SEC

In April, 2013, we distinguished the difference between multilevel marketing (“MLM”) and a pyramid scheme.  (See Multi-Level Marketing Programs Vs. Pyramid Schemes).  Two days ago, United States Senator Edward J. Markey of Massachusetts sent separate letters to the Federal Trade Commission (“FTC”) and the United States Securities and Exchange Commission (“SEC”) urging them to investigate the business practices of Herbalife, Ltd. and its domestic subsidiary Herbalife International of America, Inc. (collectively, “Herbalife”).  In his correspondence, Senator Markey notes that “Herbalife claims that it is a multilevel marketing company . . . .  However, there have been suggestions that Herbalife may not, in fact, be organized as a multilevel marketing company, but instead may be a pyramid scheme, based on Herbalife’s business operations.”  Spurred by William A. Ackerman of Pershing Square Capital Management, Senator Markey’s letter and any subsequent regulatory investigation should serve as a cautionary tale to those engaged in multilevel marketing.

Allegations against Herbalife

In his letters, Senator Markey begins by noting the “significant differences” between an MLM program and a pyramid scheme.  Senator Markey affirmatively states that “[m]ultilevel marketing is a valid business operation” but also notes that “the main difference [between an MLM and a pyramid scheme] is whether sales are aimed inward at other members of a company or outward to the general public.”  In his letter to the FTC, Senator Markey anecdotally refers to several Massachusetts residents whose complaints suggest that Herbalife does not operate as a valid MLM operation.  In correspondence to the SEC, Senator Markey also discusses allegations made by the Hispanic Federation and other civic groups complaining about Herablife’s business practices.

In addition, Senator Markey wrote to Herbalife directly, asking targeted questions about Herbalife’s alleged MLM program and seeking statistical and other business information.

MLM vs. Pyramid Scheme

There is a fine line between a legitimate MLM business and an illegal pyramid scheme.  To illustrate, both offer participants the opportunity to earn commissions, and both often require new members to make an initial investment.  Among other factors, the fundamental differences between the two business methods come down to the amount of the initial investment that is required by the participant, the means by which the constituent products or services are sold, and the basis on which commissions are earned.  Pyramid schemes are characterized by the requirement that participants pay money in return for two things: (1) the right to sell a product or service; and (2) the right to receive, in return for recruiting other participants into the program, rewards that are unrelated to the sale of applicable products or services to ultimate retail customers.

Two red flags that regulatory agencies often look for in ascertaining whether an illegal pyramid scheme exists are: (1) “inventory loading,” in which a company’s incentive program forces recruits to buy more products than they could ever sell, often at inflated prices; and (2) a lack of retail sales, so that sales only (or primarily) occur between people in the applicable marketing venture or to new recruits, not to consumers in the general public.  In contrast to an illegal pyramid scheme, a legitimate MLM program has a real, marketable product or service to sell — one that is sold to the general public without requiring consumers to pay an additional fee to join the MLM program.   MLMs may pay commissions to a long string of distributors, but these commissions should be paid for actual retail sales, not for obtaining new recruits.

Protect Yourself

If you are contemplating engaging in an MLM venture, it is advisable that you contact a seasoned attorney to review the terms of compensation to determine whether the program can confirm its claims about the amount of money distributors can make.  As demonstrated by the Herbalife situation, regulatory bodies will not hesitate to investigate pyramid scheme accusations and it is a best practice to preemptively protect your company from the time and expense associated with a regulatory action.

If you are interested in learning more about this topic or are contemplating engaging in a multi-level marketing campaign, please e-mail us at info@kleinmoynihan.com or call us at (212) 246-0900.

The material contained herein is provided for informational purposes only and is not legal advice, nor is it a substitute for obtaining legal advice from an attorney.  Each situation is unique, and you should not act or rely on any information contained herein without seeking the advice of an experienced attorney.

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