Direct Sales and MLM

6 Lessons From Direct Selling Industry's Win Over FTC

By
Kevin Thompson

This is an excellent article prepared by Branko Jovanovic and Monica Zhong, two economists at Edgeworth Economics. I’m sharing it in full, with permission.

Branko Jovanovic and Monica Zhong

————–

6 Lessons From Direct Selling Industry's Win Over FTC

By Monica Zhong and Branko Jovanovic (October 5, 2023)

U.S. District Judge Barbara Lynn's decision in Federal Trade Commission v. Neora LLC in the U.S. District Court for the Northern District of Texas last week marks a landmark victory for the direct selling industry.[1]

Many direct selling cases have been awaiting this decision, anticipating that it would clarify the criteria for assessing whether companies like Neora are operating a pyramid scheme.

While the importance of the decision for the direct selling industry cannot be overstated, it is worth noting that Neora was in a position to show that many of the rewards it offered to its participants did not depend on recruiting new distributors, and to demonstrate that the vast majority of sales were consistent with genuine demand for Neora's products.

In determining whether Neora ran an illegal pyramid scheme, Judge Lynn examined the FTC's evidence regarding whether Neora's operations satisfied two prongs of the test articulated by the FTC in In re: Koscot Interplanetary Inc. in 1975: (1) "the right to sell a product" and (2) "the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of product to ultimate users."[2]

Because Neora's compensation plan requires that participants who join Neora's business opportunity must pay for an enrollment kit, Judge Lynn found that the first prong of the Koscot test was clearly satisfied: The payments granted participants "the right to receive rewards for recruiting new [brand partners] and selling products."[3]

Judge Lynn's determination that the first prong of the Koscot test was clearly satisfied echoes the May U.S. District Court for the District of Arizona decision that U.S. District Judge Dominic Lanza issued in FTC v. Noland. Judge Lanza determined that there is no "dispute that consumers were required to pay an annual fee of $49 to be [Success by Health] Affiliates," and that "by paying this fee, Affiliates gained the right to sell SBH products on their [replicated SBH] webpage."[4]

These two recent decisions make it clear that the first prong of Koscot test will be met by any direct selling organization requiring its distributors to purchase a starter kit or pay an annual fee.

In FTC v. Neora, the court's focus was proving the second prong of the Koscot test — whether Neora participants "receive rewards for recruiting other participants, unrelated to the sale of product to ultimate users."[5]

The court rejected the FTC's expert witness Stacie Bosley's assumption that purchases by Neora distributors were not sales to ultimate users and highlighted the importance of "actual operational data and internal structure of Neora's business."

In its criticism of Bosley for "look[ing] only to the compensation plan in isolation,"[6] the court emphasized that the Koscot test was really about proving whether the compensation plan was funded primarily by repeatable product sales to ultimate users, or if it was funded by upfront fees and inventory loading from a continuous supply of recruits.

From an economic perspective, Judge Lynn's decision offers several key takeaways.

1. Drawing the Line Between Distributors and Agents

The court found that Neora distributors are not agents of Neora, and that therefore Neora cannot be held accountable for the statements made by its distributors.

Referencing the FTC's argument that brand partners should be considered agents as a matter of law, the court commented that "the existence of an agency relationship is a question of fact."[7]

The court noted that there was insufficient evidence of the agency relationship since brand partners have the choice to "completely forgo the business opportunity" and Neora cannot "enforce performance," unpersuaded by FTC's claim that the "[d]efendants control [brand partners] by approving applications, disciplining and terminating [brand partners], prohibiting [brand partners] from selling competing products, and restricting [brand partners] to using only approved marketing materials."[8]

2. Personal Consumption Cannot Be Ignored

The court found that Neora had a robust preferred customer program. Because the first four rewards or bonuses in Neora's compensation plan were entirely based on sales to preferred customers (as opposed to brand partners), which are considered ultimate end users, the court focused on assessing whether the remaining rewards in the compensation plan that required recruitment were "unrelated to sale of the product to ultimate users."[9]

Bosley's testimony that the "vast majority of participants will lose money" relied on her assumption that "none of [brand partners'] purchases for personal consumption qualify as sales to an ultimate end user."[10] This assumption, however, was not supported by evidence, rendering baseless Bosley's conclusion that Neora was operating a pyramid scheme because those recruitment-based rewards were unrelated to ultimate user sales.

3. Some Preferred Customers Join as Distributors to Be Eligible for Higher Discounts

The court found that Bosely's assumption that "none of [brand partners'] purchases for personal consumption qualify as sales to an ultimate end user" in fact contradicts with survey evidence provided by Neora.

Neora provided survey results that reported the intentions of brand partners who elected to become a brand partner, and the top reason was to get discounts on the product.[11]

Survey evidence implies that it is important to assess the intentions of participants deciding to become brand partners, and in this case, these participants "enroll[ed] without ever intending to pursue the business opportunity, and are instead savings seekers, looking to take advantage of the biggest product discounts that are available only to [brand partners]."[12]

Notably, the court discounted Bosley's assumption that brand partners who never made sales or earned commissions were "disappointed victims of an illegal pyramid scheme, simply because [they] never made a sale, recruited another [brand partner], or earned a commission."[13]

4. Sales to Nondistributors Matter

Neora's ability to present evidence highlighting the "magnitude of sales of Neora's products to non- [brand partner] consumers" distinguishes Neora from the other cases relied on by the FTC: the U.S. District Court for the District of Arizona's 2015 decision in FTC v. Vemma Nutrition Co., and the U.S. Court of Appeals for the Ninth Circuit's 2014 decision in FTC v. BurnLounge Inc.[14]

Unlike Vemma and BurnLounge, roughly 80% of Neora's product sales are to preferred customers, with the remainder to brand partners, reversing the numbers in Vemma.[15]

The court found that the FTC "does not meaningfully address the magnitude of purchases by [preferred customers]." [16]

5. Thorough Review of Distributor-Level Data Is Necessary

Judge Lynn pointed out that the assessment of direct selling companies' business model requires a thorough review of companies' data; otherwise "the pyramid scheme inquiry" would end with "a reading of the Compensation Plan and an evaluation of whether it is theoretically possible for a [brand partner] to earn recruitment-based rewards without individually making a single sale to an ultimate user."[17]

Instead of "slavishly" reading the compensation plan, there should be a thorough review of the company's actual operational data and internal structure of its business.[18]

6. The Value of the Product Matters

The court's decision also emphasized that assessing whether the product at issue has value is important in the assessment of an illegal pyramid scheme. The court slashed the FTC's claim that because 96% of Neora brand partners lose money and "walk away poorer than they started, having paid more into the company than they ever got out," this constitutes an illegal pyramid scheme.[19]

This claim wholly ignored that brand partners can enroll in Neora because they consider the product to have value and they are "only purchasing product for personal consumption at discount."[20]

The court directly refuted the FTC's argument with a similar analogy that "we may 'walk away poorer than we started' after a trip to the grocery store, but because we obtained valuable goods or services in return for our money, that exchange is not characterized as a loss."[21]

Conclusion

The Neora win is a landmark decision for the direct selling industry and could provide important guidance for direct selling companies. Judge Lynn's decision highlights the significance of a good track record of sales data and the ability to demonstrate product value to both distributors and nondistributors.

Direct selling companies can enhance their ability to prove that the vast majority of sales are consistent with genuine demand by taking the following steps:

- Mandate tracking of retail sales.

- Implement and incentivize preferred customer programs to distinguish participants who are not interested in the business opportunities.

- Analyze business intelligence data to determine the share of sales volume potentially consistent with strategic purchases versus genuine demand.

- Require distributors to designate their personal consumption purchases as such at the time of the order.

- Ensure that at least the majority of the commissions are paid on the sales to final customers instead on distributors' wholesale purchases.

Monica Zhong is a managing consultant and Branko Jovanovic is a partner at Edgeworth Economics.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of their employer, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] Findings of Fact and Conclusions of Law In Re Federal Trade Commission v. Neora LLC, et al., In the U.S. District Court for the Northern District of Texas Dallas Division, September 28, 2023 ("Findings").

[2] Findings, p. 25.

[3] Plaintiff Federal Trade Commission's Post-Trial Brief In Re Federal Trade Commission v. Neora LLC, et al., In the U.S. District Court for the Northern District of Texas Dallas Division, November 23, 2022, p. 6.

[4] Order In Re Federal Trade Commission v. James D. Noland, Jr. et al.  , In the U.S. District Court for the District of Arizona, May 23, 2023, p. 80:7–9.

[5] Findings, p. 29.

[6] Findings, p. 41.

[7] Findings, p. 42.

[8] Findings, pp. 43-44. The Court commented on this matter that "Neora does not control and has no right to control how much [brand partners] work (if at all), how much they spend on their pursuit of the business opportunity, or how they exercise their choice of work activities."

[9] Findings, p. 30.

[10] Findings, p. 31.

[11] Findings, p. 32.

[12] Ibid.

[13] Findings, p. 37.

[14] Findings, p. 35.

[15] Ibid.

[16] Findings, pp. 40-41.

[17] Findings, pp. 40-41.

[18] Ibid.

[19] Findings, pp. 36-37.

[20] Findings, p. 37.

[21] Ibid.

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