Aug 18, 2014

What is a pyramid scheme?

Excerpted from "Sometimes, life is like a box of cacao products," by Scotty Reifsnyder, The Washington Post, August 1, 2014.

In the controversy over multilevel marketing, the central question is whether the companies are fraudulent pyramid schemes. There is no federal law defining a pyramid scheme, and courts have interpreted the concept in various ways.

"A significant percentage of MLMs could be pyramid schemes," said Bill Keep, the dean of the School of Business at The College of New Jersey - and the man Wall Street turns to with questions on the matter. "We don't know how much."

Traditionally, pyramid schemes are organizations in which people pay some amount to join and then can profit by recruiting other people to buy into the organization. Bernard Madoff's infamous swindle exploited new investors to pay off earlier investors. Such schemes, which have no products to sell and depend on new recruits for revenue, are widely recognized by the courts as fraudulent.

Multilevel marketing organizations are relatively ambiguous because of an unusual characteristic many of them share: Most of their customers are salespeople who also buy products for themselves. Many dissatisfied former distributors have stories, like Martinez's, about gorging themselves on the companies' products.

The industry's defenders point to these customers as evidence that the companies are filling a demand in the market. In surveys commissioned by the trade association, more than half of distributors identify discounts on products as a reason they joined the ranks of multilevel marketers.

On the other hand, opponents of multilevel marketing contend that distributors buy inventory solely to establish and maintain their position in an organization, with the goal of making money. Bruce Craig, a retired assistant attorney general for Wisconsin who successfully prosecuted several multilevel networks, estimated that about 99 percent of recruits in major companies will take losses.

In any case, many distributors discover that the only way to find new buyers for products is to recruit new distributors. Whether these recruits want the products for themselves or are hoping to make money is generally not clear.

That fact makes it difficult to distinguish between a legitimate retailer that seeks to broaden its base of customers and a fraudulent pyramid scheme that relies on continual recruitment.

The trade association requires its members to offer distributors refunds on unsold inventory, arguing that refunds allow distributors to keep only the products that they want for themselves or can resell. "No pyramid scheme would ever be able to sustain such a policy," said Mariano, the association president.

Yet advocacy organizations say that even when refunds are available, the emotional pressure of multilevel marketing and the close relationships that develop among distributors can lead them to consume or throw away unwanted products rather than return them. "These companies have some sort of magical hold over people," said Wilkes, whose organization began collecting Latin Americans' complaints about Herbalife and other multilevel marketers after discussions with Ackman, the hedge-fund manager.

Joe Mariano, the President of the Direct Selling Association called it "extraordinarily elitist" to suggest that so many people could be so easily brainwashed. He also accused Ackman of manipulating investors and journalists, impugning Herbalife, and multilevel marketing generally, for his clients' financial gain.

"The real people that are direct sellers are somehow going to rely upon a Bill Ackman or a Washington Post reporter to represent them and protect their interest, and they can't?" Mariano said. "I find that, on their behalf, so offensive."

But without a clear standard for identifying pyramid schemes, critics argue, prosecuting even unambiguously fraudulent companies is difficult.

"Regulatory actions over the last 20 years have been insufficient to provide, I think, good consumer protection," Keep said.