Multilevel franchise or pyramid scheme?

MULTILEVEL FRANCHISE OR PYRAMID SCHEME?

Multilevel franchises have a special appeal for many small business investors because of the low initial investments required and the promise of business autonomy. These same individuals are highly vulnerable to the pitches of pyramid promoters

Pyramid sales schemes similar to those that experienced tremendous growth during the late 1960s and early 1970s are reappearing. In Utah, which is sometimes regarded as an incubator of pyramid schemes and other forms of consumer and security fraud, at least 210 such companies were formed during the first six months of 1981. Utah corporations alone have defrauded investors around the country of as much as $80 million.

Not all multilevel distribution plans are illegal, of course. Amway Corporation, Mary Kay Cosmetics, and other quite legitimate operations are experiencing growth while operating within the vast network of state and federal regulations. Multilevel franchises have become big businesses which may eventually displace department and discount stores as the primary mode of mass merchandising.

The problem faced by small business investors, whether promoters or participants, is distinguishing between such legal multilevel franchises and illegal pyramid schemes. Numerous court and commission rulings on pyramid schemes cut across a variety of regulatory theories. Since no central theory of regulation nor one comprehensive summary of the various theories exists, the small business investor has little guidance to evaluate a multilevel franchise's marketing plan.

In this article, the significant features of multilevel franchises and pyramid schemes are outlined and contrasted. In addition, implications of major regulatory theories for actual practice are presented. Finally, criteria are suggested for small business investors to use when screening promotional marketing plans.

MULTILEVEL FRANCHISE

VERSUS PYRAMID SCHEME

Nearly every manufacturing firm uses a system of middlemen to distribute its products. Various wholesalers add value to the product by breaking bulk and facilitating distribution. A pyramid shape emerges, with the manufacturer at the apex, supported by an ever-widening group of wholesalers and retailers, based upon a foundation of consumers.

A common method of retailing is direct, or door-to-door, sales. The strategy is to go directly to the customer to create demand for the product rather than allowing the customer to be exposed to competing products at a retail store. The key to success is a large number of sales people. Since salaries are paid on straight commission, the sales force's efforts are a variable cost to management. The company achieves flexibility to hire as many sales people as possible, and theoretically, each person's effort is the only constraint on his or her income. Because of the need for managerial personnel to supervise and hire sales people, multiple organizational levels are created.

Multilevel franchises combine both traditional distribution and direct selling techniques. Consequences stem from promotional marketing plans which allow distributors to enlist other participants to sell the product. Typically, the product travels through the chain of distribution at a wholesale cost to the lower level distributors, who sell it at a retail price to the consumer. Intermediate distributors profit not only by their retail sales, but also through a series of bonuses or override commissions from the sales volume of their underlings. As a distributor acquires more downline sales people, he ascends within the distribution system and his bonus increases. Most multilevel franchises have three or four levels.

Pyramid schemes likewise involve three or four levels through which products are channeled to the ultimate consumer. A participant can normally enter at any level. He or she is required to purchase a predetermined amount of the company's product at a percentage of its retail cost. The higher levels of the distribution resell their products to the next level below at a percentage of cost, and so on. One or two lower levels of the pyramid sell their goods to consumers at the full retail price. The top levels are entitled to earn fees by recruiting others into the distribution plan. A higher level participant is entitled to a fee when a lower level participant is elevated. Often, however, a salesperson will not be elevated at all unless he or she finds a replacement to fill the position to be vacated.

Neither the mere existence of a large direct sales force nor a market system that forms a pyramid shape are indicators of an illegal distribution system. Whereas a multilevel franchise system focuses on the sale of products, a pyramid scheme sells distributorships as well. The essential element of a pyramid scheme is an intensive program to recruit new members for a commission, rather than the sale of products to ultimate consumers.

Pyramid schemes are attacked with numerous regulatory theories. However, most commission and court rulings are lengthy and technical. Isolating key business activities from the litigation facilitates understanding of the legal issues.

Skill or Expertise

Often state courts approach pyramid schemes as lotteries. By definition, a lottery is any scheme where one pays something of value to another in order to receive a return based upon some formula of chance. Its basic elements are: (1) an element of lot or chance; (2) a price; (3) a payment of consideration. With pyramid schemes, the element of chance is present because the financial gain is not within the control of the participant. The prize is the financial gain from recruiting others, and the consideration is the participant's investment.

The participant must supply some skill or expertise in the franchise rather than relying purely on mathematical probabilities for success. Otherwise, the operation will be treated as illegal gambling, which voids all contracts directly associated with the marketing plan.

Managerial Control

The primary purpose of securities regulation is to eliminate serious abuses in largely unregulated capital markets. These statutes focus on the sale of securities to raise capital for profit-making purposes, the trading of securities on exchanges, and the need for regulation to prevent fraud and protect the interest of investors.

A security's existence depends upon the degree of managerial control, and the performance of company-related duties. "(I)n the (Security and Exchange) Commission's view a security is offered or sold where the franchisee is not required to make significant efforts in the operation of the franchise in order to obtain the promised return."

The test for managerial control is whether the efforts made by the investor are undeniably those managerial efforts that affect the business enterprise's failure or success. Investing money for franchise rights, persuading prospects to attend meetings, or spending to create an illusion of affluence does not exert enough entrepreneurial effort. The acts of consummating the sale must be more than ministerial, or a mere investment contract exists.

An investment contract can be identified by three elements: (1) an investment of money for the original purchase of the "franchise;" (2) a common enterprise, as "evidenced by the fact that the fortunes of all investors are inextricably tied to the efficacy of meetings and guidelines on recruiting prospects and consummating sales;" and (3) a dependency on the efforts of others in the opportunity meetings. In contrast, a traditional franchise is one where the promoters exercise remote controls and the investors operate independently.

Although few franchises or multilevel marketing plans fall within the purview of the Securities and Exchange Commission, SEC rulings are of major significance for the ones that do. The agreement must be registered in accordance with the Securities Act of 1933 unless exemption is available, and any person who participates in the distribution of the franchise agreement may be required to register under the Securities Exchange Act of 1934. In addition, participants who engage in deceptive practices in connection with the offering or selling of a pyramid scheme violate the antifraud provisions of both acts.

Price Fixing

Both state and federal courts conclude that certain aspects of pyramid schemes restrain trade and violate antitrust regulations. Not only are explicit pricing agreements illegal per se, but implicit agreements or "Rules of Conduct" with a direct and substantial affect on retail prices are also in violation.

The Federal Trade Commission (FTC) allows a "cross-group selling rule," where a distributor can buy products only from his sponsor. A "retail store rule," where a distributor cannot market through retail outlets, is also permitted so long as no direct resale price maintenance exists.

The FTC is also charged with preserving free trade, fair competition, and consumer rights in the marketplace. The FTC Act declares unlawful any "unfair methods of competition in commerce and unfair or deceptive acts in commerce." The relevant standard under this section is the capacity to deceive rather than the proof of actual deception.

Initiation Fees

Initiation fees, membership fees, or large initial inventory requirements make a marketing plan suspect. Any initial sales or promotion materials should be sold at or near cost, with any unused units refundable upon leaving the business. The sponsoring distributor should receive nothing from the mere act of recruiting, and begin earning money only when the new recruit actually begins to purchase products.

Inventory Loading

Inventory loading is the accumulation of products by intermediate participants that creates internal sales and generates bonuses without actual sales to consumers. When this situation occurs, whether voluntarily or involuntarily, the participant often is burdened with more inventory than can be sold or financed.

A "buy-back rule" which requires the sponsoring distributor to repurchase any inventory from his personally sponsored distributors reduces sponsor pressure. Also, a "70 percent rule"--which requires that a distributor must sell as retail or wholesale 70 percent of his or her monthly purchases to receive a performance bonus--discourages internal sales. Finally, a "ten-customer rule," which requires that a sponsoring distributor make at least one sale to at least ten different customers each month, insures that retailing is an essential duty of the distributor.

Advertising and Representation

Advertising rules may be restrictive so long as they do not foreclose distributors from advertising prices. Rules prohibiting producing or procuring literature from anyone other than the company, advertising by mass media without permission, or using the logo unrestrictedly on wholesale offices, automobiles, checks, and in telephone directories may be reasonable to protect trademarks and servicemarks.

Representations of distributors' earnings, recruiting potential, expenses, or turnover among recruited distributors must be realistic. Non-earnings claims such as "opportunity," "possibility," or "chance" are considered primarily inspirational or motivational. However, claims containing specific dollar incomes that distributors are unlikely to earn create unrealistic impressions despite prominent disclaimers. To comply, the company must conspicuously disclose the percentages of all distributors who actually achieved stated sales, profits, or earnings when such claims are made.

GUIDELINES

Full financial disclosure is a must for any investment. With multilevel distribution systems, however, full marketing disclosure is also a necessity. Since the law is multifaceted and complex, the small business investor should also seek further information: as promoters, small business persons should consult an attorney when preparing marketing plans; as prospective participants, they should investigate the reliability of the firm with existing participants, former participants, and independent agencies. The guidelines that follow can also help the small business investor to assess the legitimacy of a multilevel marketing plan.

* Sales methods must be based on skill or expertise.

* Participants must maintain managerial control over the essential conduct of the enterprise, and no compensation of any kind may be earned from the mere recruiting of others into the system.

* Resale price maintenance agreements at either the wholesale or retail level, or any action to enforce suggested prices or to prevent advertising of retail prices is prohibited.

* No initiation fees, charges, memberships, or large initial inventories may be required.

* To discourage inventory loading and encourage retailing to ultimate consumers, "buy-back," "70 percent," and "ten-customer" rules are necessary.

* Advertising rules can be restrictive except for prices. Specific dollar representations of sales, profits, or earnings must include the category's average or the percent of individuals who achieved the indicated level of success.

CONCLUSION

Multilevel franchises are very attractive to small business investors because of their availability, minimal capital requirements, and flexibility. Small business investors are also drawn to such operations because of the independence they afford.

Various commissions and courts regulate franchise operations, but these rulings are diverse and technical and provide little practical direction for the prospective small business investor. Inconsistent legislation and enforcement aggravate the problem. With no accessible criteria, it is difficult to distinguish between legal multilevel franchises and illegal pyramid schemes. The legal interpretations, regulations, and guidelines presented in this article should help small business investors to recognize legitimate prospects and steer away from illegal schemes.