The Omnitrition Appeal - An Industry Issue

By Jeffrey A. Babener
February 1997

PHASE I - TWO STEPS FORWARD ...

If you wish to understand the legal history of the MLM industry, you should look at the undulating sine curve on the screen of an oscilloscope. It goes up and down, and up and down, but like the Dow Jones averages, the whole curve seems to inch up every decade. A couple of peaks of the curve are worth noting, as well as a few of its dips. "The future is longer than the present."

Milton Friedman, Economist,
University of Chicago

The Amway case ...

In 1979, after several years of litigation with the Federal Trade Commission, an administrative law judge held Amway to be a legitimate business opportunity as opposed to an illegitimate pyramid scheme. The court based its ruling on Amway's 70 percent rule, buyback policy and retail customer rule. The 70 percent rule required distributors to sell or use product before reordering. The buyback policy afforded terminating distributors an ability to leave the business and have monies refunded for inventory. The ten retail customer rule required ongoing retailing requirements by Amway distributors. These rules came to be known and cited in many subsequent cases as the "Amway safeguards." Since Amway had initially been charged as being an illegal pyramid scheme in the litigation, had it not prevailed, the multilevel industry might not exist today.

Omnitrition does well ...

The second peak of the curve occurred in 1994 as the result of a federal trial court's favorable decision involving Omnitrition in a class action case. In the past several years, the network marketing industry has been plagued by a series of class actions against leading companies. Omnitrition was one of several companies sued.

Omnitrition's compensation plan, a stairstep breakaway, is not dissimilar from other leading network marketing companies. In a federal class action, Omnitrition was charged with being a pyramid scheme and violating federal racketeering and securities laws. In a summary judgment in favor of Omnitrition, the federal trial judge found that Omnitrition's program was neither a pyramid scheme nor did it violate federal racketeering and securities laws. The court's ruling enforced the importance of the "Amway safeguards test" when evaluating the difference between a pyramid scheme and a legitimate business opportunity. The decision was very supportive of the industry in that: (1) this represented one of the first positive statements on network marketing by a federal trial court (the Amway case was an administrative judge); (2) it was the first major adjudication in a series of class actions against network marketing companies; (3) the federal court followed the definition for retail sales adopted by leading direct selling companies, California, Texas and other states, as well as Canada, on whether or not personal consumption by distributors constitutes a retail sale. In the trial court's ruling, the court recognized that products purchased for personal use by distributors constituted a retail sale in the same fashion that sales to nonparticipants would constitute a retail sale. In a way, for the first time, this was a recognition of the reality of the "workings" of a well-established industry in the United States. This decision was widely heralded by the direct selling industry as a helpful standard for judging legitimate multilevel marketing companies.

PHASE II ... AND ONE STEP BACK

Omnitrition - things aren't well

If you keep your eye on this oscilloscope, however, you will note that, despite the general upward trend, the peaks of this sine wave can give way to troughs occasionally. In March, 1996, a three judge panel of a U.S. appeals court (U.S. Court of Appeals for the Ninth Circuit) issued an opinion reversing the trial court's entry of summary judgment, and sent the matter back to the trial court for trial. The appeals court found that there was not adequate evidence to enter a summary judgment that the Amway safeguards had been enforced by Omnitrition. Had that been the extent of the appeals court decision, its opinion would not be so troubling. The court, however, "threw in" some additional language and pronouncements that, if allowed to stand as precedent would be inconsistent with the way the entire direct selling industry operates.

In an earlier famous decision entitled Koscot, a federal appeals court had ruled that a multilevel program could become a pyramid scheme if the payment of commissions were unrelated to the sale of product to the "ultimate user." This standard is very livable for legitimate companies in the direct selling industry. However, the appeals court in Omnitrition, perhaps misunderstanding the direct selling industry, went a few steps further in interpreting the earlier Koscot decision. The Omnitrition appeals court indicated that, on its face, a multilevel marketing structure appeared to be a pyramid, and that only if commissions were paid on the sale of product to nondistributors, could the program be deemed to be legitimate, and could the program survive the standards of both the Amway FTC case and the Koscot case. The court even equated the monthly personal volume activity requirement adopted by almost all direct selling companies, with the evil of inventory loading. (It made this erroneous conclusion in the face of the 70 percent rule and buyback policy adopted by Omnitrition.) Could even Amway, Shaklee and Mary Kay survive this test?

The ninth circuit's approach is a serious threat to the direct selling industry because it creates a presumption of illegality of a multilevel marketing plan. The approach is inconsistent with the realities of the direct selling industry because it denies the ability of a multilevel marketing program to count personal or family use by distributors as "sales to the ultimate user." Almost all leading direct selling companies pay commissions based on the wholesale movement of product, and, recognize personal and family use by distributors as legitimate retail sales. Despite paying commissions on wholesale movement of product, the direct selling industry has protected its distributors from the abuses of inventory loading pyramid schemes by well-established buyback policies and the 70 percent rule.

The appeals court decision appeared to be flawed for several reasons. First, the decision appeared to be inconsistent with the evidence as decided by the trial court. Second, it did not pay attention to the facts of prior appellate cases. It did not focus on the abuses that were found by earlier court decisions to be the "real" driving elements of pyramid schemes: big up-front investments, nonreturnable inventory, headhunting fees for recruiting, inflated prices, worthless product, earnings hype and misrepresentations, and no evidence of use of products. Most importantly, the court ignored the reality of how marketing programs in this well-established industry function. It shifted the burden of proof to legitimate companies to prove they are "not" pyramids. Its assertion that such marketing programs are bound to collapse is inconsistent with decades of success by such companies as Amway, Shaklee & Mary Kay.

Keeping in mind the purposes of the securities laws and pyramid cases, as intending to protect the ultimate consumer from abusive pyramid practices, it really is the flagrant abuse that should be focused upon in evaluating a pyramid scheme according to most other courts. Industry observers believe that by creating a presumption that a multilevel is an illegal pyramid unless all commissions are based on sales to nonparticipants, the court has not only climbed the wrong tree, it appears to have stepped off its longest branch into thin air.

PHASE III ... IN STEPS THE INDUSTRY

The DSA Amicus Brief

It appeared important that the direct selling industry speak out loud and clear about its concerns.

It did not take long for leaders in the direct selling industry, nor leading legal minds to conclude that the Omnitrition appeals court decision was inimicable to the interests of both the direct selling industry, as well as its millions of independent distributors. Although this decision might be looked at as an interim decision, a procedural step in the process of returning the matter to the trial court for a fuller trial, most observers believe that the language in this decision would be dangerous if left to stand long term. For its many years of successes and triumphs, and having adopted standards to protect the American consumer, the industry would now be on the defensive as to whether or not it was operating a pyramid scheme. It appeared important that the direct selling industry speak out loud and clear about its concerns.

These concerns culminated in the filing of an amicus brief by the Direct Selling Association, the leading spokes-organization on behalf of the industry. In its brief, the Direct Selling Association, which includes such members as Avon, Tupperware, Amway, Mary Kay and Shaklee, raised grave reservations about the decision. The amicus brief (friend of the court brief) requested the appeals court to reconsider its decision and requested not only the three judge panel to rehear the matter, but all of the judges of the Ninth Circuit Court of Appeals to rehear the matter. The technical term of this rehearing is a rehearing, en banc.

Although it has been done before, the filing of such an amicus brief by the Direct Selling Association in a private case has been used rarely and sparingly. In its brief, the DSA noted that over 6.3 million individuals were involved in the direct selling industry in the United States generating over $16 billion in sales. It noted that over 70 percent of DSA members classified themselves as multilevel marketing companies and that the livelihoods of scores of leading companies and millions of distributors could be jeopardized by the appeals court opinion.

The DSA thought it imperative to bring to the court's attention facts, of which, perhaps the court was unaware, in rendering its decision. It requested that the court take:

"... notice that consumption by participants of direct selling companies' products is a natural and appropriate element of direct sales. Many participants in direct selling plans of all types, including multilevel marketing, become interested in the plan only after becoming satisfied consumers of the products they now sell. It is an axiom of direct selling that a company must successfully market is products to its own distributors if it is to have any hope that its distributors will successfully market its products and its opportunity to others."

To point out the incompatibility of the court's opinion with the reality of how the direct selling industry worked, the DSA pointed to a statistical analysis of personal use by distributors:

"Sales to distributors and their use of a plan's products can be crucial to the success of a bona fide direct selling company. The first 'customers' for many direct selling companies are their distributors. A 1992 survey of individuals involved in direct selling found that 90.7% of individual direct sellers entered direct selling because they liked and believed in the products. A 1995 industry-wide survey of direct selling companies found that personal consumption by salespeople and their families constituted nearly one-third of 1994 retail direct sales by direct selling companies. -

1995 Direct Selling Industry-Wide Growth and Outlook Survey;
1992 Direct Selling Association Survey of Direct Sellers."

In bringing to the court's attention the reality of an industry that has operated in the United States for several decades, the DSA argued that the court was embarking on the wrong standard by creating a presumption of illegality of multilevel marketing plans as being pyramid schemes if commissions are not based solely on the sale of product to nonparticipants. Rather, the DSA argued that established industry buyback standards and legislative buyback standards already dealt with the underlying purposes of the securities laws to protect consumers, i.e. unfortunate incidents of inventory loading or large monetary losses to participants. The DSA pointed out that such legislative and case authority safeguards, as the Amway safeguards, had been in place for many years and were working quite well. It should be noted that, as well as most leading companies, many states and even the Canadian government in its new federal legislation, recognize personal use by distributors as legitimate "retail sales or sales to the ultimate user" as was identified in the Koscot case.

Legal observers note that such appeals courts infrequently grant such rehearings. Nevertheless, even if a rehearing is not granted, the industry has gone on record as to what standards it believes should be used by courts and legislatures to determine the legitimacy of a multilevel marketing program. While the Omnitrition case winds its way through the courts, the language of the appeals court could be around for years, and the unanimity of the industry stating its position on this subject can be of immense use in other pending court proceedings, or to legislators who are considering legislation.

What's the proper standard?

What is the proper definition of a "retail sale" or a "sale to the ultimate user" that should be used by courts and by legislators? The Omnitrition appeals court has a point that not all personal purchases should be granted recognition. On the other hand, the industry has a very valid point that purchases which are used by distributors should be granted recognition of sales to the "ultimate user." Perhaps the following definition of "retail sale" or "sale to the ultimate user" would be a fair standard:

"A retail sale or a sale to the ultimate user consists of a sale to a nondistributor or a sale to a distributor for personal or family use in reasonable amounts and which purchase is not made solely for purposes of qualifying for commissions, overrides or status position in the marketing program."

Such an approach has been utilized by state legislatures, by the Canadian government, by various courts and regulatory agencies and consent decrees in fashioning a fair standard that protects both an important industry as well as consumers of such business opportunities.

PHASE IV ... WHERE DO WE GO FROM HERE?

After the Omnitrition appeals case, is it all over? Should the industry pack up its bags and go home? Or is this decision merely a blip on the undulating sine wave on the oscilloscope?

"Nothing has happened. Sorry. Let's go."

The Rev. Chang Man-ho of a church in Seoul, Korea, after the world didn't end Wednesday, October 28, 1992, as predicted.

From a procedural standpoint, many things could happen. The court of appeals may reconsider; the matter may be returned to the trial court with a favorable or unfavorable finding for Omnitrition; the matter may make its way back up to another appeals panel who may render a different standard. Something is clear, and that is that in the long run, this is not a standard that this well-established industry can live with. Ultimately, it will be modified if the courts are to take into account the realities of a legitimate industry versus the need to protect the American consumer against egregious pyramid schemes.

In addition, legislative relief, if necessary, at the federal level should not be discounted - but could take years. The direct selling industry counts its friends in both the Republican and Democratic parties, in the White House and in the Congress. Regulatory agencies such as the SEC, FTC and representatives of attorneys general's offices have been frequent participants in direct selling conferences and, as a general matter, applaud consumer protection standards adopted by the industry. None of these agencies have found the need to take such a restricted view as this court. The keynote speaker at the 1995 annual meeting of the Direct Selling Association was Newt Gingrich, Speaker of the House of Representatives. Is there a political message in all of this? Would six million letters to Congress help?

In Sum ...

Although the Omnitrition appeals decision may have brought the legal history of the direct selling industry to a momentary trough, in the long run, things are likely to work out. As Milton Friedman, the famed economist said, "The future is longer than the present."

Jeffrey A. Babener
Babener & Associates
121 SW Morrison, Suite 1020
Portland, OR 97204
Jeffrey A. Babener, the principal attorney in the Portland, Oregon law firm of Babener & Associates, represents many of the leading direct selling companies in the United States and abroad.

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