What Exactly Is a ‘Pyramid Scheme’?

Given the princely sums currently being wagered by the likes of Bill Ackman, Carl Icahn and George Soros on the ultimate fate of Herbalife, I thought you would like to know the critical difference between a legitimate multi-level marketing program (MLM) and an illegal pyramid scheme.

In both MLMs and pyramid schemes, the business promoters recruit independent contractors to purchase products (or services) from them at wholesale prices and then on-sell them either at a mark-up to retail customers or at wholesale to other distributors that they themselves recruit.  The new distributors then repeat the process to their “downline” recruits and so on.  All of the distributors earn the mark-ups on their retail sales and are awarded bonuses by the business promoters for their downline sales (known as “upline rewards”).  All of the sales are one-on-one and no retail stores are involved in the distribution chain.

To find out how MLMs differ from pyramid schemes, the person to ask is Professor William Keep of the College of New Jersey whose 2002 paper on MLM — Marketing Fraud: An Approach for Differentiating Multilevel Marketing from Pyramid Schemes – is considered the seminal tract on the subject.  Professor Keep has reportedly been consulted by both Ackman and Soros in connection with their Herbalife investments.

Professor Keep’s analysis focuses on the reward system of the company’s distribution chain.  If each downline distributor is more incentivized to recruit new distributors than to consummate retail sales outside the distribution network, the arrangement is considered a marketing fraud.  In other words, a pyramid scheme promotes a putative retail sales program that is effectively a sham.

In a landmark case called FTC v. Koscot (1975), the Federal Trade Commission defined a pyramid scheme as an arrangement in which participants pay money in return for which they receive (1) the right to sell a product and (2) the right to receive rewards in return for recruiting other participants into the program that are unrelated to the sale of the product to ultimate users outside the organization.

While both MLMs and pyramid schemes involve distributors as consumers, recruiters and retailers, distributors in pyramid schemes are primarily recruiters who focus considerably less on personal consumption and retailing.  Some schemes do not even require the completion of a consumer sale before paying a reward for recruitment.

In other words, pyramid schemes are not designed to build viable retail organizations.  Their compensation structures are just mechanisms for transferring funds from new recruits to distributors higher up in the organization.  As the pyramids grow larger and larger, new recruits will eventually dry up and those in the lower rungs — the vast majority of distributors — will not recoup their investments.  That is why such schemes are considered marketing frauds.

Conversely, in FTC v. Amway (1979), Amway succeeded in defending its status as an MLM rather than a pyramid scheme because it required distributors (1) to wholesale or retail at least 70% of the company’s cleaning supplies and other household products that it purchased each month (rather than forcing them to load up on non-returnable inventory), (2) to sell their inventory to at least ten different retail customers each month and (3) to buy back any unused and marketable products from their recruits upon request.  These three policies prevented distributors from buying or forcing others to buy unneeded inventory just to earn bonuses and underscored the fact that Amway’s business model was ultimately to move its products through a retail network.

The acid test for MLM is the extent to which participant earnings in the distribution chain are either upline rewards granted for the recruitment of new distributors or mark-ups on retail sales to customers outside the company’s network.  If distributors derive their earnings primarily from recruitment bonuses rather than from retail sales, the organization is deemed a pyramid scheme.