FTC's Directive to DSA: Times are changing
Edith Ramirez, chairwoman of the Federal Trade Commission, gave a powerful speech at the DSA’s Business and Policy Conference in Washington on October 25th. While some in attendance were expecting a non-substantive speech, the kind one would expect from a high-ranking government official, Ramirez was anything but boring. She gracefully navigated some very controversial terrain in the industry, covering several challenging issues we’ve been discussing for years. Immediately after the Herbalife settlement was announced in July, Ramirez said she would be issuing formal guidance to the industry to make the FTC’s expectations clear. There’s no need to wait -- she made the FTC’s position crystal clear! The full transcript of her speech can be found here.
“Real Sales to Real Customers”
In July of 2016, Herbalife settled with the FTC on charges of unfair business practices. The terms of the settlement / injunction were pretty significant, leading many of us to wonder whether the FTC intended for these restrictions to apply to everyone. The short answer: The Herbalife settlement is a solid “guide” for companies looking to stay out of trouble. As a recap, the terms of the Herbalife settlement are summarized here on our site. Regarding what parts are more important than others, it’s up for interpretation, which will largely be decided in future lawsuits.Those of us in attendance received a parental-like lecture, the kind where mom in complete exhaustion says, “I’ve had enough!” Clearly Ramirez, and her fellow commissioners, are not content with the status of the industry. There’s too much consumer harm, too little product value, and too much talk with too little action.
But there’s a problem: There were some inconsistencies with what she said versus what’s embedded in case law. But if companies dare challenge the FTC on this new position, they do so at their own risk. We’re in this strange limbo where the elites in the industry, the in-house lawyers and company executives, are divided as to what to do going forward. This sort of over-correction from the FTC is, in my view, a direct response to the industry’s failure to take meaningful measures to improve itself.When I first started my practice in 2009, I wrote an ebook titled “Saving the network marketing industry by defining the gray.” The thesis of the ebook was simple: The gray that separates legitimate MLMs from pyramid schemes is too large. It allows bad companies to masquerade as legitimate network marketing companies, which further soils the industry’s reputation.Shrink the gray, weed out the bad companies, improve the industry. Simple. But there was a catch: In order to shrink the gray, companies need to be willing to change. And change is tough, sometimes painful. Change was a challenge that few companies have accepted. Thus, we have a seemingly adverse relationship with regulators. In the ebook I wrote,
In an industry with hundreds of network marketing companies launching each year, the case-by-case approach [by the FTC] might prove ineffective at curbing inappropriate marketing tactics. Due to the size of this “gray area,” it’s as if the majority of network marketing companies are a herd of gazelles running from the regulatory lions with each company trying to outrun the slowest.
Bottom Line: The FTC is tired of chasing pyramid schemes. There’s too many and their current “case by case” approach is ineffective; thus, they’re fighting to create bright-line rules. And those bright-line rules are tough.
The FTC’s Attitude
The crux of Ramirez's directive can be boiled down to two main discussion points: income claims and identifying the characteristics of a legitimate MLM.
This is well-plodded terrain, which is why I’ll spend the least amount of time on it. Ramirez stated, “It is time that MLM income representations matched the income reality of the majority of multi-level marketing participants.” She gave some specific examples, giving us all a sense of what the FTC finds offensive. Going forward, we need to pitch the business opportunity as a way for establishing supplemental income. Statements like “set for life,” “fire your boss,” “earn career-level income,” “travel the world” will all be considered misleading. We’ve provided some guidance in the past on this subject here. Also, Ramirez stated that companies need to both TRAIN distributors on this issue and actively MONITOR for problems. These are two areas where startup companies tend to struggle, as they oftentimes lack sufficient resources to execute. It’s not good enough to say “We’re not able to control those knuckle-head distributors. . .”. Companies need to take proactive measures to prevent problems (through education) and catch them (with monitoring).
What Does a Legitimate MLM Look Like?
The core principle: “Real sales to real customers.” Ramirez provides four aspects that help explain her thoughts on this principle. These aspects largely mimic the spirit of the Herbalife settlement. The problem, as will be explained later, some of these areas are inconsistent with existing case law. This creates a dilemma for companies: Do they capitulate, or do they roll the dice with the hopes that (a) they’re not chosen for a lawsuit; or (b) if they get sued, they can prevail.
(1) Legitimate MLMs must be focused on real customers
Ramirez defines “real customers” as “consumers who are not pursuing a business opportunity.” She points to the Herbalife consent order that requires Herbalife to create two categories of customers: Retail customers and preferred customers.Ramirez suggests various policies designed to ensure the majority of a company’s revenue comes via retail sales instead of purchases made by distributors (internal consumption). She makes this clear when she said, “Simply put, products sold by a legitimate MLM should be principally sold to consumers who are not pursing a business opportunity.” I interpret “principally” to be at least 50%, preferably more.
(2) Legitimate MLMs must base their compensation on sales that are profitable and verifiable
Retail sales need to be profitable AND verifiable. Companies are no longer able to claim ignorance and argue they have no way of knowing if distributors are moving inventory to customers. In order to be truly commissionable, companies need to show that the vast majority of purchases are moving to participants unaffiliated with the income opportunity.While there’s some room for commissions generated via personal consumption (purchases made by distributors), the extent that this kind of revenue can drive the pay plan is limited.
(3) Legitimate MLMs should not use targets or thresholds that are met by mere product purchases.
This basically means that companies should refrain from having monthly quotas that can be met via personal purchases / autoships. On paper, companies create this policy to ensure distributors are actively moving product. In practice, according to the FTC, the policy puts pressure on distributors to buy in order to remain qualified for commissions. Ramirez said, “Legitimate MLM should not use targets or thresholds to satisfy eligibility for compensation or rewards that are met by mere product purchases. Because the focus of a legitimate MLM, and the basis for the compensation it pays, must be real sales to real customers, business opportunity participants should buy product only in response to actual consumer demand.” She further said, “MLMs should not contrive ways to get their business opportunity participants to make purchases for reasons other than actual retail demand.”I’ve written about this in the past, calling on the DSA to make this part of its code of ethics. In fact, the majority of my suggestions for the DSA’s Code of Ethics, made two years ago, are now being adopted. Late is better than never.
(4) Compensation paid by a legitimate MLM must be tied to retail sales.
This last point is really a summary of the prior three. She states that companies should take measures to ensure product is adequately moving to customers. While distributor consumption counts, the revenue needs to be weighted in favor of customer revenue. In Herbalife’s case, the revenue needs to be dramatically weighted in favor of customer revenue (65+%). In Herbalife’s case, if a certain percentage of revenue cannot be traced to legitimate customer sales, Herbalife is limited in what it can pay out via commissions. More customer sales equals more compensation in the plan. It’s an algorithmic way to ensure Herbalife, as an organization, takes responsibility for the big picture. Ramirez hinted that other companies in the industry would be wise to adopt similar policies.
Internal Consumption: Dividing Lines
This is where the issues get complicated for companies. In the forefront of Edith Ramirez’s remarks was this notion that commissions driven via internal consumption are inappropriate. However, prior statements from the FTC AND well-settled case law suggests otherwise. Ramirez said,
The Herbalife order also reflects the law’s justified skepticism of compensation based on the presumed ‘internal’ or ‘personal’ consumption of recruits who are pursuing a business opportunity. To address this issue, the order incorporates a number of provisions that impose reasonable limits on the compensation paid for the consumption of products by business opportunity [distributors]. I will highlight one in particular: at least two-thirds of the compensation paid by Herbalife must be based on sales to retail customers or preferred customers, not on consumption by business opportunity participants.
In the FTC’s Staff Advisory Letter, the FTC stated in 2002, “In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme.” In court, the FTC tried arguing the opposite. They said, “Applying this Court’s teachings in Omnitrition, internal sales to other [distributors] CANNOT be sales to ultimate users consistent with Koscot.” (emphasis mine). It was sneaky, and it was ineffective. In fact, the Ninth Circuit held the FTC’s argument to “not be supported by the case law.”Is two-thirds retail the new rule? While it’s not embedded in case law (yet), it certainly seems to be the FTC’s preference going forward.
While the FTC’s current attitude is not solidified in law, companies would be ill-advised to disregard these guidelines. And bear in mind, it is likely that the FTC will eventually bang this attitude into the law via future court cases. When they can get an immediate injunction and asset freeze against alleged pyramid schemes, there’s not much ability for litigation on the issues. I suspect the FTC will solidify these principles by suing some of the medium to smaller companies, the kinds that lack the resources to fight.The Herbalife order provides a good template for how a legitimate MLM operates. However, Edith Ramirez made it clear that the Herbalife order is not a requirement and does not represent the only way for companies to operate. I’ve developed an acrostic summarizing the Herbalife requirements. Companies more consistent with the Herbalife order will be fine, no problem. The further away from the order companies stray, the more risk they take.
R equired volume. Herbalife cannot impose personal volume requirements for qualifications.
E arnings claims need to be under control. Representations of career-level income must stop.
M onitoring: Companies need to actively monitor the field for policy infractions.
O ver 50% retail. While the Herbalife order calls for two-thirds of Herbalife’s revenue to be generated via revenue, I would suspect that 50% would be sufficient. At this time, there’s no hard answer.
D epth. In order to climb in rank and earn deeper into the pay plans, distributors are required to achieve retail sales goals driven EXCLUSIVELY by retail sales metrics. Achieving rank via downline group volume is out of line, according to the FTC’s current attitude.
E ducation. Companies need to take proactive measures to TRAIN distributors on proper behaviors.
L abel. Companies need to start properly coding distributors and customers. The idea of burying customers in the database with the rest of the field is a non-starter. Again, this was one of my proposals for the updates to the DSA code of ethics two years ago.It’s a lot to process. Edith Ramirez said the FTC would be issuing more formal guidance in the future. But candidly, the speech she dropped was guidance enough. It’s time to either put up or shut up. There’s never been a better time to start a company. But for existing companies, with existing problems, it’s going to be a challenge to re-train a sales force deeply ingrained with bad habits. For existing companies, it might be time for some fresh perspective. Retain counsel with a fresh set of eyes to look at your businesses, poke holes in it, and help you improve.If you want to watch my video commentary, it's available below.