The FTC’s primary cause of action alleges that business practices constitute unfair and deceptive trade practices and are therefore a violation of Section 5 of the FTC Act. The FTC is ultimately seeking to prove that the program is a pyramid because all pyramids are inherently deceptive. The fundamental element of a pyramid is that is pays commissions based primarily on recruitment of individuals into the plan rather than on the product or service sales.
Any compensation plan that requires a monthly purchase of product or service in order for distributors to earn a commission is problematic. It is fairly common for MLMs to incorporate the pay-to-play feature as a prerequisite to eligibility to participate in their compensation plans. The legal problems associated with a pay-to-play plan arise because product or service sales cannot be distinguished from distinguished from distributor enrollment. Therefore, the questions arise whether the mandatory product or service purchases are actually: 1) a disguise for a head-hunting fee; and/or 2) and inventory loading game. If the answer to either of these questions is yes, the program is a pyramid because commissions are actually paid based on recruitment rather than bona fide product sales. Regulators will always presume that the answer to both questions is yes if a plan follows the pay-to-play format, so MLM companies will be cast into the difficult position of trying to convince regulators that their presumptions are unfounded.
The strongest position available to an MLM to rebut a regulators’ presumption that a mandatory purchase is a head-hunting fee and an inventory loading game requires that the company prove that its distributors actually retail the products they purchase. If distributors are reselling their monthly purchase quotas, there is no inventory loading problem since the distributors do not retain the products. In addition, if the products are resold it is evident that the there is a bona fide sales program in place.
However, in most MLM programs the majority of the distributor force does not resell the products. Under these circumstances it is more difficult to rebut a regulator’s presumption, but there are several ways to address this issue. First, the company must have a strong inventory repurchase policy and must be able to prove that it actually abides by it. The industry norm is to provide distributors with a refund of 90% of their net inventory cost for up to one year after purchase. If a company can prove that it abides by such a policy, it is in a good position to rebut a claim that it is playing an inventory loading game.
Secondly, if the mandatory minimum purchase is low and the products being sold are truly consumable, there is a viable argument that the distributor and her family can legitimately personally consume the products themselves each month. Since the distributor is the end consumer there is no inventory load. Caution must be exercised however, because the strength of this argument declines as monthly quotas increase. While a distributor and her family may easily consume $100.00 of nutritional supplements a month, it is unlikely that they will consume $1,000.00 per month, so any company that intends to rely on this argument should ensure that it has a conservative monthly purchase requirement.
In addition, the strength of an inventory repurchase policy also loses its punch as a purchase quotas rise. If a distributor purchases $100.00 per month, and at the end of the 12 months decides to return all of it for a refund, she will lose 120.00 if the company has a 90% inventory repurchase rule in effect. However, if a distributor is required to purchase $1,000.00 per month, and decides to return all of it at the end of a year, she will be out of pocket $1,200.00. The same 90% inventory repurchase policy may be in effect, but there is a big difference from the $100.00 per month case and it is far more likely that regulators will stand firm by their presumption that the minimum quota is a camouflaged head-hunting fee and inventory load.
In addition to the inventory loading and pyramid issues, a company that requires its distributors to purchase a minimum monthly quota runs a great risk of being classified as a business opportunity under state laws. Under the laws of 22 states a program must register as a business opportunity if there is an initial required investment that exceeds a certain threshold. These thresholds range from $200.00 – $500.00 within the first six months of the contract or over the length of a contract if a term is specified. If a company requires the purchase of $100.00 each month, within six months its distributors will surpass the minimum investment threshold in every state and therefore be classified as a business opportunity. While business opportunities are not illegal, they must be registered with the states and abide by very burdensome disclosure obligations. Failure to do so constitutes a deceptive trade practice under the state laws and can lead to severe sanctions against the company.
Ultimately, a pay-to-play program is a bad idea and I discourage anyone from promoting a pay-to-play plan. The risks are high, and unless the company can prove that its distributors are really reselling the products (which is very rare, except in party-plans), the defenses available to the company are tenuous.