MLM, nirvana for lawyers, not laws

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by Rogier v Vlissingen

With a wink to Gore Vidal, who always said America is a land of lawyers, not of laws, we explore how MLM law practice has evolved.

I was first exposed to MLM in the early 90’s and went on a deep exploration. I was finishing up my study of economics at the time and considered doing a paper on it, but never managed to pull it together enough. A friend had asked me to look into Amway, and I asked him for six months to evaluate it. At the end of six months I told him Amway would not be for me. My main reason was, after, among other things, studying the ‘79 Amway ruling, that in Amway ‘trainings,’ in this case by the Bill Britt organization, people were overtly told to manufacture receipts to ‘document’ their retail sales in order to meet the ‘70% rule.’ In short, the company was actively encouraging breaking the law and in the process setting up ‘plausible deniability’, for these trainings were done by distributors. I had seen and heard enough at that point.

Again, at the time, I really could not get my head around the economics of the story, but I saw the legal problem. Subsequent to my rejection of Amway, I was pitched on MLM again and again, and one day, of all people, it was by my accountant at the time, who had a client who was making big bucks in Nu Skin. Talk about credibility… My accountant prepared this guy’s taxes. But I passed on Nu Skin. Could not get my head around it. I also fired the accountant later. Then, however, others came along and the most popular pitch of the day was that they were not like Amway. I went to MLM conferences and met the likes of Rod Cook and MLM-lawyer Jeffrey Babener, and eventually I swallowed all the ‘accepted legal reasoning’ of what made an MLM a pyramid scheme, or not. I got involved. I guess, I had to learn the hard way.

I did get involved in a few MLMs but always dropped out again, but, following the information from the FTC closely, I kept thinking the problem was that this MLM did not do things right. After all, the FTC keeps advising us that a legal MLM is possible and all the MLM-lawyers could explain exactly why your MLM (their client) was not a pyramid scheme.

In the early 2000s I watched from the sidelines as Skybiz came along. But later I got involved, with a friend of mine who had once made good money in Calorad, in BigSmart, for just a few months. Slowly, I began to figure out that the company was going to fail for what I thought was a clear violation of the applicable laws, and I turned around, with my friend and we had a conference call with one of the owners, who stuck his head in the sand completely — his lawyers had it handled. We advised all the people who were involved with us to get out, only to see BigSmart shut down by the FTC six months later and afterwards we got some chump change back from the subsequent settlement.

I thought I was done then. For good. Except in circa 2010, North American Power came along and it was again ‘not like Amway’ and it could not possibly be a pyramid scheme for there was no up-front fee, and they promoted ‘green’ power, which was something I supported, so what could be wrong — except everything of course… A few years later, Bill Ackman’s Herbalife short came along, and I thought, great, it’s a dirty job, but somebody has to do it. However, until Carl Icahn moved in with a long position in Herbalife opposing Ackman, I did not get excited. It was Icahn’s position that made me take up the pen, and I started writing about this episode on the Seeking Alpha website, which resulted in something like nearly 70 articles in the next five years, most of them on Seeking Alpha — for details, see my SA profile.

Starting out, I was clear that Herbalife was a pyramid scheme and that Ackman would win. As clear as you reasonably could be. We all know how that ended, for now. For now … for Icahn has not yet liquidated 2/3rds of his Herbalife position, and the stock is clearly wildly overvalued. In his position, it is clearly hard to sneak out the back door. He may be about to, as I write this, and we will see how this story ends.

For me, the Herbalife story was a big lesson. Writing helps me to think. In my case, I began to see, while writing, how even North American Power could be a pyramid scheme. This is what set me to thinking. When I had signed up for North American Power and referred some customers, I made about $1,500 in referral fees before I even thought of ordering business cards for $60. But then, I signed up a neighbor, who ordered business cards right away, even though I counseled him to first make money before spending any. He would not listen, spent the money and never made any money. This was how I began to see that the typical MLM-frenzy just seduces people into permanently spending more money than they take in. Even if there were no fees, people went to “trainings” etc. and most of the people I signed up never made much money, even though I did.

Then, there was an episode of apparent over-charges by the company, and I explained to them that excessive mark-ups were merely another way to fund a pyramid scheme and that they were opening themselves up to being challenged that way. Initially, they ignored me, for they claimed that four different law firms had looked at their business plan and given it their blessings. In response, I simply asked if any of the four law firms had any credible expertise on MLMs and pyramid schemes. Eventually. the President of the company found a fifth law firm to review a letter that I had sent them, where I outlined 20 changes they needed to make in order not to risk regulatory action for being a pyramid scheme. It meant their distributors would have to sell. So the hard-core MLMers balked. Nevertheless, the company began to introduce some changes towards the end of 2014, and riots broke out. Finally, on January 13th, 2015, they shut down their MLM-program altogether, since evidently the “heavy hitters” were not interested in running a legally sound business. Fortunately for them, they also had regular, “old fashioned” sales and the company made out OK. So, what went on here?

Founder Kerry Breitbart had once, on a fluke, participated in an MLM, one with an $500 ‘starter pack,’ which he had left after winning some kudos for his effective recruiting. He did not need the money himself, being independently wealthy and he was bothered by the fact that the vast majority of folks he had signed up never made a dime, so they lost at least the initial $500 plus any subsequent purchases, and any money, time, and effort they put into it. And then he met John Costino, a lawyer who at one time had founded The Free Network, which was a telecom MLM that famously did not have an entry fee. The Free Network had failed eventually, because of some technology challenges, but Costino was retired. John Costino was convinced that his formula would never be challenged as a pyramid scheme and he convinced Kerry Breitbart of the same. That is how North American Power came to launch its MLM program. So what happened here?

The MLM-legal paradise

Simply put, MLM-lawyering is not about legal advice in the traditional sense.

There is a way to practice business law with an honesty and integrity. We all realize that any business needs to follow regulations and laws and may need advice, and that is why you need lawyers. There is another way of business-lawyering that seeks to make its money by exploiting legal loopholes. We see this prominently in the area of tax-shelters. Lawyers and accountants team up and develop tax-shelter strategies and create new ‘products,’ always with appropriate disclaimers that these are just opinions on the likely legal viability of the new construct — nobody will know until the IRS rules. Of course, the same lawyers will be happy to defend you if the IRS rules against you… for a fee. If the whole thing blows up in your face, the lawyers will learn from the defeat to devise the next tax-shelter that seeks to evade the particular pitfall that doomed the last one. In short, this sort of law practice is mostly in bad faith, it seeks to exploit loopholes in the law for profit, and the difficulty of prosecution means that statistically, the lawyers and accountants win in the long run, and so do the clients, most of the time. Except the few who lose money. For the most part however, this is a sport for the wealthy, who can afford to be wrong on occasion and take the losses, quite aside from what you may think of the ethics.

MLM lawyers practice in the same spirit as the ones who develop tax shelters. The objective is to maximize law-evasion for profit, and the calculus is that so few ever get prosecuted that most will win most of the time. The Amway ruling of ‘79 was a case in point. The ruling was drafted by Amway’s lawyers, for an inexperienced administrative law judge of the FTC, Judge James P. Timony, and subsequently adopted by the FTC which has hampered its effectiveness in this area ever since. The essence of the ruling was that Amway would observe certain safeguards that would prevent it from being ruled a pyramid scheme, and the unstated truth was that these safeguards were so widely impractical and unenforceable, with the burden of proof remaining with the FTC, that, de facto, the ruling immunized Amway against pyramid scheme prosecutions. The 70% retail sales rule was just the most obvious fallacy.

It was also a red herring argument. Economics 101 would suggest that if you recruit distributors indefinitely, you will squeeze the margins of your retailers to zero eventually. The way this is phrased in economics textbooks is: “under perfect competition, profits go to zero.”

In MLM practice, profits for retailers often go negative, for in the end the competition for new distributors becomes so fierce that people give away product to promote the presumed business opportunity. Plus, they are spending money on trainings and other business expenses. This is how the majority of practitioners in the MLM space end up losing money for years, and most never ever make it. Some people “make it” in the end, and some who do, like my good friend E. Robert Smith, author of the novel Downline “…an intolerable potential to deceive”, eventually realize that they have become professional liars in the process of promoting a business where 99% predictably lose money. You stay afloat by lying better than the next guy.

Meanwhile, the lawyers keep the FTC and law enforcement tied up with various red herring arguments, and no one seems to go back to basics — the underlying economics. One example was a recent Twitter exchange I had with MLM-attorney Kevin Thompson, who questioned why I called Herbalife a pyramid scheme and asked me to name the reasons why. I did explain it to him in two follow-up tweets and that’s the last I heard of him (with minor corrections in spelling):

Rogier v Vlissingen‏ @vliscony Aug 2

Rogier v Vlissingen Retweeted Kevin Thompson

On the contrary, those issues are well founded in the existing law, they were not rendered very well in the $HLF settlement agreement, but are otherwise well supported, and are also basic economics 101, which eventually will win the day. Law sometimes slow to catch up to reality

Rogier v Vlissingen added,

Kevin Thompson @KPTlaw
Replying to @vliscony

I agree it’s a pyramid as defined by you, just not one defined by law.

Kevin Thompson‏ @KPTlaw Aug 2

Name the case. Those concepts are certainly not in Burnlounge. You’re basically accusing the FTC of major incompetence, even after they secured the most stringent settlement in industry history.

Rogier v Vlissingen‏@vliscony Aug 2

1/2 The point is that under perfect competition, profits go to zero. That much is economics 101. Under Koscot it is very clear $HLF would still not pass the smell test, and it follows directly from this observation of basic economics.

Rogier v Vlissingen‏ @vliscony

Replying to @vliscony@KPTlaw

2/2 If overrides are defined on the basis of MSRP and thus “protected,” while retail margins are not protected, the compensation for recruiting is de facto unrelated to enduser sales and therefore $HLF would still NOT be not a pyramid scheme. @FTC @MOhlhausenFTC  [account suspended]

1:37 PM – 2 Aug 2018

Screen Shot 2018-08-07 at 11.09.30 am

In short, the point is that the basic economic logic implies that unlimited recruiting will infinitely erode any retail profits, so that the majority of participants will be left stuck with the business expenses without ever making any meaningful money. Moreover, there is a legal test in the Koscot case, which states that if compensation is unrelated to retail sales, we have a pyramid scheme, and no MLM I have ever seen can meet that test. Simply put, all marketing plans stipulate precisely the overrides you make, regardless of the losses of the retailers. Again and again MLMs fizzle out, or distributors quit and 99% of them lose money. Recruitment is only possible by hiding the numbers of distributors, so that people are recruited without knowing what their chances are of ever making any retail profits and without any protection if they ever do.

At the end of the day, even the recent settlement with Herbalife fails on this point and leaves unlimited recruiting in tact, even while it tries to do the Amway ‘79 ruling one better. It was an amazing piece of work in many ways, but unfortunately ineffective, even aside from issues with actual enforcement, of which to date there is no sign. Somehow, the FTC seems to be committed to maintaining the position that MLM could be legitimate, because they are lost in the legalese and do not go back to the utterly simple economic realities that underlie the whole argument.

The net effect of this game of whack-a-mole by the FTC is that it leaves them permanently behind the eight-ball, and that the other players in the industry derive a certain faux-legitimacy from the whole game, as in: Clearly, we must not be a pyramid scheme, or else we would have been shut down already, which flies in the face of the whole point of law enforcement: the point is always to deter crime, not to ever catch every last criminal, except in the MLM case the odds against being shut down are so tremendous and the profits to be made so magnificent, that it never seems to stop. The odds are completely against being prosecuted.

In short, these days, my position is that, purely as a matter of economic analysis, every MLM is by nature a pyramid scheme, disguised to look like a direct sales business. That much is an economic fact. Every MLM marketing plan has a ‘trap door,’ in the form of a monthly sales (read: inventory) requirement, that provides access to recruiting bonuses, and soon the participants realize that the only way they ever might make money is by recruiting, not by selling.

I am not law enforcement and the question if the FTC, SEC, or DOJ, or lawmakers will ever get around to facing the fact that this is so, and dealing with it legally is completely beyond my control. The book Downline provides a fictional scenario of how it all could end one day. Maybe it will happen some year, most likely it won’t, but the internet is a viable way for people to learn from the mistakes of others, if they would dig around just a little bit.

Photo by Sebastian Pichler on Unsplash

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