They are relatively simple to understand and offer fast-paced growth opportunities. Companies find them attractive for the same reasons. In addition, several companies utilizing binary plans have recently entered the market and generated eye-popping sales and profits. This, of course, has led to an influx of programs modeled after the highly successful plans.
Unfortunately, not all that glitters is gold. The multilevel marketing industry has seen a dramatic increase in regulatory actions. These actions have come in the form of joint efforts between the states and the Federal Trade Commission (notably Project TeleSweep in 1995 and Project Missed Fortune in 1996), as well as numerous individual and joint state actions. Companies utilizing binary compensation plans have been hit particularly hard in these actions. As a result, those companies that have been hit have had stringent limitations placed on their programs. These limitations oftentimes strike at the heart of their method of doing business and require significant changes to their marketing approach.(2)
So what is the problem with binary plans? Why have states attacked them with so much more vigor than companies utilizing other compensation plans? I have many people ask me if binaries are “legal.” The short answer is the proverbial and oh-so-lawyerly “Yes—but” response. Yes, they can be designed to operate legally, but in addition to proper design, companies must properly implement their programs so that they accurately follow the design. Several relatively new MLMs that entered the industry using binary plans simply failed to adhere to the legal principals governing the MLM industry in implementing their plans. Unfortunately, these companies were quite visible, and consequently there have been highly publicized actions brought against them. Naturally flowing from these actions is a great deal of bad press that has tarnished the image of binary plans, including those that are operating legitimately.
Fortunately, solutions are available, but they require companies to carefully analyze their programs and make some painstaking changes. This article will discuss several key areas of law applicable to the multilevel marketing industry and apply these legal principles to the operation of binary compensation plans. In conducting the analysis, it will focus on a common binary format utilized by companies selling prepaid long distance telephone cards. Although not all binary plans follow this format, it is a blueprint that has been frequently copied by new companies entering the marketplace. Moreover, since companies selling prepaid telephone cards utilizing this format have been among the hardest hit by regulatory agencies, these plans provide an ideal case study for legal analysis. Bear in mind however, that the principles apply to all binary programs regardless of the product or service that is being offered. The plans used by the prepaid telephone card companies are simply an illustration of problems that can arise in any program.
What is a Binary Compensation Plan?
A binary plan is a multilevel marketing compensation plan which allows distributors to have only two front-line distributors. If a distributor sponsors more than two distributors, the excess are placed at levels below the sponsoring distributor’s front-line. This “spillover” is one of the most attractive features to new distributors since they need only sponsor two distributors to participate in the compensation plan. The primary limitation is that distributors must “balance” their two downline legs to receive commissions. Balancing legs typically requires that the number of sales from one downline leg constitute no more than a specified percentage of the distributor’s total sales.
Multiple Business Centers
A unique attribute of binary plans is that distributors are allowed to operate multiple positions, or “business centers,” under the umbrella of a single distributorship. A business center is simply a position within one’s own marketing organization. When a distributor enrolls, he is automatically assigned his first business center. The distributor may then purchase additional business centers and place the centers at strategic locations within his downline organization. The typical cost for each business center is $100.00, which gets the distributor the position and an inventory of phone cards to service the center. Each business center must independently meet their two person enrollment requirements. Historically, Distributors have been allowed to purchase up to seven business centers, but the current trend is to allow only three centers.
The Three Phase Program
A common component to binary plans is a three phase sales and compensation cycle. In the first phase, a distributor joins by paying $100.00 for an initial inventory of phone cards and a business center. Because the distributor receives an initial inventory of phone cards for this payment, it constitutes a “sale” which is commissionable to his upline. The distributor then enrolls two new business centers for $100.00 each. One business center is placed on his right downline leg and the other on the left leg. After 12 business centers have been enrolled (i.e., 12 “sales”), the distributor is entitled to a $100.00 commission (assuming the proper balance is achieved between legs). After a total of 50 sales, the distributor is entitled to a $500.00 commission. Fifty sales completes the first phase of the compensation plan.
Upon completing the first phase, a distributor can re-enter phase one by paying another $100.00 and receiving additional inventory. This re-entry again qualifies as a commissionable sale to the distributor’s upline. Rather than stay in phase one, the distributor may elect to enter phase two by paying $300.00, which may be automatically deducted from the distributor’s phase one $500.00 commission. This $300.00 sale gets the distributor additional inventory and promotes him to phase two. Under phase two, the distributor receives a $500.00 commission after 12 sales, and a $2,000.00 commission after 50 sales. This completes phase two.
Phase three requires the distributor to pay $1,000.00 for additional inventory. This is again deducted from his $2,000.00 phase two commission. In phase three, the distributor receives a $2,000.00 commission after 12 sales and a $7,000.00 commission after 50 sales. After completing phase three, the distributor again re-enters phase three, with the required $1,000.00 inventory purchase being deducted from his previous commission. In addition to phase three income, the programs usually allow distributors to participate in phases one and two concurrently with phase three.
Multilevel pre-paid telephone card companies have adopted the binary plan as the program of choice. Until recently, most programs were strikingly similar to one another, right down to the prices charged for the products. Upon each entry into phase one of a program, distributors received an inventory of phone cards with a total of 60 minutes of long distance time for their initial $100.00 payment. Upon cycling into phase two, companies charged $300.00 for phone cards totaling 300 minutes of time. The $1,000.00 charge as a distributor entered phase three netted 960 minutes of phone card time. Recently, companies have begun lowering their prices as they have recognized the necessity of becoming more price competitive.
The Legal Framework Governing Binary Compensation Plans
Amid the confusion and concern over the legality of binary plans, many people have lost sight of the fact that binary plans operate under the same laws that govern other multilevel compensation plans. There is no law stating that operation of a binary compensation plan constitutes a consumer fraud, or a company using a binary plan is a pyramid. Thus, so long as the implementation of a binary plan complies with the laws governing the operation of multilevel business, it will be legal. However, because of their structure, binary plans have unique challenges to implementing their programs within that legal framework.
Four principal areas of law governing the multilevel marketing industry are: 1) anti-pyramid laws; 2) business opportunity laws; 3) securities laws; and 4) lottery laws. A comprehensive discussion of each of these areas of law is properly the subject matter of its own article. However, a brief overview will assist us in examining which aspects of a binary plan present the greatest risk of running into legal problems.
Pyramids are illegal in every state as well as under federal law. It would be convenient if these laws were uniform and cohesive; unfortunately, the industry is not so lucky. The application and enforcement of the laws varies from state to state, so the best we can do in the limited space of this article is generalize about what actions will cause a company to violate pyramid laws.
The fundamental question that must be asked in every pyramid analysis is “What must a distributor do to earn a commission?” If a company pays its distributors based on the recruitment of other distributors (headhunting) rather than for legitimate sales to end consumers, it is a pyramid. This rule appears straightforward, but its application can be difficult because most pyramid operators are not so foolish as to blatantly pay a commission based on recruitment of other participants. Rather, they typically disguise the program as a legitimate multilevel marketing business by offering a product or service that the distributors can sell.
The question then becomes, “How do you determine if a company is simply offering a product or service that is merely a facade for a pyramid?” In a nutshell, a legitimate program will incorporate and enforce policies which effectively deter and prevent inventory loading. But on this point, industry and law enforcement officials diverge on what constitutes “inventory loading,” and what measures are appropriate to deter it. Ever since the Federal Trade Commission’s decision in The Matter of Amway Corporation, Inc.,(3) industry has taken the position that so long as a company is willing to repurchase unwanted inventory at a rate of at least 90% of the net cost to the distributor for those individuals who elect to cancel their participation in a program, the company is not engaged in inventory loading. Law enforcement officials have, however, seized upon dicta(4) contained in the recent Ninth Circuit Court of Appeals decision in Webster v. Omnitrition International, Inc.(5) which states that “Inventory loading” occurs when distributors make the minimum required purchases to receive recruitment-based bonuses without reselling the products to consumers.(6)
The focus of regulators is therefore on retail sales of product. If the products or services are being purchased and used primarily by individuals who are participating in the compensation plan, or who are purchasing in order to qualify for compensation, they contend that the sale is not a true retail sale. Following this line of reasoning, they have attacked programs (not just binary plans) as pyramids. If, on the other hand, distributors are retailing the goods or services to persons who are not involved in, or trying to become involved in, the compensation plan, regulators consider a legitimate retail sale exists. Industry takes strong exception to this approach because it dramatically restricts companies’ ability to pay commissions on products and services that are consumed by its distributors. Although this debate between industry and law enforcement is not settled, we are clearly seeing a trend in states with aggressive attorney generals directed at ensuring companies require their distributors to incorporate retail sales quotas in their programs.(7)
The degree to which true retail sales are occurring within a company’s program is difficult to monitor. Since actual distributor surveys presenting data on retail sales levels are generally not available at the investigatory stage, there are several factors which regulatory officials consider evidence that a program is not offering a true retail sales opportunity. Principal among these are: 1) excessive inventory requirements; 2) overpriced products; 3) a primary emphasis on recruiting rather than product sales.
Excessive Inventory Requirements
A court or regulatory body will look skeptically on programs that generate sales through excessive inventory requirements. These purchases, whether a front-end load or a monthly maintenance requirement, will be viewed simply as a participation fee from which commissions are paid. Of course, it is common for multilevel companies to require monthly production quotas of their sales force, so the mere fact that a maintenance requirement exists does not prove that no true retail opportunity exists. The amount distributors must spend must also be taken into consideration. Programs with high mandatory purchase requirements will be scrutinized much more closely than programs with modest requirements. Although there is no magic number as to what constitutes a monthly maintenance quota that is too high, a strong dose of common sense is in order. Clearly, the danger of inventory loading is dramatically decreased if production quotas are $75.00 per month rather than $1,000.00 per month.
Binary plans are closely watched by law enforcement officials because they require significant investment in inventory as distributors progress through the phases of the program. For example, if a distributor is participating concurrently in phases I, II, and III of a program, the cost of his inventory may easily be $1,400.00 each time he cycles through the three phases. It is unlikely that a distributor will be able to use or resell $1,400.00 worth of product before repeating each cycle and is again forced to purchase yet another $1,400.00 in merchandise. This danger is magnified even further if the distributor operates multiple business centers. If a person has seven business centers in phase three of a cycle, he will have $7,000.00 worth of inventory for that phase alone (if he has cycled through and re-entered phases one and two, he will have more inventory than that). Clearly, the danger that a distributor will be loaded with unsaleable merchandise is significant under this scenario.
Uncompetitively Priced Products
Because retail sales are so important in the eyes of regulators, multilevel companies must ensure their products are priced competitively. Distributors simply will not be able to retail goods and services that are too expensive. Regulators recognize this, and therefore those programs whose products and services are excessively priced will be subject to greater regulatory scrutiny. Indeed, if a product is priced so high that no reasonable person would purchase it, it is evident that the only reason distributors are buying the product is to participate in the company’s compensation plan. In this case, regulators and courts will consider the product simply a disguised recruiting fee.
Many companies operating binary plans have found themselves under the regulatory microscope partially as a result of excessively priced products. In the pre-paid phone card example, the price per minute for phone time runs from 96 per minute to $1.60 per minute. This is dramatically higher than the price of phone cards offered through retail channels, which typically range from 20 to 50 cents per minute. Based on the difference in price between the retail cards and those offered through binary plans, there is no reason for a consumer to purchase a phone card through a binary plan other than to participate in the compensation plan. Thus, the likelihood of these goods being retailed by distributors is slim to none.
Because excessive prices precluded any meaningful retail sales opportunities, distributors often simply gave away excess cards as a means of garnering the interest of prospects. Whether or not this was done at the urging of company officials will be disputed. Regardless of the source, however, the practice cast a negative shadow on those programs that engaged in it. Regulators take the view that if a product must be given away, it has little or no legitimate economic value. Absent any inherent economic value attached to the product, the price paid by distributors is simply a masked head-hunting fee, and the program will collapse without a constant supply of new recruits.
Primary Emphasis on Recruiting Rather than Product Sales
If a program primarily focuses on recruiting new distributors rather than sales of products or services, law enforcement officials will attack it as a head-hunting operation. Legitimate programs are driven by the sales of products and services, not by recruitment of new people. This is not to say that companies should not train distributors in recruitment techniques, for clearly, recruitment is an essential component to building a multilevel business. However, companies must strike a balance between emphasizing recruitment and product sales. On this point, there is no magic formula to determine whether excessive emphasis is placed on recruitment, as this is a very subjective determination. Companies should be advised, however, that attorney generals will attend their meetings incognito, and will literally put a stopwatch to the duration of the product discussion and the compensation plan discussion. This is oftentimes an unfair practice, as a compensation plan may be much more difficult to explain than is a product or service, but it is nonetheless a common practice.
The design of binary plans arguably focus on enrollments rather than sales in two key ways. The first is classifying the enrollment of a business center as a “sale.” Calling an enrollment a “sale” is asking for trouble because there is a direct one-to-one correlation between enrollments and distributors’ commissions. This problem is easily resolved by requiring distributors to balance the sales volume in each of their legs rather than to balance the number of enrollments in each leg. If for example a program required distributors to have at least one-third of their total sales volume in each leg to qualify for commissions, the direct relationship between enrollments and commissions is diluted.
The second design aspect of binary plans which results in an emphasis on recruiting over sales arises from the practice of selling multiple business centers. This format lends itself to the argument that the companies are more interested in head-hunting, or “selling positions” rather than moving products to end consumers. For example, if a company allows each distributor to enroll seven business centers, the value to the company of each distributor who takes the seven center plunge is $700.00 rather than $100.00. It is true that there is never a “requirement” that a distributor operate more than one business center. However, if in actual practice distributors are “strongly urged” to open multiple business centers, law enforcement will consider the emphasis to be on acquiring bodies for the program rather than product sales to end consumers. Moreover, the $700.00 initial fee, although “optional” will be attacked as a front-end load or initiation fee.
Business Opportunity Laws
The Federal Trade Commission and many of the states regulate the offering of business opportunities. Although the F.T.C. and state definitions of a business opportunity differ, they share a common goal of ensuring that persons who invest significant sums of money in a business opportunity have the benefit of full disclosure of information surrounding the opportunity so the investor can evaluate potential risks. Therefore, if classified as a business opportunity, the promoter must make detailed disclosures about the program, its finances, the history of the business, the personal history of the promoters, the identities of other distributors, and other detailed information. In some states this information must simply be filed with the state, whereas other states require the promoter to provide each prospective distributor with a copy of the disclosure statement ten days before the distributor can be enrolled in the program. In addition, some states require the promoter to secure a surety bond before doing business in the state. These onerous requirements will suffocate any multilevel marketing opportunity.
The drafters of business opportunity statutes recognize that not every investment of money constitutes a significant sum which requires regulatory intervention. The business opportunity laws therefore exempt programs which require an “initial investment” below a specified dollar figure from the definition of a business opportunity. These thresholds limits differ between states, and range from $200.00 to $500.00. The “initial investment” is most often defined as all payments that are required within the first six months of entering a program, or the total of all payments that are required pursuant to the terms of a contract. Required payments for sales aids and training materials are usually not applied to the initial investment if they are sold to distributors at the company’s cost.
Prudent multilevel companies seek to avoid being classified as business opportunities by keeping required purchases below the initial investment threshold limits. Close analysis of many MLM programs reveals that although distributors must meet monthly quotas, these quotas can usually be satisfied by purchases made by their direct retail customers. In this way, companies can claim that these purchases are optional, and therefore are not properly allocated to the initial investment column because the purchases are not “required.”
This position, while within the letter of the law, will not necessarily stop an attorney general from attacking a plan. They will take the position that although technically “optional,” in reality the program works because the overwhelming majority of distributors personally purchase their own monthly quotas rather than meet them through the purchases of their personal direct customers. They will then tally distributors’ monthly purchases to determine if the applicable initial investment threshold has been satisfied. Under this approach, a modest monthly quota can result in the institution of an investigation or enforcement action. While this position does not follow the letter of the law, it is nevertheless largely within the regulators’ prerogative to institute an investigation or action. To date, states have had success in negotiating settlements based on this argument. Unfortunately, very few companies have been inclined to go so far as to allow a court to decide whether the attorney generals’ position is proper.(8)
Programs that encourage distributors to purchase multiple business centers are always suspect as business opportunities in the eyes of regulators. If the emphasis is on purchasing seven centers at $100.00 each, the initial investment will be $700.00, which is over the $500.00 F.T.C. threshold as well as that found in most states. Even if a company only allows three business centers, a $300.00 investment will surpass the threshold in several states. Regardless that these purchases are optional, if the company or its field force place an emphasis on the purchase of multiple centers, regulators will argue that these purchases are in reality required initial investments. Moreover, mandatory inventory purchases will also be added to the total. Thus, as a distributor cycles into subsequent phases of a plan and is automatically charged for inventory, it is impossible to stay below the $500.00 threshold under the attorney generals’ interpretation.
Multilevel marketing programs are often attacked as offering a type of security known as an “investment contract.” These securities are subject to the registration and disclosure requirements of the Securities Act of 1933 and the Securities and Exchange Act of 1934, as well as a number of similar state securities laws. Selling an unregistered investment contract security is a serious issue for multilevel companies, for there are significant criminal and civil penalties that can be imposed.
Neither the Securities Act of 1933 nor the Securities and Exchange Act of 1934 define an investment contract. Rather, the definition has been supplied by a series of United States Supreme Court and Circuit Court of Appeals decisions. These decisions have established a three part test to determine if an investment contract exists. These elements include: 1) an investment of money; 2) in a common enterprise; and 3) the investor is lead to anticipate profits primarily from the efforts of the promoter or some third party. Of these three elements, courts and regulators focus most keenly on the third element. While this is not a technically correct application of the law, you are probably getting the idea by now that in the real world, the law is not always applied in a technically correct fashion, particularly at the administrative investigation stage.
While all multilevel companies must be careful to avoid promoting their programs as securities, binary plans must be especially cautious due to the inherently rapid spillover rate which results from each distributor having only two front-line positions. Unfortunately, since the spillover is one of the most attractive features to binary plans from a marketing standpoint, companies have been anything but bashful about trumpeting the downline building power of the system. A very common field pitch is “All you have to do is get your two and you’re done!”
This is precisely the pitch which courts and securities regulators have a problem with. The message is that all a distributor need do is enroll two people. The rest is done by the system, either through the efforts of the distributor’s upline or the two whom the distributor enrolls. In any event, the managerial efforts which a distributor must put forth to be successful are minimal, and therefore the income stream is largely a passive investment because it is generated primarily from the efforts of others.
To avoid this pitfall, distributors must engage in true managerial activities to build their businesses and promote sales. Most companies have a policy that requires distributors to continue to train, supervise, and motivate their downline, as well as ongoing sales requirements. These policies should be taken seriously as they impose ongoing managerial requirements on distributors so that their income is not primarily dependent on the efforts of others. Under no circumstances, however, should a program be promoted as “get your two and you’re done.”
The next obvious question is “how much downline management is required to satisfy the law?” Unfortunately, there is no bright-line test to determine how much is enough. However, we do know that promoting a program through reliance on spillover, without personal involvement by upline distributors, will dramatically increase a company’s securities exposure. Ultimately, the question of “how much is enough?” will be answered on a case-by-case basis as companies negotiate with law enforcement officials following the institution of regulatory action.
Lottery issues always follow on the heels of securities issues. A lottery exists when: 1) an individual pays consideration (i.e., money); 2) to receive a prize; and 3) the prize is awarded based on the element of chance rather than on the skill or effort of the participant. In a multilevel marketing analysis, regulators will argue an enrollment fee or mandatory product purchase satisfies the first element of the test, and that the “prize” is the commissions from downline purchases. They will further argue the element of chance (luck) exists if a distributor’s downline can be built with little or no effort on her part.
Because binary plans place a heavy emphasis on the spillover effect of their programs, and because they have been promoted by companies and distributors as “simply get your two and you’re done,” the element of chance can play a significant role in the success of distributors. If a distributor need only get two enrollees, law enforcement officials will argue they must be relying heavily on luck that a productive downline will be developed below them because the distributors are putting forth only minimal effort to personally contribute to its success.
Companies must remove the element of chance from their programs to avoid falling prey to lottery laws. As with the securities analysis, this is done by requiring participants to engage in bona fide management responsibilities and ongoing sales and marketing efforts. Again, how much is enough will be determined on a case-by-case basis as individual programs are analyzed.
In addition, the mandatory purchase of product to activate a business center and to re-enter a phase provides ample support for the position that the consideration element of the lottery test is satisfied. By removing all mandatory purchase requirements from a program, companies will be able to argue that the consideration element is not satisfied.
The Bottom Line
Binary plans definitely have their place among multilevel compensation plans. If operated properly, they are a classic example of a “people helping people” multilevel program. There is no question that they can be designed and operated legally. However, companies using the plans have had more than their fair share of law enforcement actions brought against them. But the battles that have been fought are teaching the industry a lesson, and industry is listening. We are seeing companies that have been attacked by regulators changing their plans to diminish the potential for inventory loading and to increase the ability of distributors to engage in bona fide retail sales of merchandise. Similarly, new companies that adopt binary plans are not all following the standard format of the prepaid phone card companies that have run into so much resistance from regulators. The current trend is to allow only three business centers rather than seven, to balance legs based on sales volume rather than enrollments of new business centers, and to require distributors to engage in retail sales activities before allowing them to collect commissions or cycle into subsequent commission phases.
Is it too little too late? Certainly binary plans have been tainted in the eyes of many regulators, and they are now viewed skeptically. While regulators’ skepticism does not make a plan illegal, it does raise the probability that companies using binary plans will be investigated. The negative press that follows a regulatory investigation is sufficient to cause serious problems for a company. To address this problem, it is up to the companies using binary plans to teach regulators how they differ from plans that have been attacked in the past. Those companies that cling to the old ways of the binary plan may prosper in the short term. However, given the recent barrage of regulatory action we have seen against companies using this format, it is a safe bet that those who do not voluntarily change will have changes forced upon them through regulatory action.
1. Spencer Reese is a partner in the law firm of Grimes & Reese. He is a graduate of the Washington University School of law and is a member of the Idaho, Missouri and Colorado bars. He was formerly in-house counsel for Melaleuca, Inc., a multilevel marketing company with sales in excess of $260 million. Mr. Reese’s current practice includes representing and advising multilevel marketing companies on all aspects of their business, including consumer protection issues, advertising law, litigation, contracts, marketing plan design, regulatory compliance, trademark law, FDA law, policy development and distributor compliance. Grimes & Reese is a supplier-member to the Direct Selling Association and the Professional Association of Network Marketers. Visit the firm’s website at www.mlmlaw.com. Mr. Reese can be contacted at (208) 522-2600.
2. Some well recognized companies appear on the list of those attacked by regulatory agencies. On February 4, 1997 the Arizona Attorney General entered into a settlement agreement with Tele-Sales, Inc. wherein the company was required to pay a $25,000 settlement fee. More importantly, however, the Arizona A.G. also sent letters to the company’s top distributors in the state, accusing them of violating the state’s pyramid law. The letters demanded that the distributors enter into a settlement agreement and that each individual distributor pay a $25,000.00 fine, otherwise, the A.G. would sue them individually. On February 28, 1997, the Alameda County Prosecutor and the California Attorney General entered the offices of Destiny Telecom and seized business records to be used in actions against the company. The same day, they filed a $20,000,000.00 civil suit against the company, alleging it was promoting an illegal pyramid. Two weeks after the suit was filed, Destiny settled the case for $1.6 million. In 1996, Strategic Telecom Systems, Inc. was investigated by the states of Pennsylvania and Florida, which resulted in fines against the company, and the imposition of sales requirements which required the company to dramatically change the way it conducted and promoted its business.
3. 93 F.T.C. 618 (1979)
4. “Dicta” is a legal term that refers to the opinion of the judge who authors a judicial decision, but which does not constitute a statement of law.
5. 79 F.3d 776 (1996)
6. 79 F.3d at 783, note 3.
7. Despite the position of some regulators that commissions are not properly paid based on products or services consumed by distributors, there is a movement among industry to pass legislation reversing this position. Texas and Oklahoma have passed such legislation, and Direct Selling Association is working on introducing similar legislation in other states. 21 Okl.St. 1072; Tex. Bus. & Com. Code 17.461.
8. One company, Travel Max, recently did take this issue to court in Kentucky. The state requested that the court impose a temporary restraining order on Travel Max operations based on the arguments that Travel Max was operating a pyramid and an unregistered business opportunity. The judge denied the state’s motion for a TRO on the business opportunity claim because distributors’ purchases, other than an initial $25.00 sales kit, were optional.