Is MLM Legal?

by Robert L. FitzPatrick

The time has come to question and challenge the legal basis of the multi-level marketing (MLM) industry (MLM). I reached this conclusion not only from the five years of research into the MLM business that led to co-authoring False Profits, but more so from the information and personal testimonies that have come to us after publishing the book. Studies of legal technicalities did not get me to this point but the manifest unfairness, deception, manipulation, personal harm and financial losses associated with this business.

If we do not morally and legislatively address MLM now, we are in danger of institutionalizing pyramid schemes as legitimate free market operations. A parallel threat to the legitimate marketplace was faced in the stock market in the 1980s when 'penny stocks' grew at explosive rates and led millions of small investors into financial losses (see "The Penny Stock Parallel" in the index window)

There have been recent court developments which lean strongly in the direction of restricting MLM to the point of making it illegal. However, the laws that apply to MLM are not uniform state to state. Despite its massive growth and its financial and social effects on millions of Americans, there is no nationally governing legislation for this unique business model.

Overall legality of the multi-level marketing industry was officially established by the FTC ruling on the Amway corporation in 1979.This ruling enabled MLM to develop into the large-scale business it now is. Nevertheless, many MLMs have been prosecuted by the FTC and various state Attorneys General. Usually, the companies that are prosecuted are found unlawful on the basis of pyramid scheme definitions.

When is an MLM company a pyramid scheme and when is it not? Opinions differ and as do pyramid definitions. My own evaluation has led me to see that, with rare exceptions, the MLM industry is mostly composed of pyramid operations.

The persistent and widespread involvement of Americans of all income and educational levels in illegal pyramid schemes proves that few people know a pyramid scheme even when they are in one. This fact is further verified by the thousands of MLM advocates and investors who protest federal or state intervention in companies they are associated with even when the courts declare that they are operating illegally.

Pyramid schemes are illegal because they are inherently fraudulent. They are structured in such a way that they cannot continue to deliver on the promise they make to investors. A classic pyramid scheme was the "Airplane Game" that is dramatically described in False Profits. Groups of people assembled in which eight people each gave $1,500 to one person. As the system unfolded this expansion and enrollment process was to continue indefinitely. Each of the eight who invested their $1,5000 would each be given the same amount by eight more individuals. A $1,500 investment would return $12,000. In the beginning, the system fully delivered on its promise. Early investors all gained their $12,000 return. They were also able to reinvest over and over gain and even to financially sponsor others participants and take a portion of their returns. Some early participants gained as much as $100,0000 in the course of about 8 weeks on their initial $1,500 investment. What a system!

The more rational people who were solicited took note of the mathematics involved. For the game to continue many more people would have to be enrolled. The numbers expanded by the multiple of eight with each full cycle of payment. 8; 64;512; 4,096; 32,768; 262,144; 2,097,152; 16,777,216 and so on to numbers beyond the population of the USA and then the entire earth. At some point, a lot of people were going to lose, guaranteed.

Therefore, to keep enrolling people or even to begin such a program is a fraud. Yet, many participants argued that it had not yet collapsed, so why intervene now? They said it's like a lottery, a game of chance, taking a flyer in the stock market or any free market speculation. Let the market and arithmetic take their course!

Of course, to assert these arguments requires either an ethical or an intelligence by-pass, or both. They are valid only if gullible and uninformed people can be persuaded to keep joining. To defend that scheme would be to defend outright deception, cold hearted manipulation and enticement of people who would definitely lose their funds. Had we come to this every-man-for himself, predatory condition? And this was among friend's, neighbors, church members and family!! Denial and greed-driven rationalizations can take bizarre forms indeed.

In the case of the Airplane Game, the Broward County sheriff's office intervened. Ironically ten years later, the Broward County Sheriff Office was itself the scene of a similar pyramid scheme running wild among its deputies. (See "Pyramid Schemes Infiltrate The Police" on page ) More evidence that few people can make the discernment needed when they are solicited to join a pyramid scheme.

The red flags that most often attract the prosecutors are "fees for membership" and the requirement for continuous enrollment in order to recoup your investment. The Airplane boldly raised both of these flags. To participate, a fee of $1,500 was required. Unless more people joined there was no way at all to make money. What if a pyramid structure could be designed in such a way that no one actually pays to join and enrollment of others is not required? Voila! The modern day MLM!

As some MLM spokesman have said to me on talk radio, "No one pays a penny to join. In fact, we do not make any money at all until someone "buys something from us." That is, there is no enrollment fee. Further, the person could buy the product for resale and make money on it. That is, there is no continuous enrollment required in order to recoup investments. This is not a pyramid scheme at all, it is said, but a new sales and distribution model in which person-to-person networking is utilized rather than mass advertising and retail stores.

Presenting itself as a radical new type of sales and distribution business, MLM has flourished and grown for more than 20 years since the court declared that Amway was not an illegal pyramid scheme.

Recently, the courts have begun to look a bit closer. Like Herman Melville's "Confidence Man" in the book by that name, the pyramid scheme can take on many disguises. For example, the purchase of a product can itself be an enrollment fee. And, while it is true that the product can be resold at a profit to a customer, the actual practice and policy of the company may be to continuously enroll re-sellers. The buying and reselling of products in this scenario is only an elaborate diversion. The real business is still enrollment of investors who make their money by enrolling investors below them. An ever expanding number must be found for the plan to continue. Functioning essentially in the same manner as the Airplane Game scheme, this MLM plan encounters exactly the same mathematical restrictions as the Airplane Game did. The result is that those at the bottom must lose. The free market of sales is converted to a confidence scheme. The only way to win in this scheme, as in the Airplane Game, is to enter early or to become a master manipulator and deceiver of those you enroll. There's a loser in this game. The trick is to not let it be you.

If mathematics assure eventual collapse, how could MLMs continue for 30 years or more as many, including Amway, have done? They can continue forever, as long as (1) the law allows them to and (2) new people keep joining. The Airplane Game itself could be operating today if the police had not arrested its leaders and if more losers could have been enrolled. Besides legality, the Airplane Game would also need to aggressively market its income potential, publicly showcase the wealth and success of those at the top, argue that anyone can be a winner if they can just get enough people in their downline, and further argue that those who do not succeed are just personal failures. Success with this marketing approach could assure that new people continue to enroll despite the fact that nearly everyone who did would eventually lose their investments.

And so it is that an MLM business that focuses upon continuously enrolling re-sellers - rather than actually selling product - can go on for years. Money is made exactly as in the Airplane Game by exponentially expanding enrollments. As the base reaches maximum size, it can keep operating by continuously enrolling replacements of the losers who are cycled in and out. Products move down the chain, often over-priced products the consuming public neither wants nor needs, but are acquired and resold by enrollees as a "fee" for joining and the means of maintaining a position on the pyramid structure.

A tiny elite sits at the pinnacles of those operations collecting on all the frantic activity below. As long as a steady flow of new recruits is brought in, legal protection is upheld and the masquerades of "distribution" and "sales" are maintained, their positions are secure and extraordinarily lucrative. Their riches and exorbitant lifestyles are flaunted to the new recruits to excite their envy, distract their intelligence and compromise their ethics.

Occasionally some new recruits are so talented and aggressive they do build a modest downline network below them. They are anomalies because mathematics require that the system can only support a small number of financial winners. If a thousand downliners are needed for a distributor to earn a respectable profit from this system, those thousand will need one million more to similarly support them and that one million will, accordingly, need one billion!

Currently, the law allows this type of organization to continuously recruit and to promise all who invest that the opportunity is always "unlimited."