Personal Use - A Call To Action

By Jeffrey A. Babener
April 1997

ON A ROLL ... ALMOST

The industry was doing so well. It was on a roll - $20 billion in sales ... 10 million plus distributors ... good press ... even good legislation ... complacency. How fragile are these life and times? A three judge panel in a court which few networkers could identify published a brief decision, challenging the basic integrity of the way the network marketing industry does business. The legal paradigm changed overnight ... man the barricades ... networkers, wake up ...

On government regulation:

"Once the tyrant gets his nose in the fence, you can be assured his butt will follow."

Professor Walter Williams,
Professor of Economics
George Mason University

It was the U.S. Court of Appeals for the Ninth Circuit rendering an interim decision reversing the trial court's summary judgment in favor of Omnitrition on pyramid allegations. Industry observers say that the court made decisions it didn't need to make in an interim setting and it said things it didn't need to say. Critics called the decision ill-informed, poorly reasoned and an exercise in "officious intermeddling." Regulatory officials jumped up and down. What a tool! Legal experts predicted that regulators could use the Omnitrition ruling to hold the industry at ransom. The language in the ruling put the "tyrant's nose" in the fence, and many correctly predicted that the rest of the beast was sure to follow.

IN ITS WAKE ... A TRAIL OF DEBRIS

Despite the industry's protest that the Omnitrition ruling was merely one court's "meandering" in an interim proceeding, regulatory officials soon began to herald Omnitrition as a new legal standard. In fact, Omnitrition became regulatory mantra as officials sought to bludgeon the industry with unrealistic rules and top-down government micro-management. From California to North Carolina, from New York to Florida, companies were pressured under threat of lawsuit, injunction or adverse press releases to capitulate to consent agreements which required them to operate at complete variance with how this industry has operated for over three decades. Younger companies found themselves operating under restrictive arbitrary standards, different than those required of older well-established companies. Those older companies, however, had to realize that their survival is at stake as well with the issue that Omnitrition and regulatory officials have put on the table - is personal use of products by company distributors a legitimate end use of the sales of network marketing companies. Relying on the court's ruling, regulatory officials became confused as to the meaning of the famous Amway 70 percent rule, an anti-inventory loading rule, claiming that network marketing companies were pyramids, unless at least 70 percent of all product purchased by network marketing distributors was resold to nonparticipants. Failing to understand that personal use by distributors was an important component of the strategy of all leading direct selling companies, regulatory officials, say industry critics, may have as well lived on Mars for their lack of understanding of how this major industry works.

WHERE THE OMNITRITION COURT WENT WRONG

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 was 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 that 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 opened the door to regulatory bullying. Although this decision might be looked at as an interim decision,. . .  most observers believe that the language in this decision would be dangerous if left to stand long term.

THE INDUSTRY SPEAKS OUT ... WHO IS LISTENING?

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 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.

It's a rare day when so many competing companies speak out so loudly in one voice. Unfortunately, their protests may as well have been cries in the wilderness. The court did not consider the amicus brief, and the matter was sent back to the trial court for further proceedings. That is where the matter stands. That is, except for the day-to-day thrashing of companies by regulatory officials in the name of Omnitrition. Omnitrition hangs over the industry like the "sword of Damocles."
UNDER A SWORD

Omnitrition hangs over the industry like the "sword of Damocles." On any given day, years of work by owners of network marketing companies and their millions of distributors are at total risk. In the presence of vague and ambiguous pyramid and deceptive trade practices statutes, regulatory officials may cite Omnitrition to argue that these companies are pyramids. What needs to be done to give them relief? Actually, it is quite simple - amend state pyramid statutes, federal securities and FTC statutes to recognize that personal use by distributors in reasonable amounts is a legitimate retail sale of products and services. A simple amendment to legislation would clear the air.

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 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 to adopt as an amendment to state and federal laws:

"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 (such as Texas and Kentucky), 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.

THERE IS OPPORTUNITY IN ADVERSITY

Maybe it's time to clear the air. Maybe it's time for an industry which claims ten million constituents to call in some relief from their elected representatives. The Omnitrition cloud for networkers will not disappear for them by merely closing their eyes and hoping that the problem will go away. Simple but effective amendments are needed to state and federal legislation. This is one of those "crossroads" issues which justifies "a call to action."

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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