscot to Amway to BurnLounge that “ultimate users” include non-participant customers as well as participants who purchase in reasonable amounts for actual personal or family use. Language in the bill lines up perfectly with the established standard of the Koscot case.

Point by point, H.R. 3409 satisfies the goals of both the case law, the new FTC Guidance and industry standards that have been adopted long since in so many states. The bill:

(1)       Condemns inventory loading;

(2)       Calls out as “evil” pyramid headhunting recruitment schemes;

(3)       Per the Koscot case, forbids payment of commissions or rewards that are unrelated or not based on sale of products and services to the “ultimate consumer;”

(4)       Absolutely rejects programs in which distributor product purchases are made in unreasonable amounts, either for resale or actual personal and family use; and

(5)       Demands, as a condition of legitimacy that companies adopt a repurchase policy in which terminating distributors will be refunded for returned product inventory, in resalable condition, that has been purchased within 12 months of termination.

And the industry cannot sit on its “laurels.” Leading members of the industry are already implementing technology solutions to track the segmentation of distributors and non-distributor users of products. In addition, many leading companies have instituted reclassification programs in which distributors who use product regularly, but do not really “work the opportunity,” can be reclassified into “preferred customer” programs that carry favorable pricing and a host of consumer benefits and incentives. These efforts at self-regulation will continue, regardless of legislation, and are the type lauded by the new FTC Guidance.

For a full look at the new FTC Guidance, see: FTC Direct Selling Guidance 

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The post The New FTC Direct Selling Guidance… Imperfect, But a Good Start appeared first on The World of Direct Selling.

Jeff is a graduate of the University of Southern California Law School. He is an active member of the State Bars of California and Oregon.

Guest Post by Jeff Babener
FTC and Direct Selling Come to the Table as Stakeholders: H.R. 3409

Everything dies baby, that’s a fact.
But maybe everything that dies someday comes back.
Bruce Springsteen, Atlantic City

What a difference a year makes. In a well-received presentation to the November 2017 DSA Regulatory Conference, FTC Acting Chairperson, Maureen Ohlhausen, struck a totally different tone in regard to forward looking FTC enforcement policy on direct selling, contrasted with the October 2016 presentation of former FTC Chairperson, Edith Ramirez.

The Contrasting Messages:

2016: Ramirez: We are the regulator, new rules to live by, just live with it, it’s our way or the highway…

2017: Ohlhausen: We are all in this together… We are all stakeholders… Let’s work together for the benefit of both, fostering the success of an entrepreneurial and small business direct selling industry, and protecting the security of consumers.

Came floating on a lemon leaf
Flying in on a jasmine wind
The Band’s Visit, Broadway Show, 2017

What happened? Why the rapprochement? Why the goodwill? Will it take hold? Well, it’s a guess, but there are many factors:

(1)       The former chairperson “termed out.”

(2)       A presidential election swept in with an anti-regulatory, pro-growth, pro-entrepreneurial and small business message.

(3)       The going forward composition of the FTC Commission will be Republican and more likely to be sensitive to the concerns of the “regulated.”

(4)       Importantly, the previous FTC aggressive position pushed the industry to seek certainty in their business that could only be achieved by federal anti-pyramid legislation firmly rooted in long standing case authority rather than arbitrary administrative enforcement, i.e., the bi-partisan H.R. 3409 Anti-Pyramid bill was introduced and gaining momentum.

(5)       Finally, the FTC may have realized that it had been heavy handed in recently announced enforcement positions.

Point/Counter-Point: Contrasting Punch Lists

It is worthwhile to contrast the “punch lists” of presentations and positions by the 2016 Ramirez and the 2017 Ohlhausen:

Former Chairperson Ramirez’s presentation followed the successful FTC prosecution of FTC v. Vemma and the overly rigid terms of the FTC vs. Herbalife settlement. Although very well-articulated, the presentation warned of potential future FTC guidance that was not rooted in 50 years of case authority, but rather in the newly adopted positions of the Chairperson and FTC staff… an enforcement policy that that would require a complete overhaul of the model of many leading direct selling companies:

(1)       She renounced use of the famous Amway Safeguards Standard, adopted in the landmark FTC case, In re Amway, 1979 as being irrelevant, overrated and not really relied on by courts in pyramid cases. (an unfortunate misinterpretation of case law).

(2)       She redefined the famous Koscot Standard to require compensation to upline to be based on sales to  nonparticipant retail customers rather than based upon Koscot’s language—ie., commissions must be based on sales to “ultimate users”, effectively reclassifying distributor users as “second class” “ultimate users.”

(3)       She pivoted away from a legal analysis in the most recent BurnLounge case, which demanded, in pyramid cases, a factual analysis of the “primary motivation” test in which a court asks “what is the primary motivation for distributors when they make purchases”… instead migrating to a punch list of inflexible operating restrictions imposed on Herbalife in its recent settlement.

(4)       She essentially attempted to create a new legal standard, the “percentages test”, an arbitrary new rule in which upline distributors would be limited to receive commission credit for only one-third of sales volume attributed to personal use by downline distributors, whether or not such purchases were reasonable in quantity and for actual use by the distributor “ultimate user.”

(5)       She announced that a long time practice of almost all leading direct selling companies, autoship to distributors, should, effectively, be prohibited.

(6)       She pivoted away from a well-established component of leading direct selling programs, stating that monthly activity volume requirements may not include any purchases by distributors.

(7)       She asserted that the long time practice of established direct selling companies, tracking of performance activity, connected to wholesale purchasing, should be banned.

Acting Chairperson Ohlhausen, on the other hand took the train in a totally different direction, rooting a going forward FTC policy on long established case authority and principles of government/industry collaboration rather than top down directives.

As acting chairperson of the FTC, Chairperson Olhausen underscored her goals for the direct selling industry… Gone were threats to upend long standing direct selling models:

(1)       One of her overriding goals, she said, “was to increase the FTC’s support of small business and entrepreneurs.”

(2)       She noted: “I recognize that at the heart of the direct selling model are entrepreneurs—those men and women who are out there innovating, taking risks, and trying to generate value.”

(3)       She stressed that the direct selling model offers “a lot” to entrepreneurs:

* Low startup costs;

* Administrative and logistical support from their companies;

* Promotion of efficiencies in the marketplace for friends and families and consumers;

* Varied and diverse products and services;

* Innovations in selling using internet and social media and technology.

(4)       She pointed out the importance of flexibility in regulation by the FTC and that it is important that the FTC stay away from rigid application of “one size fits all” regulatory enforcement, looking instead on “our case-by-case” enforcement process of “specific harm” in that particular case.

(5)       Consistent with the views of leading companies in the direct selling industry, she applauded industry self-regulation with government oversight as a backup, while at the same time emphasizing that government enforcement powers should be “robust and judicious.” Why judicious? Said Ohlhausen, “Over-zealous government involvement can diminish industry members’ participation in the self-regulatory system, which reduces the system’s effectiveness. Businesses that believe government action is inevitable will not participate or invest in self-regulation.”  How true, and what a great prelude to cooperation between the FTC and the direct selling industry.

(6)       Chairperson Ohlhausen took the time to lay out several “bright line” markers intended to serve as FTC’s down payment on a cooperative relationship with direct selling:

* “The FTC and the DSA have a good working relationship, and for that, I thank you. We’ll continue to cultivate that relationship…”

* The FTC took special care to understand the dynamics of direct selling, and exempted multilevel marketing programs from its recently updated Business Opportunity Rule.

* Pivoting from Chairperson Ramirez’s comments that the Herbalife settlement terms may be the basis of future FTC guidance or rules, Chairperson Ohlhausen stated unequivocally that settlements and orders do not apply to the entire industry: “The answer to that question is ‘No’. Orders arising from FTC settlements are binding only on the entities and individuals identified in the order. The orders may of course, provide industry participants with additional data points on, for example, business structures that the FTC believes comply with the law. But that’s not to say the structures outlined in those orders are the only way the FTC believes companies can comply.”*

* Does the FTC assume or believe that every multi-level company is a pyramid scheme? Responded Ohlhausen, “The answer to that question is also ‘No’… We recognize the direct selling model has a lot to offer the marketplace and consumers.”

* After hearing from Chairperson Ramirez in 2016, what the industry heard, or inferred, was that the FTC was abandoning longstanding case authority for its own “punch list” of what does or does not fit within legitimate multilevel marketing vs. pyramid scheme. Not so fast, declared Chairperson Ohlhausen, i.e., the FTC is going back to basics… a refreshing comment from the industry’s perspective and one that is the driving force behind H.R. 3409. Said the Chairperson, “At the risk of getting into too much legalese, the FTC described an unlawful pyramid scheme in our case against Koscot Interplanetary, Inc. back in 1975. Most courts have adopted that description and it’s the description we have used in our recent cases. (Author’s comment: many industry observers might take exception to the observation that this approach has been the guiding FTC enforcement position in recent cases.) Under that description, unlawful multi-level marketing structures are “characterized by the payment 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 participants into the program, rewards which are unrelated to the sale of the product to ultimate users.” (emphasis added)” Citing, In re Koscot Interplanetary, Inc., 86 F.T.C. 1106, 1180 (1975).

* And realizing that “there are a lot of nuances” packed in the Koscot Standard and analysis of legitimacy vs. pyramid, Chairperson Ohlhausen, importantly, noted, “I have instructed the FTC staff to meet with the various stakeholders, including the DSA, to discuss those nuances. We anticipate applying the information we’ve gained to issue future guidance, as well as to guide future law enforcement decisions.”

H.R. 3409: An Opportunity for both the FTC and the Direct Selling Industry

And now… an opportunity for the FTC and direct selling Industry to work together for certainty that they both deserve. A bi-partisan bill, H.R. 3409, the Anti-Pyramid Promotional Scheme Act of 2017.

The stated purpose of H.R. 3409: To amend the Federal Trade Commission Act to prohibit pyramid promotional schemes and to ensure that compensation is not based upon recruitment of participants into a plan or operation, but on sales to individuals who use and consume the products or services sold, and for other purposes.

It is the first of its kind at the federal level. Interestingly, anti-pyramid statutes have been enacted in almost all states for half a century. And, anti-pyramid laws, similar to the current federal bill, have been adopted in more than 20 states, with almost identical legislation adopted in more than a dozen states.

H.R. 3409 is the “real thing” and it slams abusive pyramid scams. The core of the legislation, is rooted in a 50 year line of cases that emanate from that case, Koscot, that Chairperson Ohlhausen describes as the backbone of “going forward” FTC policy, a rule that commissions paid to distributors must be based on sales to “ultimate users.” Bottom line: the bill would finally give the industry certainty that is found in the line of cases from Koscot to Amway to BurnLounge that “ultimate users” include non-participant customers as well as participants who purchase in reasonable amounts for actual personal or family use. Language in the bill lines up perfectly with the established standard of the Koscot case.

Point by point, H.R. 3409 satisfies the goals of both the case law, Chairperson Ohlhausen’s reliance upon Koscot and industry standards that have been adopted long since in so many states. The bill:

(1)       Condemns inventory loading;

(2)       Calls out as “evil” pyramid headhunting recruitment schemes;

(3)       Per the Koscot case, forbids payment of commissions or rewards that are unrelated or not based on sale of products and services to the “ultimate consumer;”

(4)       Absolutely rejects programs in which distributor product purchases are made in unreasonable amounts, either for resale or actual personal and family use; and

(5)       Demands, as a condition of legitimacy that companies adopt a repurchase policy in which terminating distributors will be refunded for returned product inventory, in resalable condition, that has been purchased within 12 months of termination.

All of this is not to say that the direct selling industry does not take self-regulation and protection of the consumer very seriously. The Direct Selling Association Ethics Code is replete with consumer protections, from prohibitions on inventory loading to unsubstantiated earnings claims to mandates of inventory buyback from terminating distributors. And leading members of the industry are already implementing technology solutions to track the segmentation of distributors and non-distributor users of products. In addition, many leading companies have instituted reclassification programs in which distributors who use product regularly, but do not really “work the opportunity,” can be reclassified into “preferred customer” programs that carry favorable pricing and a host of consumer benefits and incentives. These efforts at self-regulation will continue, regardless of legislation, and are the type lauded by Chairperson Ohlhausen. To some extent, such undertakings are a “down payment” on reciprocal cooperation by the FTC.

Carpe Diem… Seize the Day… We Are All Stakeholders

Just as Chairperson Ohlhausen has invited all stakeholders to the table to discuss how to implement the nuances of the Koscot line of cases, the direct selling industry should invite the FTC, as a stakeholder, to participate in the development and enactment of H.R. 3409.

Why is H.R. 3409 a great discussion topic for these “stakeholders?” Well, of course, cooperation and collaboration and good will are good goals.  But those lofty goals do not produce certainty and predictability if there is no objective standard or rule of law.

No one will argue with the fact that FTC staffs change; that, over time, FTC commissioners change; and that there is a long history of FTC vacillation on policy and enforcement. It is well past time for some objective guidance.

Will this dialogue go anywhere? Can the parties achieve some certainty for this channel of distribution? Hard to say… Hopefully, yes. We have been down this road before. But it is important to remember, as Prime Minister Indira Gandhi once said, “you cannot shake hands with a clenched fist.”

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Jeff is a graduate of the University of Southern California Law School. He is an active member of the State Bars of California and Oregon.

Guest Post by Jeff Babener
Search for Certainty in Direct Selling: A Legal and Business Rationale for H.R. 3409

Executive Summary: The legal environment and the accepted business model of leading direct selling companies has been relatively stable for 50 years. That equilibrium was upset by the regulatory proposals of a former FTC commissioner to upend that environment with new arbitrary rules that lack a basis in case authority or legislation… creating confusion in today’s direct selling market place. H.R. 3409, a mirror of many established state anti-pyramid statutes and the language of long adopted case authority, is intended to return predictability and stability and certainty to that market.

Like a poem poorly written
We are verses out of rhythm
Couplets out of rhyme
In syncopated time
Paul Simon, The Dangling Conversation

How We Got Here… Talking Past One Another

Creating Uncertainty and Confusion in an Established Market

He was born on third, but thought he hit a triple.

In July, 2016 the FTC concluded an investigation and settlement with Herbalife, without formal prosecution or litigation. No finding of wrong doing was made and no finding of “pyramid.” A substantial fine was paid. More significantly, Herbalife was obliged to radically change its MLM operating model to an extent that differentiated it from most other leading direct selling companies.

Industry observers postulated that the FTC had achieved by settlement a result that it could not have achieved through protracted litigation. And so why the result? Many experts, who follow the industry and FTC, understood the dynamics of why a publicly traded company, in the midst of a multi-year short seller attack (where its stock had spanned a volatile range of $27 to $80 over a four year period) might accede to onerous terms to bring an end to a cloud of uncertainty over its business. Many would argue that it was just a prudent move at a particularly vulnerable point of time in the financial markets. Interestingly, the fine paid was eclipsed by the surge in market cap and stock valuation as a result of the settlement, a fact that did not elude Wall Street.

Herbalife may have prevailed financially, but the FTC was playing “long ball” in terms of its long term legal position. Would the bevy of operating restrictions carry over to a change in the legal environment for the entire direct selling industry? Was the FTC emboldened to approach the direct selling industry as if it had just changed the direction of direct selling law unilaterally by settlement as opposed to achieving a change in the law by persuading a court to change the rules? Absolutely. Did it really change direct selling law? Well, sometimes history is written by the victor, whether correct or not. Or maybe that’s for the historians.

Post FTC/Herbalife Settlement, former FTC Chairwoman, Edith Ramirez, in her October, 2016 presentation to the U.S. Direct Selling Association, announced a vision for a new FTC paradigm outlook on legitimate direct selling that was totally at odds with decades of case authority, state legislation and operating models of a 50-year-old industry. To many observers, her position seemed to be drawn from “whole cloth” and fashioned as a “top down” bureaucrat “take it or leave it” style, i.e., “That’s the way it is, live with it!,” and “We know better than you…too bad.” Her position stunned CEOs of major direct selling companies. (The anxiety was heightened by another long time, and industry criticized, tactical practice of the FTC, referenced in the industry as “trial by ambush,” in which the FTC filed for a temporary restraining order and asset freeze at commencement of suit…leaving a company without any funds to defend itself… another issue for another day…)

My Way or the Highway… Bending the Arc of Direct Selling History

Her new theory of legitimate (vs. pyramid) direct selling was premised on a percentage analysis of non-participant consumption (perhaps mandating as high as two-thirds requirement to meet the FTC’s new standards), i.e., that the acid test for pyramid was demonstration of consumption by non-participants rather than the 40-year-case-standard established in the famous Koscot case, demonstration of consumption by the “ultimate user,” which could be either a non-participant or a participant…. in one “fell swoop” distributors who used product became “second class” ultimate users and direct selling companies were on notice that their model, one that long recognized personal use and one that the FTC as late as its 2004 Advisory opinion recognizing personal use, was in jeopardy.

Almost by fiat, she announced proposed upcoming FTC guidance (as of 2017, not yet issued) that would require complete overhaul of the model of many leading direct selling companies:

(1)       She renounced use of the famous Amway Safeguard Standard, adopted in the landmark FTC case, In re Amway, 1979 as being irrelevant, overrated and not really relied on by courts in pyramid cases.

(2)       She redefined the famous Koscot standard to require compensation to upline to be based on sales to the nonparticipant retailer customer rather than the Koscot’s language, ultimate user, effectively making distributors “second class” “ultimate users.”

(3)       She pivoted away from a legal analysis in the most recent BurnLounge case, which demanded, in pyramid cases, a factual analysis of the “primary motivation” test in which a court asks “what is the primary motivation for distributors when they make purchases”…instead migrating to a punch list of operating restrictions imposed on Herbalife in its recent settlement.

(4)       She essentially described a new legal standard, the percentages test, an arbitrary new rule in which upline distributors were limited to receive commission credit for only one-third of sales volume attributed to personal use by downline distributors, whether or not such purchases were reasonable in quantity and for actual use by the distributor “ultimate user.”

(5)       She announced that a long time practice of almost all leading direct selling companies, autoship to distributors, should be prohibited.

(6)       She pivoted away from a well-established component of leading direct selling programs, stating that monthly activity volume requirements may not include any purchases by distributors.

(7)       She asserted that the long time practice of established direct selling companies, tracking of performance activity connected to wholesale purchasing should be banned.

In the absence of “inventory loading,” almost all of the new restrictions on long standing industry “practices” had never been of particular concern in 40 years of cases or robust legislation at the state level.

All in all, a Molotov cocktail was thrown into the garden of direct selling occupied by icons like Avon, Mary Kay, Amway, etc.

Confusion Gives Birth to H.R. 3409?… Time for Clarity

Nature abhors a vacuum… Markets abhor uncertainty…

It was, as if the former Commissioner was talking right past those companies and models that had marshalled an important American economic channel for decades. Actually, right past case history and precedent.

A $36 billion industry had lived with and understood court guidelines for many decades, but the Chairwoman proposed to upend 40 years of legal precedent to bend the arc of direct selling history.

Did industry leaders feel ambushed? Well, that is a “charged” word… but, yes. Direct selling executives were rooted in the stability of historical case authority and state legislation respecting the role of personal use and rooting legitimacy in the Koscot standard, rewards must be related to sales to ultimate users (which includes personal use in reasonable amounts by distributors), the Amway standard, which asks companies to mandate that distributors achieve some level of retail sales, adhere to the 70%-rule which prohibits reorders unless distributors have resold product or used it for personal use in an amount of at least 70% and offer a reasonable repurchase policy for repurchase of inventory of terminating distributors, and the BurnLounge standard that rejected the FTC argument against recognition of the validity of personal use and opted for a case by case factual analysis of “primary intent” of distributor purchasing rather than a lock step rigid rule.

Was it a wholesale rejection of legal precedent and legislative standards? Probably. Did it veer away from standards carefully formulated in famous case precedents of Koscot, Amway, BurnLounge? Yes. Did it part company with the FTC’s own 2004 Advisory Opinion accepting the validity of “personal use” recognition, all the way to the point of even suggesting that the concept of MLM buying clubs was commendable? With all due respect, Yes. Did the position even conflict with the BurnLounge deposition testimony of the FTC’s own economist, who recognized the validity of personal use? Yes. Did the Commissioner’s position ignore the clear and growing trend in at least a dozen states where legislation called out the recognition of distributor personal use as a valid end destination to the ultimate user? Yes. Again, respectively, this state trend was missed altogether. (Actually, the Direct Selling Association points out that at least 21 states have adopted anti-pyramid legislation that also mirrors the anti-inventory loading/repurchase requirements seen in H.R. 3409.) Whether or not this omission was merely an oversight, who knows?

A close point by point FTC “fact check” is worthy of a read and a cup of coffee: Fact Checking the FTC’s New Legal Guidance 

For those of a more studious nature, check out the detailed analysis on the evolving legal standards in case authority (including Koscot, Amway and BurnLounge) and at the legislative level: BurnLounge Appeal Decision: Guidance on Pyramid v. Legitimate MLM and the Role of Personal Use in Pyramid Analysis

Also see legal analysis of the FTC punch list of operational restrictions arising from the Herbalife settlement: FTC v. Herbalife: Post-Settlement Legal Guidance for the Direct Selling Industry

“Anxious” is the understatement for the business environment promoted by Chairwoman Ramirez. Her position on legitimacy challenged the models of virtually every direct selling company. And with the foregone expectation that an even greater regulatory regime would inherit the White House in November, 2016, there was an expectation of “but wait there’s more, not less, regulation coming…so live with it.”

And then “poof,” the totally unexpected happened in the November, 2016 election. An anti-regulation President was elected with the opportunity to nominate a new majority of the FTC; the designated head of a “deregulation” task force was named, the largest shareholder of one of America’s leading direct selling companies; and within months of the election, the term of FTC Commissioner Ramirez came to an end.

And thus uncertainty replaced anxiety in the direct selling industry… which brings us to the legal and business rationale for pending H.R. 3409, denominated the Anti-Pyramid Promotional Scheme Act of 2017… for the first time in history, proposed federal anti-pyramid legislation.

Two Different Views of H.R. 3409… the Next Challenge

Can you hear me now?… the Verizon guy…

Pending before Congress is H.R. 3409, a bi-partisan bill entitled the Anti-Pyramid Promotional Scheme Act of 2017.

It is the first of its kind at the federal level. Interestingly, anti-pyramid statutes have been enacted in almost all states for half a century, and specific anti-pyramid laws that are almost identical to proposed H.R. 3409 have provided guidance for more than 20 years in more than a dozen states.

However, no federal anti-pyramid statute has ever appeared on the books. The FTC Act Section 5 broadly prevents “unfair or deceptive practices,” and yet it has been the principal vehicle for anti-pyramid enforcement other than the SEC and U.S. Department of Justice, whose mandate is to prosecute fraud, securities fraud and securities violations.

The stated purpose of H.R. 3409: To amend the Federal Trade Commission Act to prohibit pyramid promotional schemes and to ensure that compensation is not based upon recruitment of participants into a plan or operation, but on sales to individuals who use and consume the products or services sold, and for other purposes.

Now, does that sound any more controversial than the “mother and children protection act of _____.”  Well, guess again. Opponents of H.R. 3409 see a wolf in sheep’s clothing. They see it as a bill that seems innocuous on its face, but that is really intended to rob the FTC of its flexibility to chase after any pyramid scoundrel by actually defining the parameters of a pyramid rather than allowing the FTC to employ a vague statute, without specificity, to chase after direct selling businesses with assertions that their practices are “deceptive and unfair.”  In other less democratic countries, critics refer to such styles of governance as “a government of ‘men’ as opposed to a government of ‘laws.’”

The bipartisan sponsors of H.R. 3409 and the direct selling industry, led by the Direct Selling Association, assert that the legislation is anything but “flim flam.”  And quite honestly, a close look at H.R. 3409 does make it difficult to believe that it is anything other than robust consumer protection legislation…and that the “boogey man” is not hiding around the bend, ready to pounce on the innocent consumer. In fact, H.R. 3409 comes down like a sledge hammer on scams and schemes:

(1)       It condemns inventory loading;

(2)       It calls out as evil pyramid headhunting recruitment schemes;

(3)       It forbids payment of commissions or rewards that are unrelated or not based on sale of products and services to the “ultimate consumer;”

(4)       It absolutely rejects programs in which distributor product purchases are made in unreasonable amounts, either for resale or actual personal and family use;

(5)       And it demands, as a condition of legitimacy that companies adopt a repurchase policy in which terminating distributors will be refunded for returned product inventory, in resalable condition, that has been purchased within 12 months of termination.

If there is any new concession to the industry, it is that, in the course of protecting the consumer, H.R. 3409 also codifies case authority and state legislation in recognizing the legitimacy of reasonable personal use by distributors as being a sale to an “ultimate user.”

And there lies the rub… the parties are talking past each other…and in the words of Larry David’s grandmother… everyone is farmisht (confused as to what is the state of the law for legitimate direct selling). It is difficult to imagine that anyone could cogently argue that “uncertainty” is a good thing for a 50 year old channel of distribution in the U.S. H.R. 3409, at the very least, provides a good starting template for input from all groups of good will, consumer groups, the FTC, Congress, the States and the direct selling industry. Perhaps, even the President, who has served as a spokesperson for at least two MLM companies, will place this issue on the Executive Branch anti-regulation task force agenda.

Why H.R. 3409?…  Just One More Reason… Time for Clarity and Certainty in the Markets

It is hard to stand on shifting sands.

In the absence of some definitive resolution, the collision of the Ramirez FTC paradigm and the half century model of direct selling and 40 years of federal case authority and state legislative authority produces nothing but operational paralysis for a $36 billion industry and its 20 million participants.

Proponents and opponents of H.R. 3409 may debate ad infinitum on the goals of protecting the consumer or protecting the rights of direct selling distributors. But, a very clear unenunciated reason for passage of H.R. 3409 is that the overreaching positions of the FTC have created total uncertainty in the marketplace, and H.R. 3409 brings clarity and synchronicity to actual case authority and a clear federal standard that allows “business to be business” again. H.R. 3409 bursts the bubble of confusion.

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This new article in “Wisdom in 100 Words” series on The World of Direct Selling covers “Expanding into New Countries”. While the potential of increasing the existing business is enormous with this move, the risk of damaging it is also there.

The question was as follows:

“What would be your best advice to a direct sales company to maximize the potential benefits of going international (or, to avoid serious risks)?”

Below, you will read comments from a group of persons of expertise form the industry.

Jeffrey Babener, Legal Counsel at Babener and Associates:

“With today’s technology, communication and logistics, U.S. companies are pressured, almost from day one, to expand internationally. The opportunity is so great that most leading companies ultimately post the vast majority of global sales beyond U.S. borders. Long story short: Don’t jeopardize this expansion by playing “fast and loose” or “on the quick”. If done incorrectly, the foreign market opportunity is tainted forever. Having assisted leading companies in expansion for over 30 years, our first “go to” are our counterpart professional colleagues in other countries, to address import, trademark, fulfillment, and distribution of product and service, regulatory and legal compliance with direct selling and consumer legislation, staffing and visas and addressing a big financial structuring picture, with our tax professional colleagues, for an international seamless sponsoring system. All of these professionals have been accustomed to working under our law firm supervision for decades.”

Jack Crowley, Owner of The Crowley Collaborative Group:

“Having launched direct selling businesses in over twenty countries, experience proves no one path ensures success or eliminates errors. Formerly, as a company executive and now as a consultant to the industry, I’ve used these “Rules of the Road” to eliminate numerous obstacles and generate sound, profitable international businesses: 1. Expand internationally for the right reasons. 2. International expansion is a “full” corporate commitment. 3. Commitment starts at the top. 4. An internal and external strategic analysis is essential. 5. Think globally… act locally. 6. Have realistic expectations. 7. Do the homework (Details, details, details). 8. Strive for transparency. 9. Utilize local resources. 10. Flexibility and creativity are essential. Each of these points has numerous subsets but used as a “road map” they do help companies avoid the pitfalls and enjoy the benefits of operating internationally.”

Jonathan Gilliam, CEO of Momentum Factor:

“Avoiding shortcuts in order to meet a new market demand is paramount. When a company is interested in a new market it’s usually because they’ve seen a spike in demand in those countries, either from its own network or perhaps a competitor’s network seeking to move over. It can be tempting to dive right in, damn the torpedoes. But a company will nearly always have new and interesting regulations and legal requirements to address, and it’s important to get them right from the start. From product registration, certifications and MLM-specific legal and compliance mandates, companies will find entering new markets much slower than they would like, especially when there are people on the ground ready to join and buy their products. I think too many companies chase revenue in new countries when demand presents itself, often to the peril of sustainability that they could have enjoyed otherwise.”

Dan Jensen, President of Dan Jensen Consulting:

“Direct selling offers huge opportunities as well as dangerous pitfalls when expanding internationally. Many find themselves in a “money pit” subsidizing poorly performing markets. Lessons learned in my 38 years in direct selling include: 1. Get it right in your home market first. 2. Focus on markets similar to your home market. Different countries and cultures require different approaches. 3. Don’t launch into a new market unless you have the right team of people. 4. Find the best experts to guide you. It won’t be what you know that causes you to fail in a new market. It will be what you don’t know. 5. Only allow competent and loyal leaders to start building in the new market. Amateurs’ downlines often feel abandoned and overwhelm the office staff with questions and complaints. 6. Go slow until you perfect your launch methodology. There are countless tales of tragedy where a company launched aggressively into multiple markets and failed in every one of them. 7. Plan to spend a lot more than you think you will. 8. Look for diamonds in your own backyard first – there’s massive opportunity where you already do business.”

Brent Kugler, Partner at Scheef & Stone, LLP:

“Do your homework and determine which countries are the best expansion possibilities for your company. Many companies have felt the pressure to rush into international markets and later paid a steep price for not fully researching and understanding the business environment and culture of the country they expanded into. Develop a tiered expansion strategy with the initial focus on markets that have the lowest barriers to entry. It is also critical to partner with local resources with experience in advising companies in this industry. What works in one country may not work in another. Preparation and patience are essential to execute a successful international expansion strategy.”

Alan Luce, Senior Managing Partner at Strategic Choice Partners:

“One significant risk for young companies is going international before they have fully developed their home market. We often see this in the US with young companies anxious to go into Canada or Mexico as soon as possible, often when they have just begun to penetrate the potential of the US market. For young US companies it takes a lot more management oversight, legal and regulatory investment and arranging distribution to go into Canada with its 33 million people than it does to get strong market penetration and growth in the state of California with 38 million people. Focus on getting your home market established and building up the staff and management experience that will be needed to go into a new international market. It may not be as satisfying for your ego, but it will be a lot more beneficial for your profit line.”

Nick Mallett, Director at Pan European Solutions:

“Get expert local advice from people who know the industry. Employ senior staff who have a background in the industry from the territory in question and listen carefully to what they say, especially when they disagree with you. By all means set KPIs (Key Performance Indicators) but do not try to micro-manage remotely.”

Bobbie Wasserman Managing Director of Wave2 Alliances: 

“Direct selling companies revel in their international accomplishments – they should.  Going international is exciting – yet at the same time, a complicated, cumbersome process. A key component of succeeding on an international playing field entails having a senior-level communications executive involved in the planning process – right from the start. This can ensure that communications strategies speak to the local sensibility while keeping corporate messaging intact and creating momentum within targeted audiences and the potential distributor base. The Country Communications and Corporate Integration Plan focuses on internal and external corporate needs. External areas can include social media platforms and messaging apps priorities; content development for education and online sharing; influencer and media/blogger outreach; and reputation management. Internally, the plan can revolve around processes that ensure a company remains unified with one corporate culture. Knowing what to say and when to say it is a key formula for maximizing benefit and minimizing risk.”

…

Comment below to share your thoughts on this topic.

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Guest Post by Jeff Babener
Fact-Checking the FTC’s New Legal Guidance

Sir, you are entitled to your own opinion. You are not entitled to your own facts.
Senator/Ambassador Daniel Moynihan

Shifting Sands

In her first post-FTC v. Herbalife settlement presentation, FTC Chairwoman Edith Ramirez argued that it was time to ratchet up regulation of the direct selling industry, and not a time to “put the brakes” on more regulation of the $36 billion industry and its 20 million strong sales force.

It was clear that the FTC and the direct selling industry are on the same wavelength as to a basic goal that the direct selling industry should prosper through effective and ethical practices. But there remains a respectful divergence on methodology. During her well-articulated speech to the October 2016 DSA Policy conference, she enunciated a wish list for new legal standard that would abandon a 40-year-old gold standard, the “Amway Safeguards Rule” and that would also upend and call into question decades of industry accepted business practices.

The Chairwoman argued for:

1. Abandonment of reliance on the Amway Safeguards Rule as a key test for legitimacy.

2. Effectively creating a new legal standard patterned after those requested by the FTC, in the FTC/Herbalife settlement, that, in reality may upend decades of industry accepted practices and rewrite 40 years of court legal standards.

a) The existing Court standard derives from:

(1) Koscot… Compensation to upline should be based on sales to the “ultimate user”.

(2) Amway… A program that enforces the Amway Safeguards of a retailing mandates to qualify for mlm commissions, a 70% rule that prohibits ordering unless product is sold or used and a reasonable buy back policy for inventory for terminating distributors, if effectively enforced and, in conjunction, with avoidance of inventory loading, is indicative of legitimacy. (Also, Amway did not challenge recognition of distributor personal use purchases as legitimate sales to the “ultimate user”.)

(3) BurnLounge… The primary motivation for distributor purchases should be the purchase of product in reasonable amounts for resale or use as opposed to mere qualification in the program for rewards. A pyramid analysis will be “fact driven”.

b) On the FTC wish list for a new paradigm for legitimacy is:

(1) Abandonment of the reliance on the “Amway standard”.

(2) Redefining Koscot to require compensation to upline to be based on sales to the “non-participant retail customer” rather than the “ultimate user”.

(3) Adopting a FTC/Herbalife settlement “punch list” of mandates in lieu of the factual analysis of “primary motivation”, called for in BurnLounge, including:

a. Only one third MLM compensation to upline should come from personal use by downline distributors, whether or not such purchases are reasonable in quantity for use by the distributor “ultimate user”.
b. Autoship to distributors should be prohibited.
c. Monthly activity volume requirements may not include any purchases by distributors.
d. Tracking of performance activity connected to wholesale purchasing should be banned.

Query, are the premises for justifying the new FTC enforcement position well founded?

Although reasonable minds may differ, history does not necessarily support the Chairwoman’s position. Does it matter? Probably. Why? When a new proposed enforcement policy may so profoundly impact the business and legal landscape, it is worth visiting the issue. Although the “black and white” terms may have been quite acceptable to Herbalife in its own factual circumstances, those stringent mandates are at odds with how the mainstream direct selling industry has operated for many decades and may prove quite disruptive.

At a minimum, the threat of FTC prosecution, pursuant to the new suggested paradigm, has caused major uncertainty in the direct selling community… with attendant options of “fight”, “capitulate” or “find common ground”.

Abandoning Amway

In abandoning support for the Amway Safeguards Standard, Chairwoman Ramirez stated as a premise:

“I want to note that, although this is less common today, in the past some MLMs have sought to rely on policies similar to those referenced in the Commission’s 1979 Amway decision – specifically, the so-called “buy-back,” “70 percent,” and “10 customer” rules – as a sufficient basis for assuming that their product is purchased by real customers to satisfy genuine demand. This reliance is misplaced. The Commission found those policies were effective given the specific facts in Amway, but neither the Commission nor the courts have ever endorsed those policies for the MLM industry at large.”

FTC: Industry reliance on the Amway Safeguards standard is misplaced in that it is not such an important legal precedent to the courts.

Well, this is not quite accurate. Actually, Amway has been an integral part of a “gold standard legal analysis” for 40 years in most leading cases right up to, and including, the most recent case, U.S. Court of Appeals for the Ninth Circuit ruling, FTC v. BurnLounge, Inc., 753 F.3d 878 (9th Cir. 2014).

BurnLounge is typical of reliance on the Amway standard by courts in leading decisions. It is part of a fabric of decisions, such as Koscot, that contribute to the analysis, with the understanding that application of the Amway analysis was fact driven and, important, but not determinative, of the final conclusion.

For instance, the Omnitrition court noted that, in the presence of inventory loading, adherence to the Amway Safeguards did not guarantee “safety”. Similarly, where the evidence was that distributor purchases were primarily motivated by desire to qualify in the plan, no safety existed (BurnLounge). Or where there was no encouragement to mandate retail sales or promote retail sales, safety disappeared (Amway). And if a company failed to enforce the Amway Safeguards standard or fell short of its implementation, no safety existed.

But, nevertheless, courts embraced the Amway Safeguards standard and relied on it, along with the original Koscot mandate that compensation must be tied to sales to the “ultimate consumer” as a base starting point in pyramid cases. And whether or not the FTC future prosecutions move away from pyramid bases to mere allegations of “unfair practices that are likely to cause injury to the public”, it is difficult to imagine courts not returning to fifty years of pyramid case analysis when faced with prosecution of a direct selling company.

In actuality, the BurnLounge court cites Amway multiple times. Here, in the BurnLounge decision, the Court indicates that the Amway precedent is alive and well in current court analysis:

“In contrast, in Amway the FTC found that a MLM business was not an illegal pyramid scheme. In re Amway, 93 F.T.C. at 716-17. Though Amway created incentives for recruitment by requiring participants to purchase inventory from their recruiters, it had rules it effectively enforced that discouraged recruiters from “pushing unrealistically large amounts of inventory onto” recruits. Id. At 716. BurnLounge argues that “the only difference between Amway and BurnLounge is that BurnLounge did not require inventory purchases.” This argument is unpersuasive because BurnLounge required Moguls to purchase a product package to get the chance to earn cash rewards, provided cash rewards for the sale of packages by a Mogul’s recruits, and had no rules promoting retail sales over recruitment.”

And similar analysis and respectful reference to the Amway is to be found, over four decades of legal rulings, cited sometimes in passing, and also frequently in depth, in more than two dozen reported cases.

Creating a New Legitimacy Paradigm

FTC: The Settlement terms in FTC/Herbalife represent a more appropriate approach for the analysis of legitimacy:

Among those terms:

Only one third MLM compensation to upline should come from personal use by downline distributors, whether or not such purchases are reasonable in quantity for use by the distributor “ultimate user”.

In her presentation, notwithstanding almost 50 years of Koscot reference to “ultimate user”, the Chairwoman argues that “ultimate user” must be defined as a “real customer”, and that a “real customer” only “fits the bill” if that customer is a non-participant retail customer. This description represents a “sea change” in what is an “ultimate user”, defies codified recognition of “personal use” in more than a dozen states and goes begging for support in a long lineage of case law.

And the one case cited by the Chairwoman to demote legitimacy of personal use, Omnitrition, was actually a case that highlighted the major abuse of Omnitrition International, in failing the Amway standard, by requiring distributors to engage in “inventory loading”, buying “exorbitant amounts of products” and “thousands of dollars of products” in order to qualify for commissions in the program. Although a reference, in passing, is made to the effect that personal use alone may not satisfy sales to the “ultimate user”, no language in Omnitrition suggests or justifies devaluing “personal use” by two-thirds. Again, the gravamen of abuse in the case was promotion of inventory loading to qualify for commissions, and not “personal use”.

Other than the passing reference in Omnitrition, no court case has ever challenged the “giving of credit” for “personal use in reasonable amounts” as voiding the transaction as a sale to an ultimate user, let alone, limited such credit as drastically as the FTC suggests should be considered as the legal standard. It is true that courts have condemned inventory loading and have examined for factual evidence that purchases were for “qualification” rather than reasonable use. But they have not rendered personal use purchases “second class citizens” in the world of direct selling. In fact, as noted, more than a dozen states have codified the recognition of personal use purchases as legitimate end destination ultimate user purchases, which are due full credit.

The FTC is effectively proposing to reverse the presumption that one buys product to be used, until shown otherwise, into a presumption that if a distributor buys a product, the presumption is that the purchase is for nefarious qualification purposes of recruitment such that the purchase does not deserve full credit in the sales process.

The FTC is seeking to achieve by “guidance” what it could not get a court to accept in BurnLounge. In the BurnLounge appeal, the FTC argued against validation of personal use purchases. However, the FTC position was rejected by the U.S. Court of Appeals for the Ninth Circuit in BurnLounge as, “The FTC counters that “internal sales to other Moguls cannot be sales to ultimate users consistent with Koscot.” Neither of these arguments are supported by the case law.” (page 18 of opinion)

And this “scarlet letter” on personal use, is contrary to the FTC’s own position in its 2004 Advisory Opinion:

Internal Consumption

Much has been made of the personal, or internal, consumption issue in recent years. 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 paid to all participants 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.

It is important to distinguish an illegal pyramid scheme from a legitimate buyers club. A buyers club confers the right to purchase goods and services at a discount. If a buyers club is organized as a multi-level reward system, the purchase of goods and services by one’s downline could defray the cost of one’s own purchases (i.e., the greater the downline purchases, the greater the volume discounts that the club receives from its suppliers, the greater the discount that can be apportioned to participants through the multi-level system). The purchase of goods and services within such a system can, therefore, be distinguished from a pyramid scheme on two grounds. First, purchases by the club’s members can actually reduce costs for everyone (the goal of the club in the first place). Second, the purchase of goods and services is not merely incidental to the right to participate in a money-making venture, but rather the very reason participants join the program. Therefore, the plan does not simply transfer money from winners to losers, leaving the majority of participants with financial losses.

And even the FTC’s primary expert economist in many of its pyramid prosecutions, including BurnLounge, Dr. Peter Vander Nat, has shrugged off the need to “penalize” or automatically stigmatize a personal purchase sale. Below is an excerpt from Dr. Vander Nat’s deposition in the BurnLounge case:

Vander Nat BurnLounge deposition on issue of internal consumption (November 12, 2008):

218-219

Q. Under the heading internal consumption, the second sentence:  “In fact the amount of internal consumption in any multilevel compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme.”  Do you agree with that sentence?   

 A. I think so. Yes. I think that that is consistent with what I said this morning on this point.     

 Q. What if the sentence read a little differently? What if the sentence read the amount of internal consumption in any multilevel compensation business is not a factor in the analysis of the FTC’s determination of whether or not a plan is a pyramid? Would you still agree with the sentence?     

 A. I think I would. I said this morning, when I think back on this testimony, that I expect there to be internal consumption in the organization and the fact that it’s there is itself not determinative one way or another. I think I said that

 220

Q. And that is the sales that you consider in your analysis. And you exclude from that sales within the distribution network.     

 A. I said I exclude from it those purchases that people are required to make in order to enter the business opportunity. That’s exactly what I said about it.      

 Q. And isn’t that at least some of what internal consumption is?

 A. No. I don’t think that that’s what’s being referred to here. I mean, normally when you’re talking about internal consumption, if you just use the word generally, it means people wanting to use the product for their own use just because they like the product. I mean, that’s normally what the phrase refers to. And I simply made this other qualifier about it.  Whatever you are required to purchase of consumable goods in order to enter the business opportunity, I count that as part of your business investment because you’re required to buy it as part of the investment

 228

 Q. Do you have any opinion as to a percentage of sales within a distribution network of a company that would not make it more likely that there be a finding of pyramid?

 A. No.  As I’ve said, internal consumption doesn’t count one way or another with me. I’ve given all the factors that I use. Internal consumption is itself not one of the factors.

And notwithstanding his declarations in many FTC pyramid prosecutions that “retail sales” are the dividing line, Dr. Vander Nat cuts to the chase in his BurnLounge deposition that, in fact, the acid test is whether or not distributors are making payments as a gateway to the business opportunity, i.e. purchases incidental to the business opportunity. In this regard, he is on the same wavelength as both the case law, 2004 FTC Advisory opinion and the position of the direct selling industry.

Page 130 of the Vander Nat BurnLounge deposition:

I believe in the Mogul program people are buying the product for the sake of a business opportunity. That’s why they’re buying it.  So the VIP package has a certain business value which is distinct from the exclusive package as a business value which is again distinguished from the basic package as a business value. I am basing the analysis on this basic premise in the Mogul program people are buying into a business opportunity. They’re paying what in essence is a business investment for them.  The fact that it has some consumable items in it, that may be beneficial to them, but they’re buying it for the sake of the business opportunity.Therefore the issue of whether they’re harmed is for me they went into a business in the hopes of making money but in fact they have a business loss.  So for me the business loss is the harm.

The Other New Legitimacy Rules on the FTC Horizon

How do those other new mandates, that upend decades of industry practice, fit into the legal landscape:

* Autoship to distributors should be prohibited.
* Monthly activity volume requirements may not include any purchases by distributors.
* Tracking of performance activity connected to wholesale purchasing should be banned.

Actually, in 50 years of case authority on pyramid schemes, the courts have condemned inventory loading, earnings misrepresentations, lack of incentives on retailing, absence of return policies, programs that inadequately enforce the Amway Rules or pay out rewards on sales to those who are not what Koscot referenced as “ultimate users”.

But in the presence of adequate safeguards under Koscot, Amway or BurnLounge, no court has insisted on the type of restrictions called for by the FTC. If the FTC has the muscle to impose such marketing prohibitions, it will likely be due to “extra judicial” factors rather than reliance on the existing legal standards of 50 years of case authority.

The FTC will also need to buck an opposite trend in more than a dozen states and a proposed congressional action, H.R.5230, a bi-partisan anti-pyramid bill to codify recognition of personal use purchases and establish legitimacy standards acceptable to the direct selling industry. The bill is sponsored by Marcia Blackburn, member of the Presidential-Elect Transition Team and other bi-partisan sponsors in a post 2016 election environment that is decidedly “anti-regulatory”, where one incoming cabinet member is a family owner of Amway, where a President-Elect was formerly the branded spokesperson for multiple direct selling companies and where one prominent congressional committee chair was a previously 10-year employee of a leading direct selling company.

And so, the question: Ratchet up the regulation or ratchet down the regulation? Only time will tell. Better yet… this is a good time for the FTC and direct selling industry to find common ground and workable rules that will allow the industry to prosper in an effective and ethical manner.

…..

Please click here to read FTC Chairwoman’s speech at the US Direct Selling Association’s Business & Policy Conference.

The post Fact-Checking the FTC’s New Legal Guidance appeared first on The World of Direct Selling.

Jeffrey A. Babener’s this article follows on his well-received piece, FTC v. Herbalife Settlement: First Take.

Guest Post by Jeff Babener
FTC v. Herbalife: Post-Settlement Legal Guidance for the Direct Selling Industry

If you don’t know where you are going, it’s going to take a lot longer to get there…
Yogi Berra (paraphrase)

Well, post-FTC v. Herbalife, no one is sure exactly where we are going or where we will end up …

The July, 2016 settlement between the FTC and Herbalife is likely to have a profound impact on the direct selling industry. But, what that impact will be is uncertain. Markets do not like uncertainty.

For 40 years, the FTC sought to mold the direct selling industry to its will through litigation, but ironically, the most significant structural changes to the direct selling model will not be achieved by litigation, but rather through a current political and economic climate that may give the FTC far more leverage to force its will.

In 1979, the FTC lost its bid to have the Amway multilevel marketing model ruled to be a pyramid. In 2014, the 9^th Circuit U.S. Court of Appeals, in BurnLounge, rejected the emerging FTC position that personal use should be granted no credit in determining qualifying volume for compensation in a direct selling program.

And, from 1979 to 2004, the FTC settled into an enforcement policy that focused on “adequate disclosure” to recruits rather than “structural change” in company models. In fact, in a 2004 Advisory Opinion, the FTC even gave its tacit blessing to the concept of an MLM wholesale buying club, as well as personal use by distributors, so long as it was for the primary reason of using the product as opposed to merely qualifying in the marketing program. (Its 2004 opinion was silent as to many restrictions that it imposed in 2016, charting a new course in the FTC v. Herbalife settlement.)

But times change and FTC commission members and staff change… and today are a reflection of a much more robust and aggressive regulatory climate that comes with a change in the order of the Executive Branch of government. Aggressive regulation has not merely been limited to the direct selling industry. To be fair, the FTC response is also a response to a wave of overt pyramid schemes that have swept the U.S. and the world in recent years.



Over the next decade, FTC stated positions on retailing and personal use became clear that a more aggressive posture was emerging at the FTC. And the culmination of that evolution was reached in the FTC v. Herbalife settlement, with significant restrictions (although workable for Herbalife), if applied to the industry across the board, would change the way direct selling companies have operated for 50 years … no more autoship, no compensation tied to wholesale product movement, sales volume credit for personal use almost eliminated, reduced by two-thirds, and no more monthly volume qualifications, unless based totally on nonparticipant purchases.  And the FTC announced that it intended to issue its guidance for the industry, and it is fair to assume that its intention is to apply those standards to other direct selling companies, perhaps through investigations and enforcement actions.

In its Herbalife press release, the FTC noted:

We are pleased that this order will require Herbalife to base rewards on tracked and verified retail sales and recommend that all multi-level marketing companies likewise take sufficient steps to ensure their practices are not unfair, false, or misleading.

For its part, Herbalife indicated that it was comfortable with the new restrictions, as it had, in fact, tracked the demographics of its members and found that the vast majority actually joined Herbalife to become discount buyers. In the end, it would be a matter of reclassification.

Said Herbalife in its own press release:

We would not have settled unless we had the greatest confidence in our ability to comply with the agreement and grow our business and we believe this will be proven out over time.

As to many other direct selling companies, the answer is not as clear. It has long been accepted that distributor personal use, tracking based on wholesale sales, autoship, and monthly sales volume qualification requirements, are important components of direct selling marketing programs particularly consumables companies of health care, personal care and home care products. The industry is bewildered that business practices that survived, and were perfectly acceptable, for 40 years of case authority, may be upended by fiat… i.e., a change in policy position of a newly energized FTC.  As a result, many are nervous and speculate whether or not the industry trade association will contest the FTC’s potential impending restrictions for the industry. In fact, within 30 days of the settlement, rather than take exception to the FTC change of policy and defend personal use, the DSA signaled that companies may need to prepare to “get in line” and use technology to demonstrate compliance with the FTC demands on retailing data. (See August 4, 2016 DSA statement below.) Was this an early capitulation?  It is too soon to tell.

To some extent the industry is caught off balance because, although it achieved some favorable state legislation on personal use post the 1996 Omnitrition decision that discussed personal use, it really dropped the ball, for 20 years, on this issue at the federal level… and now, in today’s political climate, it is likely too late to achieve relief for the industry from zealous regulation.

What is at Stake After FTC v. Herbalife?

That which does not kill us, makes us stronger. 
Friedrich Nietzsche

For the industry, what, in the apparent new FTC standards is livable, what is doable, and what will turn it upside down?

Doable for the Industry

1. Requiring reps to track sales to nonparticipant retail customer and/or ultimate users. This makes sense.

2. Avoiding earnings or potential “lifestyle achievement” hype. This makes sense. Forget the Ferraris and mansions images… they are not a reasonable expectation.

3. Simplifying earnings disclosures. This is all workable. The actual problem is a consequence of “no good deed goes unpunished.” In an effort to provide transparency of the earnings opportunity, companies developed detailed earnings disclosures. Argued the FTC in its Herbalife complaint, complex earnings disclosures have the reverse effect of obfuscating the chance to succeed in the opportunity. It asked for simpler or clearer disclosures. And so, perhaps the industry should return to the original simplified approach reached in the original earnings disclosure disputes between Amway and the FTC, and between Amway and the state of Wisconsin:

a. What percentage of distributors who have signed up are active, i.e., earning any income?

b. Of those that are active, what is the average earnings?

c. If any example, testimonial or illustration of a particular income, bonus or lifestyle award is presented, what percentage of active
distributors earn at least that amount or above?

4. Capping the monthly amount of allowed purchases for personal or family use to avoid inventory loading. The industry can live with this. Perhaps a ramping up amount depending on previous production or tenure.

Problematic for the Industry:  Upending Decades of Industry Model

1. No longer track and tie upline compensation to wholesale purchases of downline distributors… i.e., upline compensation limited to verified nonparticipant retail sales plus allowable (one-third) distributor personal/family use purchases.

2. A requirement that only one-third of distributor purchases for personal or family use may be credited for computing sales volume for commission purposes. (And that total compensation paid should somehow be restricted if the company does not achieve 80% of sales, comprised of nonparticipant sales and allowable personal use credit of one-third of purchases.) Even at its peak of aggressiveness prior to the Herbalife settlement (other than some “fencing in” orders specific to companies involved in isolated litigation) the FTC only called for a standard that 50% of sales be made to nonparticipants.

3. Prohibition on a mainstay of the industry, distributor autoship. Autoship programs, which allow orderly distributor product purchasing, via monthly “standing orders,” are prohibited. (Nearly all direct selling companies have employed “standing order” options for decades and “standing order” programs are commonplace in both the commercial and retail sectors.)

4. No minimum activity requirements, except for sales to retail customers. Distributor fulfillment of minimum personal sales volume requirements are prohibited, or must be fulfilled by sales to nonparticipants… again, excluding credit for personal/family use consumption.

5. Total company commission payments are limited, in the absence of demonstration of 80% sales to the combination of nonparticipants and allowable limits (one-third) of distributor personal consumption purchases.

 Where Is This All Going?

Kevin Lomax: Are we negotiating?
John Milton: Always.
…The Devil’s Advocate

Importantly, this settlement is not case precedent, it is not an FTC rule, it is not a statute and it is not even consistent with case authority or previous FTC public positions on legal standards for pyramid. It is the beginning of a negotiation. It is the beginning of a dance. It is power politics. But, realistically, one thing is quite clear, direct selling companies should expect a much more aggressive FTC going forward.

Will the FTC enact a new MLM rule or amend its Business Opportunity Rule? Historically, this has been a long drawn out process. The last amendment to the Business Opportunity Rule involved six years of comments and hearings, from 2006 to 2012. This approach does not seem likely.

It seems more likely that the FTC will update its 2004 Advisory Opinion, or issue a public statement, to provide its guidance on what it believes is and is not acceptable in the direct selling model, and will initiate separate “strike” enforcement actions to send a message to the industry. Obviously, there will be dialogue with the industry, but the ability to initiate enforcement actions gives the FTC a powerful leverage against publicly traded MLMs whose market position can be so dramatically affected by an enforcement action, and against smaller MLMs that can ill-afford the risk of preliminary injunction, long-term “cloud of uncertainty” over their heads or the immense legal costs of defense.



Long Story Short: Prepare for Uncertainty and Risk

As noted earlier by this author*, it is a reasonable hypothesis that the Herbalife settlement, in the short term, will not change the business model of other leading companies, without further regulatory or legislative action, but it clearly creates regulatory uncertainty for all companies. And, it certainly will be timely for all direct selling companies to discuss a preferred customer program, retailing mandates and product tracking to ultimate users.

Guidance for Direct Selling Companies

In light of the FTC v. Herbalife decision and the FTC’s aggressive posture, what are companies to do?

Of course, much depends on whether the industry trade organization, the DSA, undertakes active resistance to the gutting of 50 years industry practices, or whether it capitulates.

The ultimate equilibrium will likely be somewhere between existing practices and the FTC desired restrictive practices.

In the absence of actual new case law or legislation, but rather the threat of FTC Guidance and selective enforcement, there are policy-risk decisions to be made by each company.

Companies looking for an insurance policy against enforcement action will consider a parallel adoption of the Herbalife restrictions. This would be the most conservative reaction to the FTC v. Herbalife settlement. It virtually guarantees against federal and state actions. If a company can live with these restrictions, it will make a policy decision to adopt them.

However, this may mean a wholesale change of the business model of almost all direct selling companies, particularly if they go so far as to eliminate tracking of compensation on wholesale movement of product, eliminate autoship for distributors, severely limit credit for personal use purchases of distributors and eliminate monthly activity sales volume requirements unless totally based on sales to nonparticipants.

The More Likely Scenario… The Watchful Waiting Approach

An interim conservative, but businesslike approach, akin to a modern medical therapeutic strategy, Watchful Waiting. It is likely that most companies will take this approach.

And for those companies that take the watchful waiting approach … What to do? Until there is more clarity, direct selling companies should, at the very least, take affirmative steps to avoid being a target of enforcement actions. In the absence of wholesale adoption of the Herbalife restrictions, at a minimum, companies should focus on the following actions that clearly promote anti-pyramid practices.

1. Bulletproof yourself on earnings claims. Don’t be the nail that sticks up and gets hammered down.

Avoid earnings hype in advertising, testimonials and lifestyle presentations. Scuttle the Maserati and the Tuscan villa images. Be realistic … this is the anomaly and not the norm. Take the bullseye off your forehead. In almost every FTC case, the first invitation to regulators are unrealistic earnings claims. The hype “opens” the door or lifts the canopy of the tent. And, as they say, “once the camel has his nose in the tent, you can be assured that his ‘body’ will soon follow,”

In other words, don’t be the low lying fruit. Don’t effectively, and unintentionally, “bait” the FTC to initiate an enforcement action, as Vemma is accused, by over-aggressive hype and promises.  

Absolutely do not make claims of wealth, fast wealth, easy money or sure-fire systems, nor effectively invite the FTC to inquire into a program based on earnings hype and systems based on distributor “purchasing” rather than distributor “selling” and “using.”

And, less important, and quite optional, consider simplifying those earnings disclosures to avoid the FTC accusation against Herbalife that an overly detailed earnings disclosure results in confusion and obfuscation:

a. What percentage of distributors who have signed up are active, i.e., earning any income?

b. Of those that are active, what is the average earnings?

c. If any example, testimonial or illustration of a particular income, bonus or lifestyle award is presented, what percentage of active distributors earn at least that amount or above?

Actually, the FTC criticism does not make much sense, so this suggestion is worthy of serious thought. If it is a coin flip, then it is respectfully suggested to leave the robust earnings disclosures intact.

Irrespective of the depth of the earnings disclosure, do not ever play fast and loose with earnings disclosures, nor “parse” to exaggerate the opportunity.

2. Adopt, follow and enforce the Amway safeguards.

The Amway safeguards have been the gold standard and been honored in case after case going on 40 years. Although the FTC may wish to pivot away from the Amway safeguards, the courts have not done so.

a. 70% rule to avoid inventory loading… no ordering unless 70% of previous orders have been sold or used for personal/family use. Place lids on initial orders and allow a ramp up of size of order over time. Never mandate monthly autoship to qualify for commissions.

And avoid front-loading. In the famous Omnitrition case, the court noted that the Amway safeguards are rendered ineffectual as a defense to pyramiding if a company encourages or allows front-loading of product because it becomes clear that commissions are not related to sales to ultimate users when distributors are incentivized to buy huge amounts of inventory that are out of proportion to needs for resale or the needs of personal and family use.

b. Adopt and enforce an actual nonparticipant retail sales mandate to qualify to receive commissions. Over the years, that number has been expressed in numbers from five to ten or in sales volume … often with an allowable ramp up over time.

c. Honor a buyback policy on inventory and sales support materials for terminating distributors…no less than 90% for 12 months.

3. Track, track, track… flow of product to and use by the ultimate user.

After FTC v. Herbalife, few priorities are as important as tracking and verifying the flow of product to and use by the ultimate user, whether it be nonparticipant retail customer or distributor for personal/family use. Although the FTC may wish to assert that the legal standard requires tracking to the nonparticipant retail customer, that assertion does not accurately state the case law in Koscot or BurnLounge, which speak in terms of compensation related to the sale of product to the ultimate user. The short answer: Track the flow and use of product to both nonparticipant retail customers and to distributor personal/family use. If the FTC is desirous of a new legal standard, it will not achieve it by merely stating its position, but rather through case law, federal legislation or federal rule adoption. It is also worthy to note that more than a dozen states have adopted legislation recognizing personal use.

Either way, the time to start tracking is “yesterday.”

In its August 3, 2016 Earnings Call, Herbalife gave a good explanation of what it is doing to fulfill its tracking responsibilities… and it is instructive to other companies:

The second important element is that the distributor compensation will now be paid based on their sales to customers along with an allowable level of personal consumption.

Distinguishing customers from business-building distributors simply make sense. It is something our Management and our member leaders have been contemplating for a while because we know that it will allow us to better tailor our products, training and services to meet the distinct needs of each of these groups. The second important element is that the distributor compensation will now be paid based on their sales to customers along with an allowable level of personal consumption.

We are already developing apps and tools to help our distributors track their customers’ activities and submit their customer sales receipts. These new capabilities to record and track sales data will provide valuable customer information that will provide better support to our members and we believe it will help our distributors build an even stronger business and enhance their understanding of their customers to a level similar or even better than consumer packaged goods companies.

Similarly, DSA President, Joe Mariano, in his August 4, 2016 public statement, implored companies to start using “Big Data” technology to track the flow of product:

Advances in technology and greater access to data give us the tools to monitor the market and ensure that the selling and buying experience we provide is of the highest quality. We have traditionally — and understandably — been closer to our consultants than to the ultimate consumer. But one of the greatest challenges I have in representing direct selling to various interested parties is explaining why we do not know our customers as well as we should. Analysts do not understand how we cannot be more in touch with our consumers, and regulators (and critics of the channel) cannot be convinced of the legitimacy of our model if we are unable to tell them with certainty who the people are who are using our products.

But now we have the opportunity to harness Big Data and the latest digital technology to become expert on who the people are who keep our companies afloat, what they want and how we can better serve them. The bonus here is that this will not only eliminate one of the biggest criticisms we face, it will help us win long term in the marketplace.

We should also recognize and define personal use of our products in new and accurate ways. Let’s use technology and data to demonstrate that consumers of all types — distributors and non-salespeople — are freely and legitimately using our products.

4. Irrespective of the ultimate legal standard, embrace and comply fully with the current case law legal standard from Koscot and BurnLounge.

Irrespective of what the FTC might call the legal standard, the courts, in addition to embracing the Amway safeguards, and the legal standards set forth in Koscot and BurnLounge, companies should be able to document that:

a. product makes its way on to “ultimate users” and is used.

b. compensation relates to such sales to ultimate users.

c. that distributor purchases are not incidental to the opportunity, i.e., that the primary motivation of distributor purchases is an actual need for personal use or resale as opposed to qualifying in the marketing plan.

Of course, this is the actual existing legal standard arising from Koscot and BurnLounge. But, it is not the direction of the FTC, which would argue that the great majority of product, and compensation attached, must be tracked to sales to nonparticipant retail customers. [In the case of Herbalife, compensation is to be based on sales to nonparticipant retail customers plus an allowable percentage (one-third) of sales to downline distributors for personal/family use.] The FTC may force companies to adhere to its “percentages” approach by way of enforcement actions, but the result will be achieved by “clout” rather than actual court decision. Whether or not companies can withstand the power of an FTC enforcement action is another story.

5. Emphasize sales, not recruitment.

Marketing emphasis should always be on product first, and opportunity second. The emphasis should be on sale of product for actual use and not on recruiting others to buy who recruit others to buy, etc., merely to qualify in the compensation plan.

6. Don’t target vulnerable groups.

In the aftermath of Vemma, which criticized targeting of young college students, with promises of riches, do not boldly target demographic markets that the FTC might view as vulnerable to hype and abuse. Such groups may be young people or poor populations.

Take a Deep Breath…

As Yogi said, “it’s not over ‘til it’s over.”

This is a journey and is the next chapter in the legal environment of direct selling.  And it will take a long time to unfold. Should direct selling companies turn their programs upside down in response to FTC v. Herbalife? Probably not. Will they? Probably not. Are changes coming? Absolutely. The dialogue begins.

* This article follows on the author’s article, FTC v. Herbalife Settlement: First Take

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The post FTC v. Herbalife: Post-Settlement Legal Guidance for the Direct Selling Industry appeared first on The World of Direct Selling.

For more than 25 years, he has advised leading U.S. and foreign companies in the direct selling industry, including many members of the Direct Selling Association. He has served as legal advisor to various NYSE direct selling companies, including Avon, Herbalife, USANA, and Nu Skin. Jeff has lectured and published extensively on direct selling. He is a graduate of the University of Southern California Law School. Jeff is an active member of the State Bars of California and Oregon.

Guest Post by Jeff Babener
FTC v. Herbalife Settlement: First Take

Is there a proper blessing for the Czar?

Of course. May God bless and keep the Czar…  far away from us.

Fiddler on the Roof

A Settlement is Reached

On July 14, 2016, the FTC and Herbalife concluded a multiyear investigation with a Stipulated Settlement that both, brought the investigation to a close, and delineated a going forward set of rules by which Herbalife would conduct its direct selling business. Given the fact that Herbalife is one of the largest global direct selling companies, the direct selling industry is quite focused on the meaning of the settlement to the industry, both short-term and long-term. And given the immense power of the FTC, the direct selling industry will wonder how much regulation it can withstand before it suffers irreparable harm.

Executive Summary

1. Herbalife indicates a satisfactory result, and that it is comfortable that it can live and thrive with agreed restrictions.

2. The settlement is not legal precedent beyond Herbalife, nor binding on other direct selling companies.

3. Forward Looking: The FTC will likely argue, in the future, that the Herbalife restrictions should be viewed as a new legal standard and guidance for the direct selling industry. In the absence of significant resistance by direct selling companies, the direct selling industry, the Direct Selling Association and clarifying federal legislation, the possible onerous legal standards, that may be urged by the FTC, will be very damaging to the business of direct selling companies … and, another example of over regulation of small business, to the detriment of the $36 billion dollar industry and its 20 million entrepreneurial participants.



 A Settlement Unique to the Facts and Parties

On its surface, the FTC/Herbalife settlement is an agreement, restrictions and all, unique to the parties’ negotiations.

1. This was a negotiation between equally sophisticated and strong parties, best characterized as serious “horse trading.”

2. Although there was a $200 million fine,  Herbalife stock  rose by  nearly  $1 billion the same day, the fine represented a mere two weeks of global sales … and a longstanding major hedge fund short challenge, which depended on an FTC shutdown scenario, appeared to be seriously impaired, certainly short-term, and possibly long-term.

3. Both sides could claim victory. To Herbalife’s benefit, the FTC specifically omitted an allegation of pyramid in its press release, press conference, complaint and settlement document. However, the language of the “unanswered” Complaint (including a litany of accusations of earnings misrepresentations, paucity of positive earners, challenges to viability of the stand-alone opportunity, questioning of the “real world” market for product and other deceptive practices, etc.) and permanent restrictions of the settlement, allowed it to claim a major accomplishment. Obviously, Herbalife disputed the myriad of allegations, but was ready to move on. The corollary of the FTC “chest thumping” was that Herbalife could claim vindication and strength in the settlement, and that any “model” restrictions in the Stipulated Order were clearly in its comfort zone, and are only applicable to the U.S. market, which accounts for only 20% of global sales.

4. The FTC noted that it was spared, possibly, years of litigation, and likewise, Herbalife was spared the unknown risk of a preliminary injunction request or a long-term litigation “cloud” that could dramatically impact its business and stock value.

The Settlement is Not Legal Precedent

Most importantly, this settlement is not case precedent, it is not an FTC rule, it is not a statute and it is not even consistent with case authority or previous FTC public positions on legal standards for pyramid.

Although the Settlement focused on restrictions for compensation plan credit for personal use by distributors, no statute or adjudicated case has called out specific percentages of “retail mandates” or “restrictions on credit for personal use” as a specific element of pyramid case analysis. The leading case, Koscot, stated the legal pyramid standard as a requirement that commissions be based on sales to ultimate users. In the  most recent legal precedent in BurnLounge, the court affirmed the Koscot rule and went on to state that pyramid cases are decided by a fact-based analysis of whether or not purchases by distributors are merely incidental to the business opportunity, or otherwise stated ” is the primary motivation for distributor purchases a need for the product for resale or personal use exhibited by purchases in reasonable amounts, or is the primary motivation to qualify in the opportunity for rewards and recruit others to do the same.”

More than a dozen states have explicitly recognized that distributor purchases in reasonable amounts should be recognized as sales to ultimate users. Even in its most aggressive posturing in litigation, where it has asserted that 50% of sales should come from nonparticipants, the FTC has never suggested that credit for distributor purchases should be limited to one-third of purchases, i.e., that nonparticipant sales must be 67%. In fact, in its 2004 Advisory Opinion, the FTC recognized the validity of personal use and even suggested the potential merit of an MLM buying club concept.

The direct selling industry, for 50 years, has tracked compensation on wholesale movement of product, with the assumption (accompanied by consumer safeguards such as anti-inventory loading rules, buyback policies, retailing mandates) that product is either resold or consumed by personal or family use. If it doesn’t fit one of these categories, longstanding industry practices provide that it is subject to refund for 12 months after purchase.  However, implicit in the FTC’s approach in the Herbalife settlement is that the decades old approach of tracking commissions, based on wholesale movement of product, should be revisited and even rejected. No court decision, statute or regulation has ever challenged this standard industry practice.  Rather, the going forward preference of the FTC may be that compensation should be tracked to sales to nonparticipants or limited personal use purchases. This “turnabout” would represent a wholesale change throughout the direct selling industry.  Hopefully, the chasm between these two positions can be bridged in coming years.

There is another good reason to be skeptical that the FTC’s position in a negotiated settlement is the “new gospel” of direct selling. In its 2004 Advisory Opinion, the FTC stated that it has a regular practice of overreaching and “fencing in orders” in such situations:

With regard to your second question, the Federal Trade Commission often enters into consent orders with individuals and companies that the Commission has determined have violated the FTC Act. To protect the public from those who have demonstrated unwillingness to follow the law, these orders often contain provisions that place extra constraints upon a wrongdoer that do not apply to the general public. These ‘fencing-in’ provisions only apply to the defendant signing the order and anyone with whom the defendant is acting in concert. They do not represent the general state of the law.

Forward Looking…  Searching for New Paradigms in Direct Selling

Because Herbalife had undertaken analysis to support its public assertion that more than 70% of its members join to be discount purchasers, as opposed to pursuing the MLM opportunity, the company appeared receptive to go forward redefining such individuals as nonparticipant retail customers and accept a rule that limited credit for distributor personal use at one-third of purchases, or that the majority of overall company sales should be to nonparticipants. In other words, it was “comfortable in its own shoes.”

Only time and data, following adoption of a preferred customer classification, will demonstrate the validity and accuracy of the Herbalife analysis of primary “motivation” as a desire to purchase at discount. Herbalife will have the opportunity to seek to convert discount buying motivated distributors to the status of preferred customers, but it will be the decision of the distributor. In public communication, Herbalife has been clear that it is confident of its position that the majority of its members have joined for “discount buying” status.

As to its comfort level, said Herbalife Executive Vice President, Global Corporate Affairs, Alan Hoffman, in a July 20, 2016 Business Wire press release:

After more than two years of working with the FTC, I think we understand the terms of the settlement agreement very well. We would not have settled unless we had the greatest confidence in our ability to comply with the agreement and grow our business and we believe this will be proven out over time.

Obviously, many direct selling companies will not feel comfortable with the FTC position of disqualifying substantial personal use purchases for purposes of determining compensable sales volume. Whether or not other companies, if forced, can live with an increasing nonparticipant retailing mandate is an open question. And, when and how far the FTC will pursue their new approach is also an open question. And, what legislative relief industry organizations, such as the Direct Selling Association, will pursue is also an open question.

As to several settlement “model” requirements, they seem “in keeping” with the direction of both industry and regulatory trends to reexamine and fine tune company models:

1. Requiring reps to track sales to nonparticipant retail customer/ultimate users.

2. Avoiding earnings or potential “lifestyle achievement” hype.

3. Taking care to monitor that participants (nutrition clubs in the case of Herbalife) do not make losing investments.

4. Revisiting the extent and use of autoship to avoid inventory loading.

5. Capping the monthly amount of allowed purchases for personal or family use to avoid inventory loading.

The Gathering Storm for the Industry

Obviously, the industry applauded an amicable resolution for one of its leaders, Herbalife. Although Herbalife was comfortable with operating under new marketing rules, several of the rules, if applied to other companies, would be extremely onerous and challenging to their business and to models that have been successful in the marketplace for 50 years, and will view the restrictions as another example of government micromanagement of the small business sector that has, in fact, responsibly self-regulated, voluntarily, and already adopted wide-ranging consumer safeguard “best practices” ranging from anti-inventory loading to prohibitions on earnings misrepresentations to one-year buyback policies for inventory and sales support materials:

1. A requirement that only one-third of distributor purchases for personal or family use may be credited for computing sales volume for commission purposes.

2. Distributors are limited to a “cap” amount of monthly product purchases.

3. Autoship programs, which allow orderly distributor product purchasing, via monthly “standing orders,” are prohibited. (Nearly all direct selling companies have employed “standing order” options for decades and “standing order” programs are commonplace in both the commercial and retail sectors.)

4. Distributor fulfillment of minimum personal sales volume requirements are prohibited, or must be fulfilled by sales to nonparticipants… again, excluding credit for personal/family use consumption.

5. Total company commission payments are limited, in the absence of demonstration of 80% sales to the combination of nonparticipants and allowable limits (one-third) of distributor personal consumption purchases.

6. Beyond the historical “pyramid” basis of prosecution, the FTC will now prosecute direct selling companies for deceptive/unfair practices if they deem that the marketing program is likely to cause “harm” to participants. This standard is subjective and arbitrary and may include a myriad of accusations such as “low distributor earnings” or claims that companies overstate earnings expectations. In other words, no certainty for businesses. Question: What is “actionable harm?” Answer: What day of the week is it?



Going Forward

It is a reasonable hypothesis that the Herbalife settlement, in the short term, will not change the business model of other leading companies, without further regulatory or legislative action,  but it clearly creates regulatory uncertainty for all companies. And, it certainly will be timely for all direct selling companies to discuss a preferred customer program, retailing mandates and product tracking to ultimate users.

Herbalife has indicated that it will be able to live with the new restrictions, as the negotiated settlement was tailored to issues between Herbalife and the FTC. It would have made no sense to agree to terms that would interfere with the viability of business. However, if the cumulative new restrictions were forced across the direct selling industry, might the result be severe damage to the direct selling industry?  Absolutely. Can an industry be “over-regulated to death?” Absolutely. The FTC’s next move will be keenly watched, as will the efforts of the Direct Selling Association to look out for the industry, either in dialog with the FTC or introduction of federal direct selling legislation that mirrors the MLM legislation of many states.  It is definitely a “fork in the road” time.

For actual copies of FTC v. Herbalife court documents and press releases, please visit www.mlmlegal.com.

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