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Boosting transparency to save direct sales

Podcast episode 24

Article by: Kenny Rawlins
Spencer Reese
April 16, 2018

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Spencer Reese joins us again to talk about the current legal climate for MLM companies. He talks to us about the evolving definition of inventory loading, the dangers of illegal income claims, and the surprising absence of pyramid scheme allegations in recent FTC actions against direct sellers. Spencer advocates social media monitoring, transparency in income disclosures, and training for the sales force. He also discusses the legal differences between party plans and network marketing companies. Lots of great insights in this episode of the Podcast.

Full transcript

Kenny: Hello and welcome to the Podcast. I’m your host, Kenny Rawlins, and in today’s episode we’re visiting with Spencer Reese who is an MLM attorney for Reese, Poyfair, and Richards. Spencer how are you today?

Spencer: Doing wonderful Kenny. Thanks for having me on today.

Kenny: And I guess I always introduce you as an MLM attorney but I should just say you’re an attorney. You’re an attorney. You’ve been doing this for a long time. Why don’t you give our listeners a little bit of background on some of your experience?

Spencer: Well sure thing. Yeah. And you’re right, yes. While I am indeed a lawyer, or attorney if you want to be formal about it, I have made my living in the direct selling space since being in-house counsel for a major direct selling company back in 1992. Hung out our shingle. Went into private practice, just focusing on direct selling and FDA and FTC work since 1996. So, we’ve had the great privilege of serving direct sellers for the last 20 plus years. Serving direct sellers almost exclusively really. And it’s been very, very rewarding. There’s just a handful of us in the country that do what we do and so we’re very pleased to be able to service this field.

Kenny: You and I go way back and you’ve helped me kinda cut my teeth in this industry so I’m excited to talk a little bit about this. Like you say, there’s only a few of you guys that specialize so heavily in the direct selling space. One of the things that I know you guys have a pulse on is what the FTC is doing. When you and I were talking a couple weeks ago getting ready to record this, you mentioned that it used to be the bread and butter of the FTC to go after direct sellers through the pyramid scheme complaint. You said that that’s changed a little bit. So, talk to me about how the FTC is going about their job these days.

Spencer: Well sure thing and this is really a very, very interesting topic to anybody who’s in direct sales and utilizes a multi-level compensation plan, which is just about everybody if you define direct selling as the DSA does. What we have seen is, traditionally…I’m going to go back you know some 50 years really and talk a little bit about how the FTC has traditionally pursued actions against businesses that they thought or claimed were pyramid schemes. They were very complicated, difficult actions to bring to prove. The proof of what constitutes a pyramid tended to be somewhat of a moving target. Not completely…but the evidence that come up with tended to be a moving target. I think that’s a better way of putting it.

What they traditionally would try to show that the company was inventory loading. Inventory loading, back in the 1970s and 80s really up until 1996, was defined as the required purchase of large quantities of non-refundable merchandise. Well everybody adopted a refund policy on their merchandise and consequently did not fall within the technical definition of inventory loading. So anyway, inventory loading was perceived and defined as the required purchase of large quantities of non-refundable merchandise. So, most companies adopted a 90%, one-year buyback policy on inventory so they did not fall within the technical definition of inventory loading.

In 1996 the definition of inventory loading changed in the Omnitrition case. And what happened is the Ninth Circuit Court of Appeals redefined inventory loading. Actually, they never struck the first definition so that one still applies. We now have two definitions of inventory loading. The definition of inventory loading that we more often hear about now is: inventory loading occurs when distributors make minimum required purchases or the minimum purchase is necessary to earn recruitment-based bonuses without reselling the merchandise. So, what that means is there is a transition. The original definition of inventory loading was oriented towards quantities of merchandise and the return ability of that merchandise whereas the subsequent, 1996 definition focused on the motive for purchase. If a distributor’s motive for purchasing the company’s products was to generate what they called recruitment-based bonuses and they didn’t resell the merchandise, well then that was inventory loading.

Now that second definition has come to the fore since 2015 when the Burn Lounge decision was issued because that was the definition the court focused on. In the more recent Vemma and Herbalife cases, the FTC focused on that definition of inventory loading. And the evidence that they proffered to show that the companies were inventory loading was [first] the compensation plan itself, which typically have some sort of a minimum PV quota and distributors can meet their PV quotas through personally purchasing the necessary PV each month and that keeps them active. And then they recruit others to do the same. Well from the perspective of the FTC, that is inventory loading because the purchase is financially motivated rather than motivated by bona fide consumer demand or market demand for the products. And that evidence, again, is the compensation plan and then they would use the company’s actual sales data, which would show that distributors were in fact purchasing consistently with how the compensation plan is devised.

Now you have to understand that proving motive is a very muddy water. It’s not cut and dried. There’s always going to be counter arguments to why an individual or group of distributors is purchasing. And no matter what the compensation plan or the sales data bears out, you can always create a muddy water there. Then because it’s not clear… I mean, it really isn’t! I mean, I’m not being flippant here saying that. You can always create muddy water [around motive]. It is not clear.

So, the FTC (given the standard put forth in the 2015 Burn Lounge decision) looked at that and said, “you know that’s a tough case to make but you know what, in every pyramid case we’ve ever brought there’s always a companion cause of action or claim that the company was making false and deceptive income claims.” And since the Herbalife case…

In 2018, in February, the FTC brought a case against a company called Digital Altitude. And Digital Altitude was a network marketing company. A smaller one. Not a lot of people have heard about it. But the FTC found some rather egregious facts in terms of the income claims that that the company was making. I’m not commenting on whether the facts are accurate or not. I don’t know. All I know is what has been purported by the FTC. And they alleged that the company was representing that you could make very large sums of money in just 90 days. They apparently produced sufficient evidence to the court and got an ex parte TRO (temporary restraining order). They got the company’s assets frozen and they got a receiver appointed to run the business. Now that’s the exact same relief that they seek in pyramid cases, however, they didn’t have to prove motive for purchase. Proving the income claims were false and deceptive was far far easier and far less resource-intensive than bringing a pyramid case.

So, what we’re seeing is that the FTC has another arrow in their quiver. I’m not saying that the pyramid cause of action is going away. Not by a long shot. But we do see that the FTC has another arrow in their quiver. And as we have seen in the pyramid cases, when the FTC starts a fencing in process, they start with cases where they have very favorable facts to their side and then they start setting their fence posts where they want the boundaries to be.

In my opinion, the Digital Altitude case is an effort or an initial effort to start the fencing in process as we have seen in the traditional pyramid cases. Now, the Digital Altitude case is not standing alone. It’s not some anomaly. If you look at the much more widely publicized Herbalife case, in that complaint the pyramid claim is never alleged. The p-word never even comes up. Now you can distinguish the two certainly because the Herbalife case was heavily negotiated and they certainly negotiated strongly to ensure that the pyramid word never appeared in the complaint.

Kenny: Right.

Spencer: But even though we’re confident that that was a negotiated term, nonetheless the FTC was able to resolve the case without the pyramid claim. Now in press conferences the FTC commissioner at the time danced around the question well “is this a pyramid scheme?” I mean she danced around that question five or six times. In every which way she possibly could. She just wasn’t gonna answer that. So, it was pretty evident that it was a negotiated issue. But, be that as it may, I mean between the Herbalife and the Digital Altitude cases, it’s quite apparent that the FTC has now recognized they don’t need to bring a pyramid cause of action to get substantial relief against a network marketing company. It’s far far easier to bring a claim that the company is engaging in deceptive and false representations with regard to income claims and that’s where we have to really focus.

Now the good news is that’s nothing new. We’ve known we have to reign in income claims for a long time. The bad news is that it’s proven very difficult to do as it’s still a very, very common practice. So, this is more than just a wakeup call. This wakeup call has been around for a long time. But this is much more of a call to action and immediate action. We have to understand that the FTC’s ability to bring a case and more importantly receive the traditional relief that is always sought in pyramid cases, their ability to bring those cases is much, much easier and we make it much easier for them to the extent that a company is allowing [illegal] income claims to prosper.

Kenny: I find it interesting, the way you put that, because it sounds like the end result is the same, right? And people may be taking false comfort in the fact that they don’t think that they’re a pyramid or think that they can fight that. The other thing that I found interesting is I’ve heard so many people argue that case of motive. “Hey. People aren’t buying this just to qualify.” The FTC, it sounds like you’re saying, is indicating that they may be just taking that off the table. “Fine we don’t want to fight with you on motives. Let’s just talk about these [practices].” And especially with social media and the internet and you know Periscope and YouTube and all of these things, it’s easy to pretty quickly go out there and find a bunch of people making claims that, whether they are false and misleading, you can paint them as false and misleading. So, one of the first things I want to get your thoughts on are: what’s a company’s obligation when it comes to a distributor posting something that’s not company endorsed?

Spencer: Well and that’s interesting because you know social media has become the most fertile source from which the FTC or State Attorney General or any plaintiff is going to gather evidence to support their case. And it’s just easy. You sit at your desk. You point, click and there’s all sorts of distributors making uneducated claims. It’s not like they have malintent. They’re doing it out of enthusiasm and ignorance. And it’s very easy to find that material. So, the company’s obligation…well, we have to understand that the companies are indeed responsible for whatever their sales force posts. So, if it’s an inappropriate income claim that the company itself would never make, it’s nevertheless responsible for what its sales force posts. So, it comes down to how do we deal with that? How do we address that and fix it?

This is, again, nothing new. It comes down to education and compliance and in the first instance, as I indicated, it’s my opinion that most distributors engage in non-compliant activity, especially income claims, out of enthusiasm and ignorance. They just don’t know what the rules are and they don’t know why. Their attitude is “well if this is what I really made or this is what my upline really made and it’s truthful, I can say it.” Well that’s not exactly true. It’s only partially true. And the reason is that an income claim is a type of a testimonial or an endorsement and the FTC has specific guidelines on what you have to do, additional disclosures that are necessary to make what could be viewed as a misleading income claim or a misleading testimony or endorsement to clarify that and make it non-misleading.

You can never clarify a false claim. That just doesn’t work. You can disclaim it and modify and add all the footnotes in the world, but if it’s false, it’s false. You can’t fix that.

But a claim that’s potentially misleading or can be interpreted in different ways by different people, you can clarify that with disclosures and disclaimers. That’s why we proffer or put forth an income disclosure statement. Most companies have an income disclosure statement. And honestly, we have to do a better job of making those more transparent. But that’s ultimately the fix. That’s the training part. The compliance part (the second part of that equation of fixing the problem) is, again, if you have those chronic offenders, those people that are just not teachable or just are intentionally making inappropriate income claims, then the compliance department has to step in in its enforcement hat rather than its teaching-and-training hat and take disciplinary measures against those non-compliant reps.

Kenny: You know, one of the big things that is news to far too many people is that ignorance [of distributor behavior] or the fact that they’re an independent representative does not clear you of your obligation to take those measures. First teaching and training and then second punitive measures for non-compliance. In my experience, there’s far too many companies that say “well, they’re independent distributors.”

Spencer: Yeah and they’re gonna learn the hard way.

Kenny: Yeah.

Spencer: It’s unfortunate. But they’re gonna learn the hard way because that is by far, hands down the most fertile source of evidence that any regulatory agency is going to mine and farm for evidence in any case that they bring.

Kenny: Yeah. Now the next thing you talked a little bit about [was], in your opinion, the income disclosures need to be improved and be more transparent. Can you talk a little bit more about what you think should be seen in those?

Spencer: Well sure I mean that is a big, big issue. I mean honestly, I think we look at a lot of the income disclosure statements and the companies recognized that the actual incomes of their sales force are rather disappointing to say the very least. They’re very disappointing. You know there’s not that many people that are making substantial money. Very, very few. A fraction of the single percent in fact are making substantial retirement-type or full-time income. And that’s pretty common. So, what we see is that they try to skew the numbers, the averages, and the data so that it looks more favorable. What they’ll do is they will have a large body of reps on their books as distributors but they will only report the incomes of “active distributors” and how they define an active distributor…it varies.

I mean I’m reviewing one IDS right now for a client that they do a pretty good job of it. It’s anybody who made a purchase within the preceding year. Others will only define an active rep as a rep who earned a commission. So, they’re excluding 80–90% of those that they have on their books as distributors and therefore the incomes that they’re reporting, while dismal, are vastly overstated. So, that practice was actually called out specifically in the digital altitude case and I’ve seen it many times over. So, I think we need to be more transparent in and what the actual income figures are and it comes back to income claims again.

Why do we have so many people on the books as distributors? Well that’s because that’s how we onboard them. We enroll them as distributors when in fact they only want to conduct themselves or act as customers. They have no desire or motive to build a business or to recruit anybody. They simply want to buy the products at the best price and our pricing structure—or the common pricing structure within direct selling—has been to give distributors the best price. So, there’s a starter kit cost they have to purchase but usually you can save more money by paying the starter kit price, becoming a distributor, and the savings on the products is greater than the amount that you have to pay for the sales kit, the starter kit. So, it’s reasonable consumer behavior to become a rep even if you don’t intend to build a business, so you can buy the products at the best price. We end up onboarding people as reps.

The sad truth is often they’re initially enticed to join because of income claims and then when they don’t qualify for commission and they’re not active but they do indeed like the products and stay on the products, well we direct sellers have taken the position “oh they’re not active. They’re not intending to build a business. We don’t need to include their data in our income disclosure statement.” Well if they were onboarded under the guise of the income opportunity and income claims, well then it’s not clear whether they should be a rep, or if their intent in joining was as a rep, or if their intent in staying is to be a customer. We just don’t know and so I think we have to, when dealing with the idea of income disclosure statements, we have to do a better job of onboarding.

We have to ensure that people are not enrolling based on income claims. If they want to be a customer, let’s let them onboard and join as a preferred customer or something. But get rid of income claims in the recruiting process, so that we can accurately onboard them into the right classification and then become more transparent. That inherently will cause our income disclosure statements to be more accurate because those who are joining for purposes of being customers will not be included in the distributor ranks. There won’t be any need to go through that active vs. non-active distributor distinction.

Kenny: You’re hitting on something that over the years I’ve become more and more passionate about. I don’t know if passion’s the right word. But more and more an advocate of is… you talked about the muddy waters earlier of motives… well we’ve been putting ourselves, as you’ve alluded to, we’ve been putting ourselves in a tough spot because right from day one we’ve been causing people’s motives to be unclear because there are two potential benefits to signing up as a distributor. One is a chance to potentially have those income opportunities but then two is I may never have signed up as a distributor with the intention to make a single penny except for in the case where I’m saving money. I’m getting the better price so now you’re putting somebody on your books where you have no idea even on day one what their motive was. And that’s where—you and I have talked about this in the past—but that’s where I fully endorse the concept that there should be a path to the best price that doesn’t involve being a distributor.

And I also am a big believer in required, within-30-days training of a distributor that makes it very clear that you are engaging in a business opportunity. If they’ve chosen to sign up as a distributor, now that we’ve taken the pricing off the table, it’s clearer what their motive is. But then with proper training, let people know “hey this is what it takes to be successful. And you are engaged in an entrepreneurial business opportunity which brings with it the risks associated.” And not hide behind it.

You know I’ve grown up my entire life in this industry and one of the things that we preach a lot is “it allows people to start a business or to engage in an entrepreneurial endeavor where you can be your own boss etc. etc. for very little upfront cost.” Well okay if we’re going to embrace the positive side of it we also need to train on the negative—not even negative—but train on the risks of it. This all goes back to what you’ve talked about which is transparency. If we did a better job in that onboarding process we would first of all have better, cleaner numbers that we could put in our income disclosure statements, and we would have a happier field. If you have mandatory training that we know you took through the use of technology to say “hey I took this. I just started a business.” And then you make it clear that “hey if this isn’t for you there’s a return policy.” Right? You don’t get people there who’re six months in and feel like they’ve been lied to about the opportunity! And I think it’s something we need to take the bull by the horns on and embrace and really self-police. I mean these are things I’m passionate about or have strong feelings on regardless of the regulatory environment. But by doing them then you also put yourself in a much better regulatory standing.

Spencer: I agree wholeheartedly with you, Kenny. I truly do. Really the whole practice of onboarding or enrolling or sponsoring or recruiting people based on income claims has gotten so out of hand and the FTC has gotten wind of it. They’re just sick of it. So, the bottom line is whether we want to change the process because it’s the right thing to do or because we have to because of regulatory pressure, it’s a change that’s coming. So, we can either embrace it or have it shoved down our throats and I think it would be far better if we embrace it because it’s the right thing to do. That’s just something that… it’s gotten out of hand; the practices have over the last 50 years and you know we used to truly be the direct selling field. Now, at least in the opportunity side of the equation (I’m not talking about the party clan side of the equation but in the direct selling the opportunity side of the equation), it’s turned into the direct recruiting business and let’s face it that’s—and now I’m speaking in broad terms there’s of course exceptions to that—but you know broadly speaking, you go to rep meetings—corporate executives will disagree with me, you know, till the cows come home—but you go to the distributor meetings and that’s what’s going on, that’s what’s being pitched. I can’t tell you a number of executives that disagree with me and yet they haven’t gone out to an individual distributor home meeting in ten years!

Kenny: Yeah.

Spencer: It’s unfortunate. Or they haven’t monitored social media. They’re just sticking their heads in the sand.

Kenny: Right. Yeah. And they want to pretend there’s a few bad actors. And the question isn’t “how many are there?” It’s “are they out there and are they being public about it?” And “what are we proactively doing to stop it?” Now you touched on something that I found interesting (and we’ll have this be our last topic) but one of the things that you mentioned to me in the past, just kind of in passing, is that party plans have not historically been targeted in the same way as other network marketing direct selling companies. Is there something you’re seeing that party plans are doing different that has caused that?

Spencer: They’re much more about the product of course. And motives for participating in a party plan is often not driven by income claims or the income opportunity. It’s driven by the product. It’s driven by the desire to participate in a social activity. It’s the desire to be part of a group. But it’s not driven by the income opportunity or inappropriate income claims. Certainly, the income opportunity is there with party plans. It’s just not front and center so much and it’s not emphasized so strongly. And, of course, party plans are oriented towards selling merchandise to customers. I mean true customers in the eyes of the FTC. That is people who are not reps or participants in the business. They have not enrolled as reps. You know they have a different pricing structure, and they have a wholesale or retail price, and [they have] reps you know do indeed sell the merchandise [that they purchase]. And so those distinctions are dramatic. That’s why I think we haven’t seen the FTC action against party plans. Party plans have a whole host of other legal regulatory issues they have to deal with. But the devastating and pyramid-type claims have not been an issue for party plans, nor do I foresee that they will be. The issue that we do see is, is there a pure party plan anymore? Yeah not so much. You know, they tended to migrate towards more aggressive MLM type compensation plans. But at their heart they’re still much more about the product and the motive for reps to join is not so focused and directed by income claims.

Kenny: And I think that’s something that’s helpful to point out to people because there certainly is room to look at “okay what could we do to more emulate that regulatory-friendly behavior?” Because you know people’s goals… I am a firm believer that there are some great companies. I’ve worked with them. I’ve experienced it. And what we need is some of those great companies out there to lead the way in doing some of these things and blaze a trail that others can follow. Compensation plans are a funny thing. Where if somebody is popular and regardless of whether the compensation plan is good, bad, funny, weird, normal… whatever it is people gravitate toward what the successful companies are doing. So, some of these changes, all it would take is for one or two successful companies to start making them and people would start emulating that behavior. I know you’ve been beating this drum for as long as I’ve known you and I hope that we can start to get more people on board and in following that advice. Let’s be more realistic in what we’re putting out there. More transparent. And make sure that we’re monitoring the field for bad actors.

Spencer: Agree with you wholeheartedly, Kenny. Truly. Truly. Yeah, we’ve in many respects made our bed and now we’re being forced to sleep in it. We got to change the sheets.

Kenny: Yeah.

Spencer: They’re too dirty. They’re dirty. We got to change them.

Kenny: Yep absolutely. Well Spencer, I really appreciate your time. I appreciate you joining us and we look forward to having you on again soon!

Spencer: Well thanks Kenny I really appreciate it and appreciate the time and what you guys are doing. Have a wonderful day.

Kenny: That concludes today’s episode of the podcast. Once again, I’m your host, Kenny Rawlins, and I wanna give a special thanks to Spencer Reese of Reese, Poyfair, and Richards for his expertise and knowledge. We hope you’ve enjoyed today’s episode and encourage you to go and review this episode on iTunes or wherever you get your podcasts. I also want to give a special thanks to Adam Holdaway and Jana Bangerter for production support. We hope you’ll join us again next time.

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MLM Scams and Legal News, MLM vs Pyramid Scheme, The Podcast

Kenny Rawlins

Kenny Rawlins has been fortunate enough to have been around the network marketing industry his entire life and has experienced its power...

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Spencer Reese

 Mr. Reese is a partner in the law firm of Reese, Poyfair, & Richards. He is a member of the Utah, Idaho, Colorado and Missouri Bars, and is...

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