The SEC and Multilevel Marketing

Gary Langan Goodenow Sr.

Many multilevel marketing companies are really pyramid schemes that are pretending to be product based. Pared to their essence, MLM programs can survive legal scrutiny by making sufficient money from product sales rather than from obtaining new recruits to the programs. "Pyramid schemes” reward participants for inducing other people to join the program. However, no clear line separates illegal pyramid schemes from legitimate multi-level marketing programs. Fraudsters exploit this gray area to give their scams an image of legitimacy.

The term “pyramid scheme,” as used by securities laws regulators, refers to a pyramid-structured program that chiefly exists to reward participants for inducing other people to join. Pyramids that can be considered MLMs are are considered legal. All multilevels are not considered per se deceptive and unlawful. So, it is possible that an Internet investment can have a pyramid structure and not run afoul of the SEC or Federal Trade Commission's (FTC) laws. But I don’t think it’s likely that the typical investor can really tell pyramid scams from legal MLMs by examining information on the Internet.

The term "Ponzi scheme" typically means a program that pays earlier investors with money tendered by later investors. The original scheme by Carlo Ponzi in the 1920s was simple: investors paid him one dollar on the first day of the month, and he would commit to pay them two dollars on the last day of the month. To make that last day of the month payment, Ponzi used new investors money attracted to the program by the promised high returns. After Ponzi’s program failed, he went to work for Mussolini. The original Ponzi scheme had no recruitment downline or commissions paid for recruiting investors to join below the founders. For this reason, securities law enforcement authorities, unlike the general public (and some courts), do not use the terms "pyramid scheme" and "Ponzi scheme" to mean the same thing. The difference is in the contractual relationship: all Ponzi’s investors had direct "privity," which means a contract connection, with his company, whereas a pyramid has privity downline between the members and recruits, and their recruits, on and on.

For practical purposes, however, pyramid and Ponzi schemes are indistinguishable to investors: both pay old investors with new investors money. But because there is technically a difference, fraudsters will huckster their program by declaring loud and clear: "this is not a Ponzi scheme." Sometimes they may even have a legal opinion that there program is not Ponzi scheme, because: (a) there is no SEC definition of a Ponzi scheme and (b) the issuer’s program does not exactly replicate the terms and conditions of Ponzi’s 1920s program. So the disclaimer “This is not a Ponzi scheme” should be ignored.

The legal differences between a Ponzi and a pyramid scheme may require close study to detect. The FTC and SEC seek to enjoin both on the basis that they will inevitably harm later investors. Very simply, the money has to come from somewhere, and when it stops coming, those who contributed last lose their investment. One court held that these investments are “nothing more than an elaborate chain letter device in which individuals who pay a valuable consideration with the expectation of recouping it to some degree via recruitment are bound to be disappointed.”

FTC Regulation

The FTC, not the SEC, first went to court to combat the “serious potential hazards of entrepreneurial chains” and urged the “summary exclusion of their inherently deceptive elements, without the time-consuming necessity to show occurrence of the very injury which justice should prevent.” FTC In Koscot Interplanetary case, the FTC enjoined a promoter from “offering, operating, or participating in, any marketing or sales plan or program wherein a participant is given or promised compensation for inducing other persons to become participants in the plan or program”. This FTC opinion had nothing to do with the federal securities laws. The holding was based on common law fraud concepts on the theory that such programs will inexorably fail because eventually there are not enough people on earth to support it.

The FTC test for determining what constitutes an illegal pyramid scheme holds that they “are characterized by the payment by participants of money to the company in return for which they receive the right to sell a product and the right to receive in return for recruitment, rewards which are unrelated to sale of the product to ultimate users.” The key concept is the "unrelated" idea—that the program is so divorced from economic reality or mercantile endeavor, as to be merely a chain letter passing around money.

The FTC later recognized the distinction of “saturation” between legitimate pyramid structured programs and illegal pyramid schemes. In 1979, the FTC determined that the MLM program operated by Amway was neither fraudulent nor illegal. The FTC found that Amway Corporation was essentially structured as a pyramid, not a Ponzi scheme, with an ever increasing downline privity of recruits. Nonetheless, the FTC determined that the plan did not constitute an illegal pyramid because certain Amway rules ensured a focus on retailing merchandise over pyramiding of members. This effort at retailing, the FTC found, meant that the program would never be ‘saturated’ with members sending’ money to each other until there were no further people to join. These "anti-saturation" rules saved Amway from the ambit of the anti-Ponzi and pyramid scheme rules, not the specific structure of the enterprise. So, an Amway-like program that happened to pay participants a small fixed fee for bringing in recruits could constitute a "pyramid" but not a scheme to defraud because saturation will not occur.

SEC Involvement

Securities regulators examine MLMs, pyramid schemes, and Ponzi schemes for an investment contract, and therefore, securities, as defined by Section 2(1) of the Securities Act and Section 3(a)(10) of the Securities Exchange Act of 1934. The term “investment contract” is defined as (1) an investment of money; (2) in a common enterprise or venture; (3) premised on a reasonable expectation of profits and (4) to be derived from the entrepreneurial or managerial efforts of others. Named after the leading case on the subject, this is the "Howey test." An investment contract analysis considers four elements:

1. An Investment of Money. The term “investment of money” is where an investor commits assets to a venture in a way as to subject himself to financial losses. Under the usual investment vehicle, each investor commits funds to the capital development of a plan. Should a plan be unsuccessful, than the issuer will be unable to return an investor’s money. This is always the easy element to find.

2. Common Enterprise. The common enterprise element has been discussed in concepts known as ‘horizontal and vertical commonality’. Horizontal commonality requires the fortunes of each investor be linked to the others. Vertical commonality requires a finding that the fortunes of the investor are interwoven with and dependent upon the efforts of those seeking investments by new third parties. An investment plan is typically a common enterprise under both the horizontal and vertical common interest criteria. The fortunes of each investor are dependent upon the success of the issuer in either retailing merchandise in a legal MLM, or attracting new recruits in an illegal pyramid scheme, or attracting new investors’ money in a classic Ponzi scheme. Investors have a “vertical” common interest with the promoters of the plan, or third parties, and a “horizontal” common interest with other investors.

The concept of an investment contract does not require that the efforts of promoters or third parties be the sole efforts upon which the failure or success of the enterprise is based. Historically, there was some controversy on this point. The Supreme Court wrote of this prong of the test as “with profits to come solely from the efforts of others.” The present general rule virtually ignores the adverb “solely” in Howey and holds that investments where decisions made by those other than the investors are the essential, though not the exclusive, efforts effecting the failure or success of the enterprise.

3. Reasonable Expectation of Profits. The Supreme Court’s analysis under the Howey test of the term “profits” emphasizes the economic realities of the transaction, i.e., whether a purchaser is motivated by a desire to use or consume the item purchased or whether the investor is attracted solely by the prospects of a return on investment. Almost certainly in typical Internet investments, expectation of profit exists as the primary reason for the investment.

4. Solely from the Efforts of Others. As discussed in element two on commonality, the concepts are intertwined. Courts today reject a literal application of the fourth element, “solely from the efforts of others.” One SEC enforcement action case held, in language that does not make any sense to some readers: “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” Yet his quotation expresses the general test under the fourth prong that is presently used by the SEC and state securities regulators in their enforcement actions against illegal pyramid and Ponzi schemes.

But what about efforts to recruit others? In any investment, income is earned by raising money and then developing and retailing the good or service, until ultimately, profit is generated. Accordingly, returns are due to the results of efforts by persons other than the investor. MLM defenders often state that success is not due to the “efforts of others,” and so not a “security” because the member has to recruit others, and that takes work.

As to these “efforts” by the investor, there is one very critical distinction. Efforts to recruit new members to an MLM are not considered a bona fide “effort” to take the program out of the realm of an investment run by the “efforts of others.” The regulators consider that recruitment effort is not what the normal investment contemplates. Why? Because they view it as closer to a meal recipe swap chain letter than a real business. If the business is basically a system that sends money up the pyramid, it’s not a business at all.

Playing on the needs of MLMers to find new members, many independent companies and upline distributors will sell alleged sales aids and other support. There are magazines for MLM marketing. For example, you can see for sale: “auto-pilot” advertising systems that work while you’re at the beach, “hot” prospect leads including 10,000 fax phone numbers, lists of other “networkers” in peel and stick label format and—of course—cash loans and “grants.” Here are some of the headlines:

“Explode Your Downtime On The Phone!”
“We Pay Every Monday!”
“Secret Bible Food Revealed.”
“Make Big Money And Help Others…”
“Join The #1 Team And Top $$ Earners…”
“Look Around… There’s Money Everywhere!”
“Make Hundreds, Even Thousands Of Dollars A Month, Every Month!”
“Ain’t Money Grand? How About A Few Extra Grand A Month?”
“Somebody Is Going To Get Paid…Why Not You?”
“Live In Your Dream Home Earning $900 To $3,600 A Day…”

My personal favorite is “Make Money Like A Gangster.”

Bruce A Craig, an assistant attorney general for the State of Wisconsin Department of Justice has questioned the logic of not considering Amway an illegal pyramid scheme. His comments deserve serious consideration because, during 30 years of service he has prosecuted a significant number of pyramid scheme including the Koscot case. In a letter to Robert Pitofsky, the FTC Chairman who drafted the original Amway opinion, Craig noted that since the Amway decision, “investments in pyramid type offerings have resulted in billions of dollars over the years.” He highlights that “the FTC Amway decision has created a good deal of uncertainty in respect to private and public legal efforts to deal with abuses of pyramid plans” that “will only increase with the onset of marketing over the Internet.”

I certainly agree. Every time I prosecuted a pyramid or Ponzi for the SEC, the first words out of the founder’s mouth were: “I set this up just like Amway.” Craig has urged the FTC to reexamine the aspects of Amway that make it legal because “the premise of ‘multilevel vs. pyramid’ may well represent a distinction without a difference.” I believe Craig is correct when he asks “whether these exculpatory factors can be effectively evaluated in time to prevent losses to the consuming public." In my experience, the fraudsters know that; and that is why, unfortunately, when the SEC Enforcement Division comes in with an asset freeze, the money is long gone.

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Mr. Goodenow, a former senior trial attorney in the SEC enforcement division, is licensed to practice in the Florida and the District of Columbia. His Web site discusses the shortcomings of SEC enforcement.

This article was posted on August 16, 2004.

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