The issue of depth of levels seemed to be a major focus prior to the internet and other non-postal (mail) means of communication. In the late 1980’s, the U.S. Postal service examined the numbers of compensation plan levels to make a determination, whether or not, in its opinion, the depth of levels created a “lottery” element under U.S. Postal lottery laws, that forbid payment based on chance.

Various cases and consents sorted out a safe harbor (at least from the U.S. Postal Office standpoint) for at least four levels (not necessarily agreed to by the direct selling industry). Separately, the Postal Service looked for evidence of “supervisory requirements.” Most companies adopted specific supervisory requirements of sponsors to demonstrate some managerial activity by distributors.

For the past 25 years, little recruitment activity is conducted by U.S. mail and it has been a long time since the U.S. Postal Service has expressed a serious interest in this subject. The issue of levels in a company’s compensation plan has not been the focus of the FTC or state attorneys general in the enforcement of pyramid laws. Instead, the focus for the last two decades has been on the whether or not product/service is purchased in reasonable amounts, the presence of anti-inventory loading and “buyback” rules and an emphasis of sale of product/service to the “ultimate user” as opposed to an emphasis on mere recruitment of new distributors whose primary motivation to make payments or purchases is to qualify in the income opportunity.

Watch the video for a detailed explanation by Jeff Babener, Editor of MLMLegal.com. View all of our new videos and more on our new and improved website: MLMLegal.com!

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The word “opportunity” is a generic term for the chance to advance, better one’s economic state, health, social position.

However, in the context of direct selling, “opportunity”, in addition to the chance to make money, is a reference to the “business opportunity” of a direct selling/MLM marketing program. Two dozen states and the FTC regulate the offering of business opportunities in a parallel fashion to their regulation of franchise opportunities. Because of the low threshold of entry fees, typically, modestly-priced at-cost sales kits, the business opportunity of MLM companies is generally exempt from state business opportunity laws.

In addition, the FTC has indicated that it generally does not view the offering of an MLM opportunity to trigger the FTC Business Opportunity Rule. Of course, multiple states have adopted specific MLM statutes to provide guidelines for the offering of a MLM opportunity. All of these statutes can be found in the statutes library at our website.

MLMLegal.com is bustling with educational content for direct sellers and startup/existing MLM companies! Be sure to visit us often!

If you are interested in attending the Starting and Running the Successful MLM Company conference visit our conference page, view our speaker list, or get more details. All executives/owners of direct selling companies are welcome to attend. Call 800-231-2162 to register.

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Front loading generally refers to a process in which a MLM company, or a sponsoring distributor, encourages a new distributor to purchase far more product than is commercially reasonable under the circumstances. Often the “push” is explained to the recruit as necessary to qualify in the plan. This is an unacceptable practice is often one indicia of a pyramid scheme.

On the other hand, virtually all regulatory agencies recognize that a purchase of an “at cost” sales kit is an acceptable practice in the mainstream of leading direct selling companies. Such mandated kits are typically in the $50-$100 range. They generally entail “hard copy” or online supply of sales and marketing materials as well as ongoing sales and marketing materials updates for a year. Typically the mandated sales kit does not include product and generally a company offers an optional deluxe kit that may include product. Such an optional kit, which is often referred to as a “fast start” kit, may contain several hundred dollars of product. This is not unusual. Although the same regulatory standards on upfront mandated purchases are applicable to party plan companies as they are to other companies, it is not unusual to see party plan companies mandate a beginning starter kit that contains a wide array of products, with a price tag several hundred dollars. Regulatory agencies are very liberal in their view of such mandated purchases in party plan companies because party plan companies are so overwhelmingly retail oriented and the movement of product to retail customers is the norm, and not the exception, for party plan companies.

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Here is a glimpse of very attentive entrepreneurs at the 84th MLM Conference:

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By Jeffrey A. Babener

© 2019

(First Published in World of Direct Selling)

History is Written by the Victor

Ring the bells that still can ring

Forget your perfect offering

There is a crack, a crack in everything 

That’s how the light gets in

Anthem, Leonard Cohen

Quiet Uncertainty

It was like the calm of quiet uncertainty before the storm. In May, 2019, 26 year old leading direct selling company, AdvoCare, announced that it would exit MLM in favor of a one level direct sales model. It indicated that it was doing so, and “had no choice,” after confidential talks with the FTC. That was it. No other explanation. And the industry asked: What is this all about? It may be true, as T.S. Elliot said, “the world will end in a whimper, not a bang.” For a detailed article on the May withdrawal and ramifications, see AdvoCare Abandons MLM: Uncertainty Returns to Direct Selling. (World of Direct Selling).

A Jarring Dissonance

The FTC Speaks

And then, in October 2019, a cacophony, as the other shoe dropped. The FTC announced a stipulated judgment in which AdvoCare was proclaimed online and in newspapers across the country as a pernicious pyramid scheme that had swindled hundreds of thousands.

The settlement came with a $150m fine, life time MLM bans for AdvoCare’s CEO and top distributors, and the FTC spiked the ball in the end zone, noting at its press conference,

“It is significant that we have a large and well known multilevel marketing company that is admitting that it operated as a pyramid… “

Sending an underlined message across the bow of the direct selling industry, the FTC online blog labeled the case as “the landmark settlement.”

Buyer’s Remorse

“Foul!,” called AdvoCare in an immediate responsive press release:

“The FTC incorrectly stated in a press conference that AdvoCare had admitted to operating as a pyramid. This is categorically false. AdvoCare forcefully rebutted this charge in its discussions with the FTC. To this day, AdvoCare denies it operated as a pyramid.”

Actually, AdvoCare was technically right… no such admission had been given (although it had stipulated to the veracity of the factual allegations in the Complaint), prompting the Director of the FTC Bureau of Consumer Protection to later apologize at the Washington, D.C. DSA Legal and Regulatory Conference.

A pyrrhic victory for AdvoCare, whose marketing program and opportunity for thousands of distributors was totally gutted. “Elvis had left the building.”

FTC has Non-Legal Leverage. What Now?

This was the third major DSA member company hit by the FTC in less than 5 years. And the FTC accomplished its goals, without litigation, but rather the sheer leverage it had over the companies and individuals based on their unique factual situation. For Vemma, an asset freeze. For Herbalife, the overriding need to address its position as a publicly traded company. For AdvoCare, industry speculation about the unstated jeopardy of owners and board members, as well as existential threat to the business. For better or worse, the FTC accomplished its objectives in all three cases without taking the matter to formal adjudication. Therefore, the new quasi legal standards were set by FTC leverage, without firing a litigation shot, rather than by actual case law. Case law did not change.

Serious? To paraphrase a general counsel of one of the industry’s largest MLM companies:

“Our first priority is not to prepare for a FTC confrontation, but rather to use our best efforts to stay off their radar in the first place.”

More to come? Could well be. The industry was left with a choice. It could wring its hands or treat this as a teachable moment for its future. As they say, a new reality, and “it is what it is.”

(From the industry’s perspective, were the penalties draconian? Absolutely. Might it have been more appropriate to adopt a remedial solution rather than ban the entire MLM model? Absolutely. But that is another issue for another day.)

The initial instinct of the industry was to recoil from a near death blow to a 26 year old industry leader and longtime DSA member, complaining of a new era of FTC bullying.  But, as the facts unraveled, some real concerns arise as “the crack in the bell lets the light in.” Maybe, it was not about bullying after all. The industry needs to pay serious attention and self- reflection about guidance it provides to its own companies.

Fact Checking the FTC and AdvoCare

What were the facts in issue from the standpoint of the FTC and AdvoCare? Well, as far as AdvoCare, we will never know. The company capitulated, without even filing one defensive document. And so, all we really can discern is what the FTC alleged. And from a legal standpoint, their version “stands” because, notwithstanding a preamble that states that AdvoCare neither admits nor denies any of the allegations in the Complaint, the stipulated order for permanent injunction and monetary judgment, recites:

VI.(D) The facts alleged in the Complaint will be taken as true, without further proof, in any subsequent civil litigation by or on behalf of the Commission against Settling Defendants….”

And so, we won’t really hear AdvoCare’s explanation. All we have is the uncontested FTC Complaint allegations. And history suggests that this “neither admit nor deny” stipulated order will morph into a “de facto” FTC guidance in the future.

The big picture said the FTC is that the facts support that AdvoCare crossed the line from operating a legitimate MLM program to a program that was instead an illegal pyramid scheme.

For the uncertainty created by no clear adjudication of such important issues, the industry owes “no thanks” to AdvoCare for its decision to merely “roll over,” despite contending after the settlement order that it had forcefully rebutted the pyramid charge in pre-settlement discussions with the FTC. Unfortunately, the “game over buzzer” had already sounded.

History Repeats Itself: Omnitrition Déjà Vu…

Other than ramped up aggressive enforcement and penalties (life time MLM bans for the CEO and lead distributors and forcing AdvoCare to abandon the MLM model), those looking for new insight in the AdvoCare prosecution, will not find it.

This was the opinion of the FTC and its Director of the Bureau of Consumer Protection, Andrew Smith, and a historical legal perspective would come to the same conclusion.

The AdvoCare prosecution can be summed up in a few words:

1. Inventory Loading. In other words, “pay to play,” “buy in to active qualification for “active” rank commissions and rank advancement commissions; purchasing far more product than realistically needed for either personal use or to meet resale demand to customers, focusing on recruiting business builders who buy inventory and encourage others to do the same.
2. Exaggerated Earnings Claims. It is eerie, but this is a “history repeats itself” moment. In 1996, in Webster v. Omnitrition, (79 F.3d 776) the U.S. Court of Appeals for the 9^th Circuit, held Omnitrition to be a pyramid scheme based on the company recruitment of business builders qualified with  inventory loading, who in turn, did the same. Omnitrition was co-founded by Charlie Ragus. In 1993, Ragus founded AdvoCare. It is a sad irony that 26 years later, the Ragus founded AdvoCare MLM program would be shuttered by similar inventory loading accusations as in Omnitrition.

The Omnitrition Court held that the well venerated Amway safeguards meant nothing if not enforced and if, in the presence of inventory loading.

The promise of lucrative rewards for recruiting others tends to induce participants to focus on the recruitment side of the business at the expense of their retail marketing efforts, making it unlikely that meaningful opportunities for retail sales will occur. Koscot, 86 F.T.C. at 1181. The danger of such “recruitment focus” is present in Omnitrition’s program. For example, Webster testified that Omnitrition encouraged him to “get to supervisor as quick as [he] could.” Ligon states:

[T]he product sales are driven by enrolling people. In other words, the people buy exorbitant amounts of products that normally would not be sold in an average market by virtue of the fact that they enroll, get caught up in the process, in the enthusiasm, the words of people like Charlie Ragus, president, by buying exorbitant amounts of products, giving products away and get[ting] involved in their proven plan of success, their marketing plan. It has nothing to do with the normal supply and demand in this world. It has to do with getting people enrolled, enrolling people, getting them on the bandwagon and getting them to sell product…

FN3…First, Omnitrition produced evidence of enforcement only for its ten customer rule. Even assuming that Omnitrition’s enforcement measures are effective, it is not clear that these measures serve to tie the amount of “Royalty Overrides” to retail sales. The overrides are paid based on purchases by supervisors. In order to be a supervisor, one must purchase several thousand dollars’ worth of product each month. That some amount of product was sold by each supervisor to only ten consumers each month does not insure that overrides are being paid as a result of actual retail sales.

Fast Forward 23 years and it all sounds the same. Said the FTC in its Press Release and Blog about AdvoCare:

Press Release:

AdvoCare operated an illegal pyramid scheme that pushed distributors to focus on recruiting new distributors rather than retail sales to customers. The compensation structure also incentivized distributors to purchase large quantities of AdvoCare products to participate in the business and to recruit a downline of other participants with the same incentives. The clear directive of this structure was, as one AdvoCare distributor explained during the company’s Success School training, to “recruit business builders who recruit business builders who recruit business builders…”

The FTC alleged that under the AdvoCare compensation plan, participants were charged $59 to become a distributor, making them eligible to receive discounts on products, and to sell products to the public. To earn all possible forms of compensation, however, participants had to become “advisors,” which typically required them to spend between $1,200 and $2,400 purchasing AdvoCare products and accumulate thousands of dollars of product purchase volume each year, according to the complaint. The FTC alleged that the income of AdvoCare advisors was based on their success at recruiting, with the highest rewards going to those who recruited the most advisors and generated the most purchase volume from their downline.

To recruit people, the FTC alleged, AdvoCare and the other defendants told distributors to make exaggerated claims about how much money average people could make—as much as hundreds of thousands or millions of dollars a year. The FTC alleged that distributors were told to create emotional narratives in which they struggled financially before they joined AdvoCare, but obtained financial success through AdvoCare. Distributors were also allegedly told to instill fears in potential recruits that they would suffer from regrets later if they declined to invest in AdvoCare.

The FTC alleged that the defendants told consumers that they could realize large incomes by promoting AdvoCare and that their earning capacity was limited only by their effort. For example, AdvoCare promoter Diane McDaniel told consumers that “the sky is the limit. I’m the variable. I get to decide what I truly want according to the effort I put forth” and that “there is incredible profit that can be made through infinity.”

In reality, the FTC alleged, AdvoCare did not offer consumers a viable path to financial freedom. In 2016, 72.3 percent of distributors did not earn any compensation from AdvoCare; another 18 percent earned between one cent and $250; and another 6 percent earned between $250 and $1,000. The annual earnings distribution was nearly identical for 2012 through 2015.

FTC Blog:

…people paid AdvoCare thousands of dollars to become “distributors,” buy inventory, and become eligible for cash bonuses and other rewards. But, the FTC says, AdvoCare rewarded distributors not for selling product but for recruiting other distributors to spend large sums of money pursuing the business opportunity. That push to recruit is a classic sign of a pyramid scheme.

On the earnings front, the FTC also alleged that AdvoCare earnings disclosures played fast and loose with earnings averages by extrapolating data of one month’s earnings into an annual earnings average, when in fact, the month chosen might not be a recurring event.

Legal observers are perplexed how it could happen after Omnitrition litigation that the same “front loading” fact pattern might occur again in a related successor company. Probably, the answer is that, unless one is extremely careful, these things just “creep up on you.

Unfortunately, the cultural problem was not new and was a bit of a “tiger by the tail.” The focus on recruiting and duplicating “front loading” business builders was suggested by a legal expert, who was also a former insider knowledgeable observer, to predate the FTC Order by more than a dozen years:

AdvoCare leaders encouraged new distributors to “buy their Advisor order” ($2,000) so they could begin earning commissions sooner. This was ingrained in the distributor culture… there were efforts made to discourage this and ensure that products purchased through “advisor orders” were sold to retail customers. …AdvoCare was a victim of its own success and it was unable to reign in leaders… Existing problems only become magnified when you go through a period of hyper-growth similar to what AdvoCare experienced.

Based on the “uncontested” alleged facts set forth by the FTC, serious pyramiding issues are raised. And that is all we have. Without a vigorous defense by AdvoCare, or, in fact, any defense at all, and based on the FTC Settlement Order providing that “facts alleged will be deemed to be true,” it is far more than a challenge for industry supporters to come to the support of AdvoCare in this dispute. This is a true loss for the direct selling industry. The silence of AdvoCare left the industry in an awkward uninformed position with no arrows in its quiver, akin to a performer on stage pleading, “throw me a bone, I’m dying up here.”

State of the Law

The FTC and the direct selling Industry are totally in sync on one point:

Nothing about the FTC/AdvoCare settlement changes the existing legal standards for pyramid vs. legitimate direct selling. Those case law standards weave their way in FTC cases from the Koscot case through Amway through Burnlounge:

Koscot: Multilevel commissions must be based on sales to ultimate users.

Amway: Multilevel companies must adopt procedures that encourage retail selling.

Omnitrition (9^th Circuit Class Action): In the presence of front-loading and lack of enforcement of the Amway standards, companies can expect pyramid challenges.

Burnlounge: The primary incentive to distributor purchases or payments should be a genuine need, whether for resale or personal use, as opposed to qualification in the compensation plan. Are distributor payments and commissions driven by recruitment and qualification in the plan, on the one hand, or sales to ultimate users?

Andrew Smith, FTC Director of the Bureau of Consumer Protection, was in total agreement, in his presentation to the October, 2019 Washington D.C. DSA Legal and Regulatory Conference.

In a well-received presentation, and to the surprise of many attendees, he emphasized multiple times that the FTC is supportive of the MLM model. He went out of his way to express his opinion that, in some ways, MLM is a superior business model because:

1. It provides flexibility and opportunity to individuals to earn extra income.
2. It provides a warm and attentive experience, and qualify products, to retail consumers.

He stated that the FTC welcomes compliant MLM companies. And his standards were not measurably different than existing case law.

The FTC seems to have retreated from its all-out assault on recognition of personal use, as argued and rejected by the BurnLounge court. Its attention is now turned to the basic question of whether a MLM program is placing its focus on sales to ultimate users, which includes personal use purchases in reasonable amounts and wholesale purchases for resale, in amounts reasonably calculated to fulfill retail consumer demand and for which the company can track the flow of product to ultimate users such that compensation reasonable relates to sales to ultimate users.

Overall, Director Smith’s description of the state of the law seemed consistent with case law. He suggested this analysis:

1. Does the scheme emphasize recruiting over sales to consumers? Are compensation results driven by recruiting others? Are distributors focused on recruitment and duplication rewards arising from recruiting other distributors to “buy?” Does that plan have a qualifier relating to recruitment?
2. Does the program have incentives to buy goods that are not based on satisfying a distributor’s own personal needs or reasonable inventory to supply retail customers? A telltale pattern would be monthly purchases just enough to meet compensation qualification activity requirements. Another would be front-loading which Director Smith indicated as an attribute of pyramid schemes. His observation of AdvoCare was that distributors were encouraged to buy and did buy for more than they reasonably needed or could use.

He stated that the FTC key questions are:

1. How do distributors really make money in the plan?
2. Does the company have incentives that promote recruiting and purchasing over sales?
3. Is the company gathering data to track product sales to end consumers?

Director Smith stressed:

1. At the FTC, we want you to be successful as a MLM.
2. However, we also want you to be in compliance as an MLM.
3. Effectively, he said, “we are not looking for a fight, and we want you to stay off our radar,” and he implored companies to examine and reexamine their programs to remove any practices that would put a company on the FTC radar.
4. He stated the FTC position, which no one in the industry disputes, is that a pyramid headhunting inventory loading recruitment scheme is unsustainable as a business model.

Unless completely cynical, given the tenor of his presentation, it seems fair to take Director Smith at his word. Refreshing! The industry can live with this going forward.

Guidance for Radar Avoidance in a Post AdvoCare World

Every breath you take

Every move you make…

I’ll be watching you

Every Breath You Take, Sting, The Police

If you are looking for life in a post FTC vs. AdvoCare/Herbalife/Vemma world, here are some common sense guidelines to create the strongest defense to your MLM program and for promoting anti-pyramid practices aimed at staying off the FTC radar:

1. Overriding Goal…The Big Picture.

The compliant MLM “acid test” will be a mandate and demonstration of significant sales to non-participant retail customers.

Bottom line analysis by FTC and state AGs:

A product or service with real retail customers and a good ratio of retail customers to distributors to demonstrate that people buy the product because they want it, and not just to qualify in the marketing plan.

Upline commissions must derive from sale of product to ultimate end users.

With a high retail customer to distributor ratio, experience suggests that most other legal issues (assuming no outrageous earnings or product claims) tend to recede into the background.

2. Track. Track…Flow of Product to and Use by the Ultimate User.

After Vemma, Herbalife and AdvoCare, few priorities are as important as tracking and verifying the flow of product to and use by the ultimate user, whether it be a nonparticipant retail customer or distributor for personal/family use. The short answer: Track the flow and use of product to both nonparticipant retail customers and distributor personal/family use. In fact every company and the DSA should launch a joint initiative with leading direct selling software companies to develop software which accurately tracks the flow of product such that a company can demonstrate that distributor purchases are, in fact, in reasonable amounts for distributor personal use and reasonable inventory quantities for resale, calculated to meet the ordering needs of retail customers. And software should track that every product sold is used by the ultimate user, whether for personal use by distributors or use by non-participant retail customers.

3. Promote Non-participant Retail Sales and a Preferred Customer Program.

It is in everyone’s interest, the company, distributors, the industry and regulators, to place an emphasis on retail sales to non-participant customers. After all, the business is called “direct selling,” and not “direct consumption.” The promotion of retailing should find a thread through every piece of company literature and advertising.

In addition the gold standard of retailing is the presence of non-participant preferred customers, i.e., those retail customers that are provided incentives and discounts to commit to monthly or orderly product purchases. From a legal standpoint, a robust preferred customer program makes the statement that there is a real market for the product and purchasers are purchasing because they want the product as opposed to being motivated by qualifying in the business opportunity.

4. Time to Rethink Personal/Group Volume Qualification Requirements for Active Status, Rank Status, Rank Advancement Commission Payout if the Volume is Based on Distributor Purchases that are Not Clearly Documented as End User Personal Use of Distributors or Retail Customers.

In fact, some leading direct selling companies have already initiated elimination of volume requirements for active status, fast start commissions, rank status, rank advancement and payment of enhanced commissions. The FTC has long expressed a deep concern for volume requirements that tend to trigger inventory loading or distributor purchases that are not driven by consumer demand, but instead for purposes of qualification.

Said Former FTC Commissioner Edith Ramirez in her remarks at the DSA Business and Policy Conference in September, 2016:

Any requirements or incentives that participants purchase product for reasons other than satisfying genuine consumer demand—such as to join the business opportunity, maintain or advance their status, or qualify for compensation payments—are problematic.

In Vemma and Herbalife, companies were restricted on credit that could be accorded to distributor purchases, whether for personal use or resale. Many companies are reconsidering volume requirements that are documented as reasonable personal use or retail sales. Unless a company is prepared to track end destination of product, it should reconsider volume requirements that cause suspicion that the products are purchased to qualify and not driven by consumer need.

Above all, rewards should reasonably relate to sales to end users (personal use plus retail customers.

There are multiple approaches to compensation for multilevel payments on downline purchases.

(a)      The Herbalife settlement limited credit to downline distributor purchases (only about one-third of distributor purchases qualified for credit for MLM commissions.)

(b)      Pay MLM commissions only after verification of personal use or sale.

(c)      Pay MLM commissions at time of purchase, but absolutely track and verify personal use and sale of product purchased for resale.

5. Rethink Distributor Ordering Methods that Produce “Inventory Loading” Accusations. Use a Ramp-Up Authorization Approach that Authorizes Increasing Wholesale Orders Based on Demonstration of Retail Sales.

Above all: Do not allow distributors to purchase more than they can use for reasonable personal use and/or quantities for there is a realistic resale to retail consumer need.

Actually, in today’s world of next day UPS and FedEx, online ordering and direct to consumer shipping, there really is no need any more for large inventory purchases or stocking distributors.

Approaches for Avoiding Inventory Loading:

(a)      Eliminate or reduce volume requirements for active, rank, rank advancement.

(b)      Allow volume, but track and pay only on personal use level of volume or wholesale for resale volume that is verified sold to retail customers.

(c)      Limit amount of inventory or, at least, install a ramp-up authorization based on demonstrated sale and/or personal use.

6. Bulletproof Yourself on Earnings Claims. Don’t be the Nail that Sticks Up and Gets Hammered Down.

Avoid earnings hype in advertising, testimonials and lifestyle presentations. Scuttle the Maserati and the Tuscan villa images. Be realistic… this is the anomaly and not the norm. Take the bullseye off your forehead. In almost every FTC case, the first invitation to regulators is unrealistic earnings claims. The hype “opens” the door or lifts the canopy of the tent. And, as they say, “Once the camel has his nose in the tent, you can be assured that his ‘body’ will soon follow.”

In other words, don’t be the low-lying fruit. Don’t effectively, and unintentionally, “bait” the FTC to initiate an enforcement action by over-aggressive hype and promises. 

Absolutely do not make claims of wealth, fast wealth, easy money or sure-fire systems, nor effectively invite the FTC to inquire into a program based on earnings hype and systems based on distributor “purchasing” rather than distributor “selling” and “using.”

And whether legal or not, now is the time to “ditch” the pictures and videos of distributor mansions and luxury cars. Since such MLM driven lifestyles are clearly the exception to the rule, why wear a red flag in front of a “bull.”

7. Post a Transparent Earnings Disclosure.

As a general matter, the FTC is all about disclosure so that consumers can make informed decisions. Once you have a track record, post a simple and transparent average earnings disclosure. At a minimum, you should disclose:

(a)      What percentage of distributors who have signed up are active, i.e., earning any income?

(b)      Of those that are active, what is the average earnings?           (c)      If any example, testimonial or illustration of a particular income, bonus or lifestyle award is presented, what percentage of active distributors earn at least that amount or above?

(d)      Unless the company surveys average costs of doing business by distributors, earnings averages should be represented as “gross earnings” and that they are not “net earnings.”

(e)      Absolutely disclaim that any earnings illustrations are representations of an expectation of earnings.

(f)       “Pepper” promotional material with average earnings disclosures and disclaimers at every instance that an illustration/testimonial of earnings potential is provided.

(g)      Either calculate average business costs to disclose net earnings or specifically disclose that average earnings are presented as “gross,” as opposed to “net” and do not take into account distributor business costs.

Irrespective of the depth of the earnings disclosure, do not ever play fast and loose with earnings disclosures, nor “parse” to exaggerate the opportunity.

During his presentation to the DSA Legal and Regulatory Conference, FTC Director raised a new “ask” by the FTC. He suggested that companies should not only present gross earnings, but should also present net earnings which take into account costs of doing business by distributors. Upon questioning, he recognized that this may be a daunting task. At the very least, he suggested that companies should disclose that their typical average earnings disclosures are “gross earnings” and, not net earnings, i.e., they do not take into account distributor costs of doing business. Look for more of this “ask” in the future.

8.  Adopt, Follow and Enforce the Amway Safeguards.

The Amway safeguards have been the gold standard and been honored in case after case going on 40 years. Although the FTC may wish to pivot away from the Amway safeguards, the courts have not done so.

(a)      70% rule to avoid inventory loading … no ordering unless 70% of previous orders have been sold or used for personal/family use. Place lids on initial orders and allow a ramp up of size of order over time. Never mandate monthly autoship to qualify for commissions. And avoid front-loading. In the famous Omnitrition case, the court noted that the Amway safeguards are rendered ineffectual as a defense to pyramiding if a company encourages or allows front-loading of product because it becomes clear that commissions are not related to sales to ultimate users when distributors are incentivized to buy huge amounts of inventory that are out of proportion to needs for resale or the needs of personal and family use.

(b)      Adopt and enforce an actual nonparticipant retail sales mandate to qualify to receive commissions. Over the years, that number has been expressed in numbers from five to ten or in sales volume … often with an allowable ramp up over time.

(c)      Honor a buyback policy on inventory and sales support materials for terminating distributors…no less than 90% for 12 months.

9. Consider a Reclassification Program to Convert Non-Earning Distributors to Preferred Customers.

In a new FTC enforcement era, the “name of the game” is demonstrating high ratios of non-participant retail customers to active distributors. In the retailing analysis, non-participant retail customers, who are provided discounts or other incentives in exchange for signing up as “preferred customers,” are like “gold” in “upping” the ratios. Watch for direct selling companies to use major initiatives to convert to preferred customers distributors who are loyal product purchasers, but who are not really “working the opportunity,” i.e., low or no earning in the direct selling opportunity.

The conversion can be voluntary or non-voluntary.

1. Voluntary.

For instance, in the Herbalife settlement, Herbalife was given nine months to work on a reclassification of brand loyal, but low earning distributors, to preferred customers so that the non-participant retailing ratios would be increased for personal use purchases. Other leading companies, such as USANA, followed suit, substantially increasing retailing ratios.

2. Involuntary.

Another path that companies may wish to consider is automatic involuntary conversion. Under this approach a company would adopt an automatic reclassification program that automatically reclassifies non-earning independent representatives to preferred retail customers, all the while providing superb discount pricing, special customer benefits, generous customer appreciation referral rewards. If the converted preferred customer later decides to reactivate, the company might even consider providing an option for the right, after a waiting period or based on customer referral activity, to re-sign up as an active independent representative in a reserved genealogical downline position.

10. Promote Industry Guidance on Compliant Compensation Plans.

Similar to the DSA initiative on earnings claims compliance of the Direct Selling Self-Regulatory Council (DSSRC), support the launch of a DSA task force to develop best practices compensation plan guidelines and to continuously audit and constructively advise member DSA companies for avoiding pyramiding accusations of the sort raised by the FTC in Vemma, Herbalife and AdvoCare.

11. Support Clear Federal Legislation on Direct Selling.

Companies should actively support DSA federal legislative action to set forth clear anti-pyramiding guidelines so that the FTC, states and companies are playing on the same field with the same rules and goalpost settings.

See Original FTC Advocare Documents:

FTC v. Advocare Complaint

FTC v. Advocare Stipulated Order for Permanent Injunction and Monetary Judgment

FTC v. Advocare Press Release and Blog Announcement

Jeffrey A. Babener, of Portland, Oregon, is the principal attorney in the law firm of Babener & Associates. For more than 30 years, he has advised leading U.S. and foreign companies in the direct selling industry, including many members of the Direct Selling Association. He has served as legal advisor to various major direct selling companies, including Avon, Amway, Herbalife, USANA, and NuSkin. He has lectured and published extensively on direct selling and many of his writings will be found at mlmlegal.com, of which he is Editor. He is a graduate of the University of Southern California Law School, where he was an editor of the USC Law Review. Post USC Law, he served a one-year term appointment as a law clerk to Hon. David W. Williams, U.S. District Court, Central District of California. He is an active member of the State Bars of California and Oregon.

Read the article and supplemental material at www.mlmlegal.com.

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“As Gregor Samsa awoke one morning from uneasy dreams he found himself transformed in his bed into a gigantic insect…”

Metamorphosis, Franz Kafka

A Kafka experience 1996:

Dateline Maine 1996 for one of America’s leading direct selling companies:

One day you have no presence; the next day you are the largest employer in the state…at least until the state amends its unemployment statute, in 1996, to follow the federal tax definition of independent contractor exemption for direct sellers:

Service performed by a direct seller as defined in 26 United States Code, Section 3508(b)(2).  

Maine 26 M.R.S.A. 13 sec. 1043(11)(F)(28) (Amendment 1996)

Groundhog Day 2018; Deja Vu all over again

One day, leading direct selling telecom company, ACN, had virtually no employee presence in Oregon. A day after a seminal Oregon Supreme Court ruling, ACN found itself held to be an Oregon employer, with the accompanying challenges. Future: uncertain. A similar case is playing itself out for Kirby of Norwich in Connecticut.

And so, the DSA initiative…

In July, 2018, the Direct Selling Association announced an industry-wide initiative to update state unemployment legislation to be in sync with federal standards, in place since 1982, which call out direct sellers as independent contractors.

Most observers agree that, for the vast majority of 16 million individual U.S. direct sellers, many with incremental average monthly income, often a $100 or less, the compliance costs and taxes of income tax withholding or unemployment taxes, could be devastating to direct selling companies.

With state challenges, already happening in Oregon and Connecticut, which threaten the viability of the direct selling model, the DSA undertaking could not be more timely. The initiative is the legacy of a multiyear effort in which, says the DSA, 38 states have already adopted a similar umbrella exemption that follows the historic achievement of the DSA in the 1982 amendment of the U.S. Internal Revenue Code (TEFRA…Tax Equity Fairness Responsibility Act) recognizing independent contractor status of direct sellers for federal tax purposes. 26 U.S Code § 3508. The most recent DSA accomplishment: North Carolina, effective July 1, 2018.

And the update initiative is reflective of the forward looking wisdom of the 2018 U.S. Supreme Court Wayfair decision (upholding state sales tax collection on interstate online sellers) that, to paraphrase the Court, it is imperative for courts and legislatures to recognize the changing economic realities of how interstate companies do business in the various states. In light of recent state employment direct selling decisions in Oregon and Connecticut, accommodating changing business model paradigms to economic reality is quite important.

Historic Legislation

Prior to 1982, the direct selling industry suffered a cloud over its head, i.e., the potential that the distributors of  direct selling companies might be classified as employees for federal tax purposes, with all the onerous challenges of withholding, record keeping, payment of employee taxes, etc. Such burdens threatened the economics of the direct selling model. The industry needed relief and certainty for its channel of distribution.

Led by former 40 year DSA President, Neil Offen, in 1982, Congress amended the Internal Revenue Code to recognize “direct sellers” as independent contractors for federal tax purposes. In 1995, Congress, recognizing the industry diversification (or as Wayfair might put it: changing economic reality) into sale of telecom and other services, specifically added “sale of services” to its “sale of products” exemption.

TITLE 26-INTERNAL REVENUE CODE

Subtitle C-Employment Taxes

CHAPTER 25-GENERAL PROVISIONS RELATING TO EMPLOYMENT TAXES

Sec. 3508

For purposes of this title, in the case of services performed as a direct seller—

(1) the individual performing such services shall not be treated as an employee, and

(2) the person for whom such services are performed shall not be treated as an employer.

(b) Definitions

(2) Direct seller

The term “direct seller” means any person if—

(A) such person—

(i) is engaged in the trade or business of selling (or soliciting the sale of) consumer products to any buyer on a buy-sell basis, a deposit-commission basis, or any similar basis which the Secretary prescribes by regulations, for resale (by the buyer or any other person) in the home or otherwise than ina permanent retail establishment,

(ii) is engaged in the trade or business of selling (or soliciting the sale of) consumer products in the home or otherwise than in a permanent retailestablishment, or

(iii) is engaged in the trade or business of the delivering or distribution of newspapers or shopping news (including any services directly related to such trade or business),

(B) substantially all the remuneration (whether or not paid in cash) for the performance of the services described in subparagraph (A) is directly related to sales or other output

(including the performance of services) rather than to the number of hours worked, and (C) the services performed by the person are performed pursuant to a written contract between such person and the person for whom the services are performed and such contract provides that the person will not be treated as an employee with respect to such services for Federal tax purposes.

A Multidimensional Issue

First, it must be recognized that the perennial question of employee vs. independent contractor is not a one dimensional issue. There are many legitimate competing constituencies with a stake: small businesses, entrepreneurs, taxpayers, workers, channels of distribution such as direct selling, etc. The quest for solutions is not a zero sum game.

Said the California Supreme Court in its recent Dynamex decision (4 Cal. 5th 903,  2018) holding package/document delivery drivers to be “employees” rather than “independent contractors,” and sending a shot across the bow against the entire “gig” economy of Ubers, Lyfts, etc., and maybe even precipitating a future second guessing of the existing California statutory exemption for direct selling:

Under both California and federal law, the question whether an individual worker should properly be classified as an employee or, instead, as an independent contractor has considerable significance for workers, businesses, and the public generally.¹ On the one hand, if a worker should properly be classified as an employee, the hiring business bears the responsibility of paying federal Social Security and payroll taxes, unemployment insurance taxes and state employment taxes, providing worker’s compensation insurance, and, most relevant for the present case, complying with numerous state and federal statutes and regulations governing the wages, hours, and working conditions of employees. The worker then obtains the protection of the applicable labor laws and regulations. On the other hand, if a worker should properly be classified as an independent contractor, the business does not bear any of those costs or responsibilities, the worker obtains none of the numerous labor law benefits, and the public may be required under applicable laws to assume additional financial burdens with respect to such workers and their families.

And the Court correctly noted, sometimes the decider is a veritable Solomon who must make difficult and compromising choices that will certainly not please everyone:

The difficulty that courts in all jurisdictions have experienced in devising an acceptable general test or standard that properly distinguishes employees from independent contractors is well documented. As the United States Supreme Court observed in Board v. Hearst Publications (1944) 322 U.S. 111, 121, 64 S. Ct. 851, 88 L. Ed. 1170: “Few problems in the law have given greater variety of application and conflict in results than the cases arising in the borderland between what is clearly an employer-employee relationship and what is clearly one of independent, entrepreneurial dealing.

Dark Clouds for Direct Selling

For better or worse, over the last few decades, various leading direct selling companies have become ensnared in state unemployment cases, finding themselves judicially transformed to leading employers in a state, with all the attendant regulatory and financial burdens. The thrust of the uncertainty is played out in:

1. States that earlier adopted exemptions, but unfortunately with evolving business models, the statutory exemption might no longer deliver the intended protection.

Example Oregon: A hostile work environment for direct selling.

Oregon is a good example where confusion reigns for direct selling companies in the aftermath of ACN Opportunity, LLC v. Employment Department, 362 Or. 824 (2018).

Actually, many years before Congress sought to protect direct sellers, in 1982, the state of Oregon had already done so in 1977. ORS 657.087(2)provides:

“Employment” does not include service performed:

(2)      By individuals to the extent that the compensation consists of commissions, overrides or a share of the profit realized on orders solicited or sales resulting from the in-person solicitation of orders for and making sales of consumer goods in the home.

However, in ACN Opportunity, LLC vs. Employment Department, the state of Oregon asserted that independent distributors of telecom direct seller, ACN, were in fact employees because, in general, their solicitation was not in the home. The Oregon Supreme Court agreed.

If the court really wanted to effectuate the 1977 intent to protect direct sellers, it could have done so.  It could have interpreted that either:

1. The products/services marketed by ACN distributors were for use “in the home;”

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2. Or, that distributors used a business based in their home to market products/services.

3. In fact, the Court was thrown a softball that it completely “whiffed” when it was pointed out that, in 1983, the Oregon legislature updated, for tax purposes, the exemption of a “direct seller” to be consistent with the federal statute 3508. It could have interpreted the definition in the 1977 legislation to be consistent with 1983 tax definitional updates.

It did not.

ACN also observes that the Oregon legislature adopted that same language in 1983 in ORS 316.209, which defines “direct seller” for tax purposes. See ORS 316.209(3)(a)(B) (defining a direct seller as a person who is “[e]ngaged in the trade or business of selling, or soliciting the sale of, consumer products in the home or otherwise than in a permanent retail establishment”).

ACN argues that it makes no sense for direct sellers like its IBOs to be treated as employees in some contexts (unemployment taxes) but as exempt from the definition of employment in other contexts (income taxes).

The problem, although the State of Oregon in 1977 intended to protect direct sellers, times change and in 2018 it is rare for a direct seller to solicit/sell in the home. And the long story short message from the Court was, effectively “we don’t care…if the direct selling industry thinks it should still be protected, the legislature is the place to go.”

ACN argues that that result will create an “impractical burden for workers and a regulatory nightmare for the state officials tasked with administering Oregon’s employment laws,” jeopardizing the future viability of the direct selling industry in Oregon. If that is true, then it is a policy issue that ACN can present to the legislature to address. (Footnote 6 to Decision)

Having ruled that time had passed by direct selling for its 1977 “home free” ticket, the Oregon court searched for other traditional bases for exemption, but ruled that ACN came up short. Apart from the policy issue, the Court’s legal analysis was subject to legitimate criticism by legal observers that the Court’s analysis was somewhat myopic and tunnel visioned.

1. Said the Court, the company failed to demonstrate that owners maintained business location separate from the company, as grounds for classifying owners as independent contractors, citing that direct sellers were not paying for rent or repairs on separate business facilities. This misses modern economic reality.

Try telling 400,000 U.S. Uber drivers that they “really” don’t have their own business because they don’t pay for rent or repairs on a building separate from Uber.

2. The company failed to demonstrate that owners had a right to hire and fire, as ground for classifying owners as independent contractors rather than employees. Its analysis was totally off-base, citing a non-circumvention/non-solicitation paragraph in ACN policies, common to all direct selling companies that has nothing to do with hiring and firing. Again, try telling 400,000 Uber drivers that they are not really operating their own business because Uber insists that the contracted Uber driver is the only one authorized to drive Uber passengers on his/her account in his/her car.

The Chief Justice penned a concurring opinion, agreeing with the decision, but imploring the legislature to bring the tracking of direct seller employee/independent contractor status current with “economic reality.” But, in a closer look might suggest that the concurring opinion might easily be construed as opining that the decision was not “bold” enough in addressing and protecting the modern practices and “economic reality” of direct selling and other businesses:

Of course, 1977 was before cell phones, internet (no Facebook, Craigslist, or eBay), and ubiquitous coffee shops (with wifi) holding themselves out as remote offices where a seller of goods or services might conduct business online or meet with a customer or client. The requirements the legislature used to identify exempt direct sales in 1977—in-person solicitation and sales “in the home”—may no longer be appropriate to delineate some of the kinds of direct sales that the legislature intended to reach when it enacted that exemption. In any event, different models of direct sales have emerged because of technological, social, and economic changes, while the direct sales statute remains unchanged.

…Again, given new technology, a person’s “business” may exist entirely on his or her laptop, tablet, or smart phone. And individuals may view their “business location” as wherever they and their device are located—the aforementioned coffee shop, the city library, or a shared workspace such as WeWork—or, if working at their residence, entirely from a deck chair on the porch. The existing statutes often can be useful in determining when a person is an employee or an independent contractor; however, because of the substantial changes in many sectors of the economy—in how work is done, where, by whom and under what compensation arrangements—the results courts reach in those cases may not be those that the legislature intended.

…Whatever direction such legislative or administrative changes might take, it is apparent that existing statutes and regulations do not address the realities of important parts of today’s work environment. If that legal framework can be updated to align contemporary workplace realities with the state’s policy objectives, individual workers and employers—as well as the regulators and courts who apply the laws—will benefit.

Bottomline: right or wrong, the high court has spoken; the only remedy is legislative.

2. States that have not adopted Section 3508 type exemptions, applying a common law test and/or statutory test referred to as the three prong ABC test, to which direct selling companies typically struggle to fulfill prong C:

The ABC Test:

1. The worker is free from the employer’s control or direction in performing the work.

1. The work takes place outside the usual course of the business of the company and off the site of the business.

1. Customarily, the worker is engaged in an independent trade, occupation, profession, or business.

Connecticut is a second prime example of the need for legislative update.

In 2018, the Connecticut Supreme Court, noting that the legislature had abandoned use of a favorable common law employment/independent contractor analysis with a statutory ABC Test, held that there was a challenge with Kirby of Norwich and prong C of the ABC test, and therefor its sales representatives, in that case, were now reclassified as employees rather than independent contractors, with all the attendant obligations. Kirby of Norwich v. Administrator, Unemployment Compensation Act, 328 Conn. 38 (2018)

And again, the message to the direct selling industry is a polite “too bad.” Times may be changing and you should look for relief in the legislature and not the courts:

Although we recognize the appeal of the plaintiff’s arguments, we are not persuaded that we should overrule JSF Promotions, Inc. We acknowledge that a narrow interpretation of part C of the ABC test imposes significant burdens on businesses, like the plaintiff…

We will not interpret the ABC test in such a manner.¹⁴ Although we are sympathetic to the plaintiff’s claim that part C creates certain, undesirable practical consequences as applied to the specific facts and circumstances of this case, any decision to alter or modify part C on the basis of a determination that, under such facts and circumstances, its costs outweigh its benefits must be made by the legislature, not this court.¹⁵

Even after acknowledging the DSA’s amicus brief that identify 31 states that have gone so far as to statutorily exempt direct sellers as independent contractors rather than employees, the Connecticut Supreme Court punted to its statutory ABC test. In essence said the Connecticut Court, “good luck…you are on your own.”

The amicus curiae contends that, in states without such statutes, direct sellers have been recognized as independent contractors under the common law “for decades.” The only case addressing that question in Connecticut, however, is Electrolux Corp. v. Danaher, supra, 128 Conn. at 342, 23 A.2d 135, which, as we have explained, was decided before the legislature amended the act to include the ABC test. Other jurisdictions are split on the issue of whether a putative employee must actually be engaged in an independently established occupation to satisfy part C of the ABC test. It may well be that exempting direct sellers from the act, regardless of whether they are actually engaged in an independently established occupation, is the better public policy. As we have indicated, however, that policy judgment is one to be made by the legislature, not us.

The DSA Initiative is Timely

Over the decades, the DSA has done a stellar job in protecting the direct selling industry from the challenges of “employer designation.” Its success approaches 40 states. However, the recent adverse cases in Oregon and Connecticut, suggest that its new initiative is timely. In addition the DynamexCalifornia case is a shot across the bow of the “gig” economy, and the direct selling industry should be vigilant that it is not caught in a new legislative Dynamex tsunami. The DSA has indicated that its upcoming initiative will focus on Connecticut, Oregon, and Indiana.

If the industry is looking for simple clarity and guidance, citation to the federal independent contractor tax standard, it is suggested that the model exists in the most recent DSA sponsored legislation from North Carolina.

North Carolina

H 931/S 717

Effective July, 2018

Employment:

Exclusions. – The term excludes all of the following:

…Service performed by a direct seller, as defined in section 24 3508(b)(2) of the Code.

This approach is clean, direct and sends a clear message to protect the viability of the direct selling model.

Jeffrey A. Babener, of Portland, Oregon, is the principal attorney in the law firm of Babener & Associates. For more than 30 years, he has advised leading U.S. and foreign companies in the direct selling industry, including many members of the Direct Selling Association. He has served as legal advisor to various major direct selling companies, including Avon, Amway, Herbalife, USANA, and NuSkin. He has lectured and published extensively on direct selling.

Jeff is a graduate of the University of Southern California Law School. He is an active member of the State Bars of California and Oregon.

Visit us at www.mlmlegal.com to learn more.