Multilevel Marketing Pyramids-“Lotteries”

The following article is taken from the MLM Legal Primer . This article looks specifically at how lottery laws can be and are applied to MLM companies.

Federal and state multilevel marketing and anti-pyramid statutes are components of a comprehensive consumer protection umbrella. These laws are designed to protect individuals from being defrauded through illegitimate programs which lure participants with the promise of easy money by compensating them from the investments of additional participants rather than from legitimate product sales. These programs have been called “Ponzi schemes,” “airplane plans,” “pyramids,” “chain letters,” and many other names. Although known in the United States only during the twentieth century, such programs have cost their participants hundreds of millions of dollars. Federal and state regulatory agencies have sought to proscribe such illegal activity in multiple ways, including the use of anti-pyramid, mail fraud, business opportunity, franchise, lottery, and securities laws. (Each of these areas will be discussed below.)

Whether a program is a legitimate multilevel marketing plan or an illegal pyramid depends principally on: (1) the method by which the products or services are sold; and (2) the manner in which participants are compensated. Essentially, if a marketing plan compensates participants for sales by their “”enrollees,” “recruits,” and/or their downline enrollees and recruits, that plan is multilevel. If a program compensates participants, directly or indirectly, merely for the introduction or enrollment of other participants into the program, it is a pyramid.

Lotteries

The majority of states have laws that proscribe the operation of a lottery. Lottery laws were not designed to regulate pyramids, but rather to prevent illegal gambling. Although lottery laws have been used to prosecute pyramids, more appropriate vehicles, namely anti-pyramid and multilevel laws, are now used. Consequently, the application of lottery laws to pyramids and multilevel companies rarely occurs in regulatory proceedings. ⁽³²⁾

A lottery consists of a disposition of property, on contingency determined by chance, to a person who has paid valuable consideration for the chance of winning the prize. California Penal Code 319 defines a “lottery” as:

[A]ny scheme for the disposal or distribution of property by chance, among persons who have paid or promised to pay any valuable consideration for the chance of obtaining such property or a portion of it, or for any share or any interest in such property, upon any agreement, understanding, or expectation that it is to be distributed or disposed of by lot or chance, whether called a lottery, raffle, or gift enterprise, or by whatever name the same may be known.

Each of three elements must be present to constitute a “lottery,” namely, a prize, distribution of the prize by chance, and consideration for the opportunity to win the prize.

As applied to pyramids, if the element of chance, rather than skill, determines the receipt of “the prize,” such plans have been held to be lotteries. The most notable case illustrative of this is U.S. Postal Service v. Unimax, Inc. ⁽³³⁾ In Unimax, the Administrative Law Judge determined that a participant’s compensation was beyond his control, and thus, determined by chance. Rather than allowing its distributors to place their downline distributors where they desired in their organization, Unimax assigned⁽³⁴⁾ The judge determined that the compensation received by Unimax distributors was based “principally on the exertions of others over whom they have no control and no substantial connection . . . (and that) success of such marketers is determined by chance.” distributors to positions in the downline organization. This resulted in a matrix of unrelated distributors who were spread throughout the country and were thus, less controllable.

Under a “legitimate” multilevel marketing program, a Distributor’s compensation (the prize) is “earned not won” by chance, but rather by his skill and efforts in building and maintaining a downline organization. In a lottery analysis, a Member’s efforts in building his organization would constitute “consideration,” however, this is of no consequence because the element of “chance” remains absent. Thus, a proper multilevel program is not a lottery.

Two other similar programs, contests and sweepstakes, are perfectly legal. Each combines only two of the three “lottery elements.” For example, a contest combines the elements of prize and consideration, however, the element of chance is absent. In a contest, the prize is awarded to on the basis of skill rather than luck (e.g., the person who sells the most cars, or reaches a certain goal faster than his competitors). A sweepstakes combines the elements of prize and chance, but lacks the element of consideration. A sweepstakes awards its prize solely on the basis of luck, however, a participant need not provide “consideration” (anything of value, frequently money or effort). The most common examples of sweepstakes are magazine sweepstakes. Although they welcome your purchase, none is necessary to participate.

Conclusion

It is equally important that direct sellers also include reasonable mechanisms in their programs to prevent the risks of pyramiding, securities violations, lotteries, business opportunities, and other legal maladies. This requires: (1) distributor agreements; (2) policies and procedures; and (3) the enforcement of policies and procedures intended to ensure the legitimacy of the program. Indeed, in the Omnitrition decision discussed above, one of the reasons the Ninth Circuit Court of Appeals rejected the defendant’s arguments that its plan was not a pyramid was based on the finding that the company failed to provide sufficient evidence that it actually enforced its policies. Although the company had policies in place identical to those implemented by Amway, the court stated that the mere existence of policies, without evidence of enforcement, renders the policies nugatory. Multilevel companies are therefore well advised that “staying legal” requires much more than developing a program that meets state and federal requirements. Rather, it is an ongoing process that calls for vigilance and action to ensure that distributors stay within the rules.

In summary, the emphasis of any multilevel program must be on product sales rather than the enrollment of new distributors. Companies and distributors must make a paradigm shift from business based primarily upon recruitment of downline distributors and internal consumption. Distributors should be taught that their primary function is to gather customers. Their second priority is to build a downline and to teach it about the first priority.

Copyright Grimes & Reese 1996

Reprinted by permission