Retail Sales Must Drive Multilevel Marketing Programs
The Ninth Circuit makes it painfully clear that commissions paid to distributors must be
directly tied to retail sales. The court stated: "The key to any anti-pyramiding rule ... where the basic structure serves to reward recruitment more than retailing, is that the rule must serve to tie recruitment bonuses to actual retail sales in some way." This appears a straightforward requirement, but the court threw several obstacles in the way of traditional methods of tying commissions to retail sales.
a. Products Purchased by a Distributor for Personal Consumption do not Qualify as a Retail Sale
The court stated that
sales to persons who are participants in the company's compensation program do not qualify as "retail sales" for purposes of satisfying the
Koscot test. This interpretation of the
Koscot test
5 precludes companies from paying commissions on products sold to distributors for personal consumption. This is contrary to the foundation of many MLM programs, where personal consumption by distributors is the driving force powering sales.
The court's reason for requiring that commissions be based on sales to non-distributors rests on its belief that mandatory minimum distributor purchases foist inventory on people who may not want the products or be able to sell them. Rather, the real reason for the purchase is simply to participate in the compensation plan. The facts of the Omnitrition case presented the court with compelling evidence that enrollments rather than sales were the driving force that supported the program. A key factor upon which the court focused was evidence that under the Omnitrition program, distributors were encouraged to buy large amounts of merchandise ($2,000.00 per month) and simply "give them away" in order to participate in Omnitrition's "proven plan of success." The message in this practice is that the product is irrelevant - all that matters is getting people enrolled. Once enrolled, new distributors will make their required purchases whether they can sell the merchandise or not. These mandatory sales drive the compensation plan. In the Ninth Circuit's view, companies operating under this scenario are promoting inventory loading. Although there is a sale of a legitimate product involved, the court will regard the product as nothing more than a facade to camouflage a pyramid scheme.
b. Inventory Loading - A New Standard?
Inventory loading is the principal evil which anti-pyramid laws seek to prevent. The danger presented by inventory loading is that companies may saddle distributors with large quantities of expensive inventory which they cannot resell or return for a refund. For the last 18 years, the multilevel marketing industry has operated under the F.T.C.'s definition of "inventory loading" which was handed down
In the Matter of Amway Corporation, Inc. In the
Amway decision, the F.T.C. defined "inventory loading" as a practice which "[requires] a person seeking to become a distributor to pay a large sum of money, ..., for the purchase of a large amount of nonreturnable inventory."
One of the key terms in the definition of "inventory loading" is the word "nonreturnable." Companies have traditionally avoided inventory loading by implementing inventory repurchase policies for distributors who elect to cancel their distributorship agreements. Inventory repurchase policies (sometimes called "buyback" policies) ensure that distributors can recover much or all of their inventory and sales aid expenditures if the business does not meet their expectations. Therefore, the financial risk associated with participating in a multilevel marketing program is minimal. However, the
Omnitrition court issued a new definition of "inventory loading" which completely changes the direction companies must take to avoid inventory loading. The Ninth Circuit's new definition provides:
'Inventory loading' occurs when distributors make the minimum required purchases to receive recruitment-based bonuses without reselling the products to consumers.
The court provided no basis for this definition. In fact, it omits all reference to the
Amway decision's definition of "inventory loading." Rather, the court placed this definition in a footnote, seemingly as an afterthought. However, the court's new definition has a dramatic impact on the MLM industry. First, it arguably removes an inventory repurchase policy as a defense to an inventory loading allegation. Secondly, it places in jeopardy those MLM programs that require distributors to produce minimum sales volumes to qualify for commissions. Unless the distributors resell the products, the company is engaged in inventory loading, even if the quantity of required purchases is small enough that it can easily be personally consumed by the distributor.
c. Commissions Must be Calculated Based on Actual Sales to Retail Customers
It is common for companies to calculate commissions to their distributors based on the volume of merchandise purchased by their downline organizations, whether at wholesale, suggested retail, or on a point basis. Companies can track these figures and calculate commissions with relative ease. The
Omnitrition court determined that such a practice does not sufficiently tie commissions to retail sales. The court stated that payment of compensation based on the volume of merchandise ordered by a distributor
is facially unrelated to the sale of product to ultimate users.
Prohibiting commissions from being calculated on purchases made by distributors creates enormous operational difficulties for companies. With the right software, tracking a distributor's purchases is a relatively simple process. On the other hand, few, if any, companies have the infrastructure allowing them to determine how much product has been sold to retail customers versus how much has been personally consumed by the distributor. Most companies simply rely on distributors' certifications that they have resold 70% of their prior order before ordering more merchandise.
d. Traditional Safeguards to Avoiding Pyramid Classification Are Not a Guaranteed Safety Net.
Most MLMs incorporate some form of the traditional "Amway safeguards" into their programs under the belief that these policies will protect them from operating as a pyramid. These safeguards are: 1) distributors must sell to ten retail customers each month; 2) distributors must resell 70% of the product they purchase every month; and 3) if a distributor elects to cancel his or her distributorship, the company will repurchase the distributor's remaining inventory at 90% of the cost paid by the distributor. Omnitrition incorporated these safeguards into its program, but the court nevertheless found that the mere existence of these safeguards did not deter inventory loading and promote retail sales to the degree necessary to insulate the company from operating as a pyramid.
Bookmarks