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When Should an MLM or Network Marketing Program Be Considered an Illegal Pyramid Scheme?


by Jon M. Taylor, PhD

One of the most problematical of business models is multi-level or network marketing (MLM ). Many MLM programs show all the effects and characteristics of a pyramid scheme, but the MLM industry has nonetheless been allowed to continue and flourish. Though considered benign by many, its insidious and corrupting influence and the financial and social harm suffered by participants is considerable. Unfortunately, victims of these programs seldom complain, blaming themselves for their failures.

This problem is compounded by limited resources available to enforcement agencies, faced with a profusion of both naked pyramid schemes (wherein no products are offered) and product-based pyramid schemes (PPS's), operating as MLM's. They are now appearing by the hundreds on the internet, and established MLM companies are expanding into overseas markets.

Due to inadequate definitions of what constitutes a pyramid scheme, insufficient resources, and/or lack of prosecutorial will in enforcement of existing statutes, enforcement agencies often wind up catching the minnows, but letting the sharks go free. The consequences are enormous -- millions of MLM participants are being bilked out of billions of dollars each year.

Pyramid schemes, as currently defined by the Federal Trade Commission (FTC) -- and in many state laws -- are plans which

  1. "concentrate on the commissions you could earn just for recruiting new distributors," and which
  2. "generally ignore the marketing and selling of products and services."

These two criteria, standing alone, have proven to be inadequate for determining whether or not an MLM program is a pyramid scheme. Understanding the defining characteristics and effects of pyramidal compensation systems could yield a much wider and more proactive application of the laws against pyramid schemes to PPS's.

The key to predicting potential harm to victims of a PPS is to determine the degree of leverage of the compensation system. Once a highly leveraged PPS is identified by its compensation system, the prognosis is certain: Inordinate emphasis on recruiting will follow, and only a few at the top of the pyramid will profit at the expense of the investments in product purchases by those in their downline -- most of whom lose money. In other words, emphasis on recruiting is just one of the effects, not the cause, of the problems with PPS's.

Problems with interpreting the FTC definition of a pyramid scheme have been compounded by information releases from the enforcement agencies and the Better Business Bureau, in which MLM's are distinguished from pyramid schemes -- even exonerated as non-pyramids, when in fact they are often more damaging in their effects over time than naked pyramid schemes.

In the FTC's definition of multi-level marketing, it is assumed that implementation of "rules" will keep MLM's out of the category of pyramid schemes. Such rules are ineffective unless they incorporate fundamental changes in MLM compensation systems so that they provide significantly greater rewards for retailing (outside the distributor network) than for recruiting -- in actual payout from the company, since MLM prices are generally too high for retail markup to non-distributors.

This paper provides legislators, enforcement agencies, educators, and others with three distinguishing characteristics that can be used as tools to determine proactively whether or not any given MLM program will lead to the harmful effects of a highly leveraged (product-based) pyramid scheme:

  1. A chaining hierarchy of levels of distributors -- more than is functionally justified -- is recruited without area limits, which leads to extreme leverage and perceived saturation in the marketplace.
  2. RVE-EHI. Relative vertical equality (RVE) in compensation systems leads to extreme horizontal inequality (EHI) in payout over the entire network of distributors -- huge payouts to a tiny percentage of participants, while the vast majority wind up losing the money and effort they invested over a period of time.
  3. Significant purchase or recruiting quotas are required (or incentives offered) to qualify for increasing bonus levels or purchasing discounts in an ascending hierarchy of payout levels (the "pay to play" feature).

Syndrome analysis, in which any program can be evaluated based on a set of pyramidal characteristics, can serve to corroborate the existence of a PPS.

Legislators, courts, and consumer protection agencies would serve consumers better if they improved their methods of determining whether or not an MLM business fits the definition of a pyramid scheme -- or at the very least were more cautious in implying that an MLM program is not a pyramid scheme, when in fact it has merely managed to escape corrective action. Consumers need more helpful guidelines, such as in Appendix D.

MLM recruiters should be required to disclose average net payout to distributors (total payout less purchases) from the company by percentiles. This would reveal extreme payout patterns typical of pyramid schemes. Significant resale of products at retail prices should not be assumed, as MLM products are seldom priced competitively.

Because top upline positions tend to be locked in, the odds of success in achieving payout levels should be estimated by comparing the net increase in distributors at each payout level for a given year with the total numbers of distributors who joined the program for the same year.

The concepts and analytical framework for this paper are based on first-hand experience, a broad background in marketing and entrepreneurship, education and experience as a business analyst and behavioral researcher, extensive interviews with distributors from a variety of MLM programs, and a synthesis of the thinking of the best experts in the field.

MLM industry leaders have been challenged to refute key concepts for this report, but have so far responded with silence.

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    Last updated 10/15/2004

This page last updated on 10/15/2004