Myths About Self-Consumption in MLMs

By James R Sobieraj

© 2018 (First Published in The National Law Review)

Recently, legislation has been introduced in Congress (the Blackburn-Veasey bill, H.R. 3409) that seeks to bring clarity and consistency to activities that distinguish illegal pyramids from legitimate multi-level marketing companies (“MLMs”).  A select few interest groups and certain regulators, who project a bias against MLMs, have spoken out against this legislation by relying on a false legal premise.

The false legal premise:  The opponents of the legislation, often non-lawyers, invariably make the bold assertion that for decades the courts have held that the critical difference between a legitimate MLM business and a pyramid scheme is that an MLM’s revenues must come primarily from the sale of products and services to retail customers unaffiliated with the business opportunity.  This assertion misrepresents the law.

The recently issued FTC Business Guidance Concerning Multi-Level Marketing^[i] confirms the long-standing Koscot^[ii]legal standard that a company is an illegal pyramid where “the payment by participants of money to the company in return for which they receive (1) the right to sell a product and (2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of the product to ultimate users.”^[iii]

Critics of MLMs have argued that the italicized language means that the majority of an MLM’s revenue must come from product sales to persons who are not participants in the MLM.  They call these “retail sales,” implying that a “retail sale” does not include a participant buying her vitamins from her MLM company instead of CVS.  That is not what the Koscot opinion says. 

Nor does the argument follow from the facts in Koscot.  There, the FTC found that the company was an illegal pyramid because high recruitment fees provided the primary basis for participant compensation.^[iv]  The case did not turn on participants’ self-consumption of a large portion of the company’s product sales.  In fact, for over its first year of operation, the company had no products for its distributors to sell or consume.^[v]

Shortly after Koscot, the case law clearly debunked the notion that self-consumption is the litmus test for determining if an MLM is an illegal pyramid.  After an exhaustive four-year investigation and extensive trial, the FTC ruled that Amway, the quintessential MLM, was not an illegal pyramid under the Koscot standard.^[vi]  In doing so, the FTC acknowledged that a large portion of Amway’s products were “consumed by the distributors themselves rather than resold.”^[vii]  

Did the FTC say that self-consumption by distributors were not sales to “ultimate users” as the term is used in Koscot?  No.  To the contrary, the FTC held that Amway was not an illegal pyramid even though its distributors self-consumed (that is, they were “ultimate users” of) a large portion of Amway’s product sales.

In re Amway is the seminal case for establishing that MLMs are not illegal pyramids where distributor compensation flows from product sales, including purchases by the distributors, that are not required as part of the cost to participate in the MLM.  Critics of MLMs often ignore In re Amway, or try to brush it aside with irrelevant distinctions, because it refutes their narrative that a large portion of product sales must come from purchases by non-distributors. 

The MLM critics also tend to ignore another critical point in In re Amway:  “‘Pyramid’ sales plans involve compensation for recruiting regardless of consumer sales.In such schemes, participants receive rewards for recruiting in the form of ‘headhunting fees’ or commissions on mandatory inventory purchases by the recruits known as ‘inventory loading.’”^[viii]These are the outcome-determinative factors in subsequent cases where companies were adjudged to be illegal pyramids.Yet anti-MLM advocates conflate and confuse these factors with dicta that was not outcome determinative.

Omnitrition^[ix]is often misrepresented by those who would like to implicitly overrule In re Amway.  In Omnitrition, to become a “Supervisor,” a distributor was required to purchase thousands of dollars of product each month with only limited ability to return the product for a refund.  In other words, a large recruitment fee was disguised in the form of inventory loading. 

The company defended itself by arguing it had written rules similar to those cited with approval in In re Amway.  The 9th Circuit noted a critical distinction:  Amway’s rules “served to encourage retail sales and prevent “inventory loading” by distributors.”^[x]  Whereas, Omnitrition’s rules were weaker, and evidence was lacking that they actually worked.  While Omnitrition contains dicta that suggests purchases by distributors for their own use should not be considered “retail sales” to “ultimate users,” the Court’s decision turned on the company’s failure to prevent inventory loading.

MLM critics often seize upon and distort the dicta in Omnitrition to assert that the case established a legal requirement that a majority of an MLM’s sales must come from non-participants.  In fact, the 9th Circuit said no such thing.  Nor did the Court overrule or criticize In re Amway, where distributor self-consumption constituted a large portion of the company’s sales.  The Court repeatedly noted that in In re Amway the company actually “encouraged” retail sales.^[xi]  The Court did not say that any particular amount of retail sales is required.

In the years following Omnitrition, repeated misrepresentations about the relevance of internal consumption by MLM participants led the FTC to issue an Advisory Opinion to clarify its position on the subject:

Much has been made of the personal, or internal, consumption issue in recent years. In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme.^[xii]

The FTC further explained that “a multi-level compensation system funded primarily by payments made for the right to participate in the venture is an illegal pyramid scheme.”^[xiii]  This Advisory Opinion was consistent with decades of case law where the sine qua non of an illegal pyramid scheme is that a participant’s compensation comes primarily from consideration paid by new participants for the right to participate in the enterprise, whether that consideration comes directly from registration fees or disguised as inventory loading.

Unable to refute the FTC Advisory Opinion, some MLM critics try to summarily dismiss it as “poorly worded”, and maintain their legal fiction regarding self-consumption by mischaracterizing subsequent FTC actions, such as BurnLounge, Vemma, and Herbalife.^[xiv]  In fact, none of those actions support the MLM critics’ errant notions about internal consumption and sales to non-participants.

Nowhere in BurnLounge did the 9^th Circuit say that a particular percentage of an MLM’s sales must be made to non-participants.  In fact, the Court explicitly rejected the FTC’s argument that “internal sales to other [participants known as Moguls] cannot be sales to ultimate users consistent with Koscot.”^[xv]  The Court also expressly noted that “when participants bought packages in part for internal consumption . . . , the participants were the ‘ultimate users’ of the merchandise.”^[xvi]

What made BurnLounge’s Mogul program illegal is that a participant’s compensation actually came from mandatory music package purchases that were tied to an enrollment fee and were non-refundable in practice.  In other words, a participant’s compensation was dependent on the aggregate payments of new recruits to join the Mogul program.  Again, the 9th Circuit distinguished Amway’s MLM business model as legal because it conditioned rewards on voluntary product sales (including internal consumption) and not for “the mere act of recruiting,” and Amway’s rules discouraged inventory loading.^[xvii] 

Vemma also does not support the narrative of MLM critics.  There, distributors were required to make large product purchases (a $600 initial purchase plus $150 per month); they were “very likely engaging in inventory loading”; and their bonuses were tied to purchases of products required to stay eligible for those bonuses.^[xviii]  Those key findings convinced the court to issue a preliminary injunction.  But, citing BurnLounge, the court also noted that self-consumption by distributors are sales to ultimate users and do not prove that an MLM is a pyramid scheme.  As the 9th Circuit did in Omnitrition and BurnLounge, this court also distinguished Vemma from In re Amway because Amway enforced anti-inventory loading rules.^[xix]

Herbalife involves a recent settlement between Herbalife and the FTC.  Any first year lawyer knows that a settlement agreement is not binding precedent on any other party.  The FTC also made this point clear in its 2004 Advisory Letter, where it explained that its consent orders “often contain provisions that place extra constraints upon a wrongdoer that do not apply to the general public. These ‘fencing-in’ provisions only apply to the defendant signing the order and anyone with whom the defendant is acting in concert. They do not represent the general state of the law.”^[xx]  The FTC reiterated the same point again in its recently issued Guidance.^[xxi]

Finally, the FTC’s new Guidance explicitly confirms that it is still correct “as stated in the 2004 ‘FTC Staff Advisory Opinion – Pyramid Scheme Analysis’ that ‘the amount of internal consumption does not determine whether the FTC will consider the MLM’s compensation structure unlawful.’”^[xxii]

The foregoing discussion demonstrates that MLM critics rely on and advocate a false legal premise.  Decades of case law make it clear that internal consumption by MLM distributors constitutes sales to “ultimate users,” and is not a litmus test for an illegal pyramid.  Other court decisions^[xxiii] and statute statutes^[xxiv], which the MLM critics typically ignore, reach the same conclusion.

The Blackburn-Veasey bill (H.R. 3409) is consistent with decades of precedent that distributors’ purchases for their own consumption is a legitimate sale to an ultimate user.  The legislation also would provide new enforcement tools for the FTC to go after the type of inventory loading that was the crux of the pyramid findings in Omnitrition and Vemma.  Nor does the legislation restrict the FTC from stopping the BurnLounge type of registration-payment-based compensation scheme.  If the proposed legislation had been adopted prior to those cases, the ultimate decision in each case would not have changed. 

What the proposed legislation would change is that, going forward, the federal courts would have a uniform legal standard for an illegal pyramid, and legitimate MLMs would not have to expend significant resources defending against lawsuits based on a false legal premise.

_{[i] Press Release, Fed. Trade Comm’n, FTC Staff Offers Business Guidance Concerning Multi-Level Marketing (Jan. 4, 2018),https://www.ftc.gov/news-events/press-releases/2018/01/ftc-staff-offers-....}

_{[ii] In re Koscot Interplanetary, Inc., 86 F.T.C. 1106, 1975 FTC LEXIS 24 (1975).}

_{[iii] Id. at *166–67.}

_{[iv] Id. at *162–64.}

_{[v] Id. at *67–69.}

_{[vi] In re Amway Corp., 93 F.T.C. 618, 1979 FTC LEXIS 390 (1979).}

_{[vii] Id. at *95.}

_{[viii] Id. at *97–98 (emphasis added).}

_{[ix] See generallyWebster v. Omnitrition Intern., Inc., 79 F.3d 776 (9th Cir. 1996).}

_{[x] Id. at 783 (emphasis added).}

_{[xi] Id. at 783–84 (emphasis added).}

_{[xii] See Letter of James A. Kohm, Acting Dir. of Mktg. Practices at the U.S. Fed. Trade Comm’n, to Neil H. Offen, President of the Direct Selling Ass’n 1 (Jan. 14, 2004), https://www.ftc.gov/system/files/documents/advisory_opinions/staff-advis....}

_[xiii] Id.

_{[xiv] FTC v. BurnLounge, Inc., 753 F.3d 878 (9th Cir. 2014); FTC v. Herbalife Int’l of Am., Inc., No. 2:16-cv-05217 (C.D. Cal. July 25, 2016); FTC v. Vemma Nutrition Co., 2015 U.S. Dist. LEXIS 179855 (D. Ariz. Sept. 18, 2015).}

_{[xv] BurnLounge, Inc., 753 F.3d at 887.}

_{[xvi] Id. at 887.}

_{[xvii] Id. at 886.}

_{[xviii] Vemma Nutrition Co., 2015 U.S. Dist. LEXIS 179855, at *11–13.}

_{[xix] Id. at *4–8, *26–28.}

_{[xx] Letter, supra note 13, at 3.}

_{[xxi] Press Release, supra note 2.}

_{[xxii] Id.  The Guidance discusses other factors that it will consider in evaluating MLMs, such as consumer demand, which raise new issues beyond the scope of this article.}

_{[xxiii] See, e.g., Whole Living, Inc. v. Tolman, 344 F. Supp. 2d 739, 745–46 (D. Utah 2004) (“Defendants misread the relevant case law. A structure that allows commissions on downline purchases by other distributors does not, by itself, render a multi-level marketing scheme an illegal pyramid”); State ex rel. Miller v. Am. Prof’l Mktg., Inc., 382 N.W.2d 117, 120 (Iowa 1986) (“Although a supervisor or director obtains a commission by wholesaling to personal representatives and earns bonuses based on their output, these remunerations are directly related to products that are either consumed by the personal representatives or retailed to their customers.”).}

_{[xxiv] See, e.g., Ga. Code Ann. § 16-12-38(b)(2); Idaho Code Ann. § 183101(6); Ky. Rev. Stat. Ann. § 367.830(5); La. Rev. Stat. Ann. § 51:361(1)(a); Mont. Code Ann. § 30-10-324(1)(b)(ii); Neb. Rev. Stat. § 87-302(12); Okla. Stat. tit. 21, § 1072(1)(a); S.D. Codified Laws § 37-33-8; Bus. & Com. § 17.461(1); Utah Code Ann. § 76-6a-2(1)(b); Va. Code Ann. § 18.2-239(1); Wash. Rev. Code Ann. § 19.275.020(1).}

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