SEC: We Hate Pyramids

By Jeffrey A. Babener
 July, 1993

From time to time, rumors fly through the industry that "the sky is falling." The topic of inquiry for many distributors and companies most recently is a rumor that the SEC (Securities Exchange Commission) is about to shut down the network marketing industry on the basis that network marketing constitutes a sale of a security. The answer to this inquiry is that there is good news and there is good news.

The good news is that the SEC itself in response to such inquiries has confirmed that no enforcement policy changes are or have been in the works as to this industry. And the good news is that the SEC treats such matters on a case-by-case basis and, where the abusive behavior of a network marketing company transforms it into a pyramid scheme, the SEC will, as it has in the past, take action to stop the company. Why? Because for the SEC, as well as all courts and state regulatory agencies, a pyramid scheme is a security.

Where it appears that a pyramid scheme has operated as and masqueraded as a network marketing opportunity, the SEC and other agencies have taken further action. "... for the SEC ... a pyramid scheme is a security."

In 1971, the SEC announced that in its opinion a multilevel marketing program could be transformed into a security. The 1971 SEC notice is not an indictment of the network marketing industry. Instead, it suggested that an MLM company that was more like a pyramid scheme in which the activity of a distributor was "passive" rather than "active" could trigger accusations of a passive investment scheme or security. In a pyramid scheme, rather than buying products to sell to consumers, distributors are instead buying into a position in a scheme. This is nothing new. In fact, the SEC and all state regulatory agencies have always taken the position that a pyramid scheme is by definition a security. The point is, however, that many criteria have developed over the years to differentiate a pyramid scheme from a network marketing business opportunity.

The most recent and substantial prosecution of an MLM company by the SEC in 1992 illustrates the fact that the SEC will in fact pursue a pyramid scheme which is masquerading as a network marketing company. In that case, the SEC convinced a federal court to shut down and freeze the assets of the ILN program.

The ILN program held itself out to the world as a consumer benefit service which also offered members and distributors opportunities for real estate investment. In reality, the program was probably driven by "the deal" and was a headhunting scheme. Potential recruits were invited to emotionally charged revival type meetings where they were encouraged to invest money in memberships and real estate, and make a fortune by getting others to do the same. Large amounts of money were invested with expectation of large returns. The federal courts accepted the SEC position that the ILN marketing program constituted an illegal pyramid scheme and the sale of securities.

Explaining securities law in layman's terms is not such an easy task. In layman's terms, a security is best thought of as a "passive investment", i.e. an investment of money with expectation of a return that is substantially caused by someone else than the investor. For instance, when you invest money in your own small business, that it is not a passive investment because the profit comes solely from your own work. Similarly, purchase of a franchise is an active investment. But the purchase of a share of stock in IBM is a passive investment. And so also is an investment in an MLM program which involves inventory loading and headhunting where distributors expect to make their money by merely introducing new distributor investors who also invest heavily, and where little money is made by selling product or service to the actual retail customer. The courts have continually held that a pyramid scheme constitutes the illegal sale of securities. In a pyramid scheme, participants are in reality investing in the marketing plan and counting on the marketing plan to bring them a return on their investment if they can find other investors.

In the ILN case, the court compared the ILN program to some of the abuses in famous programs, such as Dare to be Great, Koscot and "Challenge to America," all of which were accused of being pyramid schemes and thus securities.

The ILN program had elements of today's modern MLM programs, but it had much more in common with pyramid schemes of old. It's useful to contrast the ILN program from the elements of a legitimate program. According to the SEC and the court:

In a pyramid scheme, participants are in reality investing in the marketing plan and counting on the marketing plan to bring them a return on their investment if they can find other investors.
  1. The driving force in the ILN program was to solicit recruits to invest large sums of money, and encourage them to procure others to do the same. The driving force is not a product, but instead "the deal" or business opportunity. The driving force in a legitimate MLM program is, in fact, its product.

    The underlying philosophy of the ILN program was stated time and time again at the President's night recruitment meetings: "The movement of money creates wealth. What we believe is that if you organize people and get money moving, it can actually create wealth." No such hype or "get rich quick" philosophy is involved in a legitimate program where income is earned from retailing an established product.

  2. Earlier pyramid cases were characterized by the payment of headhunting fees for recruitment of new distributors. The ILN program was found to be such a program. The court found as a factual matter that "the intent is for a person to become a member first and then recruit new members." The court noted the oft quoted game like pitch of the ILN president, "You come in, then you bring your wife and your kids." Of what conceivable value could more than one consumer membership have to one household? Distributors in legitimate MLM programs are not paid for headhunting new recruits and are generally mandated to meet retailing requirements to qualify for bonuses.

  3. The court observed that the ILN membership had no real independent meaning outside the context of its marketing program. In essence, the only likely reason individuals invested in ILN was because of the business opportunity. ILN had no previous track record of marketing its memberships or real estate investments without the pyramid opportunity. The entire thrust of meetings and literature was to encourage people to invest and "to move money" to make money.

  4. Pyramid programs of the past are replete with earnings hype, check waving, and the "money humming" of the Dare to be Great type programs. The ILN program follows in that tradition. The courts have characterized its meetings as "evangelistic revival" type meetings, "part motivation and part financial evangelism." This characteristic is absent in a legitimate program.

  5. There was no evidence of actual retailing to the end consumer nonparticipant in the ILN program. Retailing is mandated to qualify for bonuses in legitimate MLM programs.

  6. The big money to be made in ILN was in large real estate investments. The ILN real estate investment program is an adaptation of an earlier such program, that even ILN officials admitted involved the sale of securities. The courts found the likelihood that the ILN membership marketing program and real estate investment marketing program were a "single interlocking program," and that the real estate program was "inextricably intertwined" with the membership marketing program. Inducements to participants to invest large sums of money have been a characteristic of earlier pyramid cases. Again this factor is conspicuously absent in legitimate programs. After purchase of an "at cost" sales kit, distributors are asked only to spend time, not money, to retail product or services to retail customers.

  7. ILN distributors were encouraged to bring recruits to pep rallies where ILN officials "close the deal." This element of "common enterprise" and "efforts of others" is typical of earlier pyramid schemes. This approach is also absent in legitimate programs, again where retailing activity and supervisorial and managerial activity are prerequisites to earning income.

So, what is the answer to the many inquiries about the SEC and the MLM industry? The answer is that from an SEC standpoint, the network marketing industry has a future. Pyramids do not. MLM companies that tolerate front-end loading, garage qualifying, buy-in qualification, or who offer programs that are driven by "the deal" rather that the product or service, are all fair game. If you are recruited for such a program -- run fast in the opposite direction.

The answer is that from an SEC standpoint, the network marketing industry has a future.

Pyramids do not.

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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