FTC CHALLENGE:
Historic Opportunity

It has been approximately seven years since the obscure language in a U.S. Court of Appeals decision prompted the FTC to commence a string of cases challenging the structure of MLM programs that did not derive more than 50 percent of income from sales to nonparticipants.  This so-called "attack" on personal use has fueled much concern in the industry and caused many leading companies to perceive a cloud of uncertainty over their head.

During these years, the principal spokesperson for the industry, the Direct Selling Association, has been very timid on this subject.  Only recently has the Direct Selling Association, at the request of leading commentators, considered amendment of its code of ethics to recognize the legitimacy of "personal use" and to initiate dialog with the FTC, and to consider lobbying for federal protective legislation on this subject.

Although recent discussion with the FTC have not been fruitful, the DSA has finally reluctantly agreed to examine amendment of its code of ethics to recognize the importance of personal use by MLM companies, as well as to consider introduction of legislation in Congress to provide some relief and certainty to MLM companies.  Now is the time for corporate executives of leading network marketing companies and their distributors to press the DSA to embolden its position and to support any protective legislation in Congress that may arise during the next year.

THE FTC RULES

The FTC made its first full scale assault on the MLM model, accusing Amway of being an illegal pyramid scheme, and thus, a "deceptive trade practice" under FTC federal legislation.  From 1975 to 1979, the FTC and Amway were engaged in litigation, climaxing with a historic loss of the FTC in 1979.  In a landmark administrative law decision, an FTC administrative law judge ruled that Amway was a legitimate business opportunity as opposed to an illegal pyramid scheme based on three primary consumer safeguards: (1) a reasonable buyback policy for terminating distributors; (2) the 70% rule, which prohibited purchases of new inventory before old inventory had been sold or used; and (3) the ten retail customer rule, which required sales to ten customers. (Interestingly today, the Amway 70% Rule defines a retail customer to include purchases for personal or family use, or sales to nonparticipants). 

The FTC v. Amway case became known for its "Amway safeguards," the general rules honored by courts, legislators and enforcement agencies to uphold legitimacy of MLM type organizations.  The FTC was quiet on this subject for the next twenty years.

In the aftermath of odd language in a civil case against an  MLM company, Omnitrition, in 1994, the FTC began a new assault.  In the Omnitrition case, the U.S. Court of Appeals for the Ninth Circuit in language known in legal circles as "dicta," i.e., language unnecessary to the ruling in the case, challenged the concept of personal use by MLM distributors as not fulfilling the mandates for retail sales in evaluating pyramid schemes versus legitimate direct selling.  A new generation of FTC officials were emboldened to revisit the legitimacy of the MLM model.

From 1996 through and into the new millennium, in a series of FTC filings involving such companies as Fortuna Alliance, World Class Network, JewelWay, Futurenet, Equinox and 2Xtreme, in a step-by-step and case-by-case assault, the FTC challenged the MLM model and the Amway safeguards.

1.         In the early cases, the FTC questioned whether or not the Amway safeguards of promoting legitimate sales were protected when a company demonstrated strong personal use by participants.

2.         Next, the FTC argued that legality was determined by compliance with the Amway safeguards, plus sales greater than 50% of revenue to nonparticipant users.

3.         In a 1999 filing against 2Xtreme, the FTC finally evolved to its position that the Amway safeguards were really irrelevant altogether.  The key issue for the FTC was that sales to nonparticipants must exceed 50%, and constitute the majority of revenue for the MLM.

4.         In addition, in the 2Xtreme case, the FTC challenged autoship programs by consumable MLM companies as evidence of a pyramid scheme.  Many leading direct selling companies have autoship programs for the convenience of their distributors. 

5.         The FTC also used the 2Xtreme case to challenge the standard of business utilized by virtually all direct selling companies, namely minimum monthly purchase or activity requirements - as evidence of inventory loading and pyramid schemes.  Again, a devastating position for the direct selling industry.

THE NEXT FTC CHALLENGE

1.         Saturation:  Two more challenges to the MLM model are probably coming in the near future by the FTC.  One former FTC official, involved in the JewelWay prosecution, noted that the FTC was concerned by the fact that JewelWay sales after several years had seemed to go flat and, therefore, the FTC was concerned that JewelWay had saturated its market, and this was evidence of a pyramid scheme.  This is a dangerous road for the MLM industry, where many leading companies, including Amway, NuSkin and Herbalife, have found the majority of their sales outside of a relatively flat U.S. market by entering foreign markets.  If this becomes the next attack for the FTC, every major direct selling company who experiences a flat U.S. market is a target.

2.         Profitability:  In addition, an FTC official that had been involved in the JewelWay litigation, indicated that it was concerned that a relatively small percentage of JewelWay distributors made significant income.  Again, this has always been the model in major direct selling companies.  Whether it be income averages released by major direct selling companies, or by the Direct Selling Association, a small percentage of distributors are highly profitable in the direct selling opportunity.  Look for analysis in upcoming FTC cases to challenge the profitability of the MLM model for average distributors, and perhaps to add this piece of evidence as an accusation that the direct selling mode is illegal rather than legitimate.

THE CURRENT ENVIRONMENT

The assault on the MLM model by the FTC has occurred over a several year period.  Unfortunately, it has been virtually unresponded to by the direct selling industry.  And, who is the proper party to speak out on behalf of the industry and to lobby the FTC, congressional and legislative agencies, the Direct Selling Association?

The Direct Selling Association has among its members the largest of direct selling companies in the world, including Avon, Tupperware, Amway, Mary Kay and Shaklee.  Among it members, the MLM model is the dominant model for sales.  No other entity, neither a group of lawyers, individual companies, nor individuals are in a position to dialog with the FTC or to have the standing to seek administrative, enforcement or legislative relief.

To its credit, the DSA spoke out in an amicus brief, although unsuccessfully, in the Omnitrition case and then proceeded to secure very admirable legislation in a few states, including Texas, Louisiana and Montana, which now recognize personal use as being as valid as a retail sale.

But, apart from the isolated local success, the DSA has adopted no formal written position nor changes in its code of ethics on this subject.  Signs are good, however, the change is coming.

The vast majority of FTC actions, to its credit, are against what the industry would refer to as "bad actors," the legal position of the FTC on personal use, and abandonment of the Amway safeguard rules, leaves virtually every major direct selling company with the MLM model at great risk and legal exposure.  Companies that believe the risk is limited to a direct assault by the FTC, are not being realistic.  The attack begun in the Omnitrition case on personal use and carried forward without opposition by the FTC for several years, manifests itself in enforcement activity by state attorneys general, litigation in cases such as International Heritage by the Securities and Exchange Commission, class action suits against such companies as Melaleuca and NuSkin, and even protracted litigation in which leading companies such as Amway are the target of accusations by critics such as Proctor and Gamble.  Not only has the entire direct selling industry been placed at risk, but major direct selling companies have been forced to spend millions of dollars in legal fees to defend their models, dollars that could have gone instead to reward their loyal distributor forces.

Those defending themselves are left naked because the industry, through the Direct Selling Association, has not yet adopted a formal position in its code of ethics or otherwise, on the issue of personal use, and one which can be referenced by companies seeking to defend themselves based on an industry standard.  Interestingly, one former FTC litigator indicates that the FTC pays attention to such formally adopted standards.

AN ACTION PLAN

What can the direct selling industry do to ensure survival of the MLM model?  Here are several concrete actions that the industry, through the Direct Selling Association, should immediately implement:

1.         Both member and non-member DSA companies should urge the Direct Selling Association to discard its passive position and place this issue ahead of all others as a priority action issue. 

2.         The DSA should adopt as part of its code of ethics the formal position that personal use by distributors should be recognized as a valid legitimate end sale just as much as a nonparticipant sale.  The DSA should adopt as a formal "safe harbor" rule the same rule that it has so successfully advocated in state legislation in Texas, Louisiana and Montana.  In that legislation, a company which adopted a reasonable buyback policy on inventory, and which paid commissions on the sale of product, whether to nonparticipants or to participants for personal use, was deemed to not be engaged in pyramid selling.  

The DSA has missed a bet on this point.  One former FTC official who handled litigation in the JewelWay case, noted that the FTC gives great deference to formal rules and standards adopted by an organization such as the Direct Selling Association.  Therefore, adoption of such a "safe harbor" rule would not only give targeted companies something with which to argue with in court, but would also be given the deference in enforcement actions and policies by the FTC and state officials.

3.         The DSA should immediately engage the FTC in a serious dialog to educate the FTC as to the legitimacy of the MLM model and the need to recognize personal use as part of its legal test to distinguish between legitimate MLM companies and pyramid schemes. 

In addition to forthrightly engaging the FTC in discussion on the personal use issue, the DSA should also engage the FTC in dialog to change its "trial by ambush strategy" in which targeted companies are "put out of business" prior to any contact by the FTC, by the application for temporary restraining orders and receivers which cripple the businesses, without even a hearing.  The "trial by ambush" approach has been used in most of the recent FTC cases, and it is contrary to fundamental fairness in resolving disputes between the FTC and targeted companies.

4.         In a similar fashion to the nutritional products industry that sought successful assistance from Congress from unduly burdensome regulation, the DSA would seek out members of Congress that would introduce legislation to provide relief on the "personal use" model.  Such legislation should amend both securities laws and the FTC Act.  Although such legislation would be a long time in forthcoming, it would, at least, encourage the dialog between the FTC and the direct selling industry, in the same way that FDA legislation did between the FDA and the nutritional products industry. 

The slow creeping FTC threat to the MLM model is real.  Good people can differ on these issues.  The FTC has proceeded in good faith, slowly but surely, to impose its position.  Probably, part of the reason for its course, has been a lack of response or feedback from the industry. 

The DSA has been an extraordinarily effective advocate for the direct selling industry in the past.  It has an articulate and highly professional staff.  And yet, for whatever reason, at the end of the millennium it did not act decisively.

Now is the time for companies and distributors in the industry to tell the DSA not to look back, but to look forward.  First, the DSA should amend its code of ethics to recognize the legitimacy of personal use and, second, it should seek federal legislation to clarify the issue and prompt dialog with the FTC to change its enforcement position.