What government can do to fight pyramid schemes
By Alia Malek
Published on Tuesday, October 14, 2014
The federal government's oversight of alleged pyramid schemes is undertaken by the Federal Trade Commission and the Securities and Exchange Commission.
Federal Trade Commission
The Federal Trade Commission Act protects consumers from "unfair or deceptive acts or practices in or affecting commerce." In the 1970s, there was a boom in direct selling and home-based businesses. One of the iconic examples of the era is the Tupperware party where guests, usually women, were introduced to the cooking products at the host’s home. Some of these direct-selling businesses were pyramid schemes in disguise; in pyramid schemes, participants make most of their money from commissions by recruiting new members, not by selling actual products. One such business was Koscot Interplanetary, a cosmetics company based in Florida that offered people the opportunity to sell its products by becoming a "beauty advisor." Participants paid $2,000 to become a "supervisor" and $5,400 to purchase advance inventory; they earned their bonuses by recruiting others to make the same up-front investments to enter the business.
Though then-Sen. Walter Mondale sponsored a federal bill targeting these schemes, it failed to pass. Meanwhile, the popularity of Koskot prompted the FTC to begin looking more closely at pyramid schemes and develop a test that it still uses today to help the agency evaluate if a business is indeed legitimate or an illegal pyramid scheme.
- When evaluating a business, the FTC looks for three things:
- Endless chain: Can a person who wants to join the business both sell the product and also recruit other participants into the program, who in turn can recruit still more participants?
- Payment: Does the person have to pay money to participate?
- Retail sales: Is the person compensated for recruiting new people to participate, unrelated to the sale of product to outside consumers?
After bringing charges against Koscot, the FTC brought a similar case against Amway Corp., an enterprise that also used multilevel-marketing techniques to sell its home-care products. The FTC ultimately found that although Amway used a pyramid structure, it was a legal multilevel-marketing business. MLMs use a marketing strategy in which the salesforce makes money not only from selling products, but also from the sales of the other salespeople whom they recruit.
- Amway won the case because the company had three internal rules that incentivized participants to actually sell the company’s products to customers:
- Distributors had to buy back any unused and marketable products from their recruits upon request.
- Distributors had to sell at wholesale or retail at least 70 percent of purchased inventory each month.
- Distributors had to make at least one retail sale to 10 different customers each month.
After this decision, MLM firms quickly adopted the Amway safeguards as a way to avoid FTC prosecution.
Measures the FTC can take against those businesses it determines are pyramid schemes include injunctive relief (an order that requires an individual or organization to cease a certain action), freezing defendants’ assets, receivership over the defendants’ business and redress or restitution for consumers.
Earlier this year, Jessica Rich, the director of the FTC’s Bureau of Consumer Protection, outlined the agency’s five enforcement priorities. While they did not mention pyramid schemes, the priorities did include protecting "vulnerable and targeted groups," which could create an opportunity to investigate when such groups are targeted by pyramid schemes.
Securities and Exchange Commission
The Securities and Exchange Commission can bring cases against alleged pyramid schemes, including those businesses that are not publicly traded, by treating the investment that participants make in a company as a security. This means the federal securities laws — particularly those that protect against fraud — are applicable to a company’s conduct. That leaves several remedies against pyramid schemes, including injunctive relief and restitution to participants.
Under the Securities Act, individuals who believe they have been defrauded by a pyramid scheme can sue companies directly, either on their own or as part of a class action.
The landmark case in which the SEC first sued an MLM company was SEC v. Glenn Turner Enterprises, Inc., in 1973. In its decision, the 9th Circuit Court of Appeals concluded that the definition of "investment contract" in federal securities laws ("an investment of money in a common enterprise with profits to come solely from the efforts of others") was broad enough to encompass MLM-type pyramid schemes.
Last month, the SEC announced two new cases against international alleged pyramid schemes eAdGear Holdings Limited and Zhunrize Inc.
States can also prosecute suspected pyramid schemes. Most states have laws that both address pyramid schemes and laws that prohibit fraud, more generally.
California’s endless-chain-scheme law was the first state law to expressly combat pyramid schemes, and it is arguably one of the strongest. It clearly prohibits payment of compensation for recruiting new participants; compensation can only be paid based on sales of products to people who are not participating in the scheme.
Most state laws follow the California model. A recent example is the case against Fortune Hi-Tech Marketing. Originally filed by the state of Montana, several years later, North Carolina, Kentucky, Illinois and the FTC later followed suit. However, the Direct Selling Association, a trade association dominated by MLM firms such as Herbalife, Amway and Nu Skin (Tupperware and Avon were members but have left), lobbies states to amend their laws. Recently, the DSA announced its success in Tennessee, which now explicitly permits purchases by participants to count as "retail sales."
Private plaintiffs can also bring cases — individually or as a class — under federal securities laws; under state laws that also create private causes of actions; or under state tort laws (which allow individuals to sue others who have caused them harm through unreasonable actions) against "common law fraud." These actions are often difficult to pursue because mandatory-arbitration clauses or class-action waivers are often written into the contract that members sign when they join the company.
However, some examples of successful lawsuits include the Jacobs v. Herbalife class-action case, in which Herbalife settled for $6 million, and the Pokorny v. Quixtar/Amway case on behalf of Amway distributors, in which a class settlement was reached for $34 million in cash and $21 million in products.