[CASE
NO.1]
FTC
v. Five Star Auto Club, Inc., United States District Court for the Southern District
of New York.
'Prohibited
marketing scheme' means a pyramid sales scheme, Ponzi scheme, chain marketing scheme, or
other marketing plan or program in which a person participates under a condition that he
or she make a payment, directly or indirectly, to receive the right, license or
opportunity to derive income as a participant primarily from: (1) the recruitment of
additional recruits by the participant, program promoter or others; or (2) non-retail
sales made to or by such recruits.
'Retail
Sales' means sales of products, services, or Business Ventures by Defendants, their
successors, assigns, agents, servants, employees, and those persons in active concert or
participation with them to third-party end users. Retail Sales do not include sales made
by participants in a prohibited marketing scheme or multi-level marketing program to other
participants or recruits in that scheme or program or to such a participants' own
accounts.
--------------------------------------------------------------------------------
Notice,
the court says that if the income is primarily derived from selling products to downline
distributors (self-consumption) then it is a "Prohibited Marketing Scheme." This
is the same analysis tacitly adopted by the Ninth Circuit Court of Appeals in Webster and
by the Nevada Federal District Court in Equinox.
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[CASE
NO.2]
People
ex rel. Hatigan v. Dynasty System Corp., 471 N.E.2d 236 (Ill.App. 1984):
The
defendants also argue that the evidence fails to show that the benefits received by TDSC
distributors are primarily based upon the inducement of others to participate and are not
primarily contingent on the volume of goods sold to persons for purposes of resale to
consumers. We disagree.
The
evidence overwhelmingly demonstrates that the primary emphasis is on commissions earned by
building a down-line organization. Testimony established that TDSC was represented as a
consuming organization and not as a selling organization. Commissions are not dependent
upon retail sales to ultimate consumers, but are paid solely upon purchases made by
distributors in the participant's down-line organization.
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[CASE
NO.3]
State
v. Phase II Sysems, Inc., 440 N.Y.S.2d 454 (S.C.N.Y 1981):
Effectively,
then, sales of products to nonmembers or nonsalespersons is unnecessary since members or
salespersons can make money just by bringing into the organization new people willing to
become a salesperson.
There
is sufficient indication herein that defendants are participating in a scheme where the
emphasis is not on the sale of a product, but on recruiting new organizational rows to
boost existing members. (See Securities & Exch. Comm. v Turner Enterprises, 474 F2d
476.)
Pursuant
to section 359-fff of the General Business Law, such a scheme is illegal. An illegal
business transaction can be enjoined pursuant to subdivision 12 of section 63 of the
Executive Law.
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[CASE
NO.4]
FTC
v. Equinox, United States District Court, District of Nevada
Equinox,
in its recruitment and training seminars, emphasizes the promise of lucrative rewards for
recruiting others. Distributors are given unrealistic hypothetical examples that their
profits will increase geometrically if distributors focus on recruitment rather than
retail sales. Equinox's video presentations and certain materials provided by Equinox
contain disclaimers as to the amount of profits obtainable. These disclaimers, however,
are difficult to read, do not accurately indicate the actual amount of earnings that can
be expected and do not immunize Equinox's exaggerated claims of income. Removatron
International Corp. v. FTC, 884 F.2d 1489, 1497 (1st Cir. 1989)(disclaimers or
qualifications in any particular advertisement are not adequate to avoid liability for
deceptive advertising unless they are sufficiently prominent and unambiguous to change
apparent meaning of claims and to leave accurate impression). Additionally, Managers are
encouraged to sell the product they purchase to new recruits rather than to end users.
Rebates and bonuses, the primary compensation emphasized by Equinox, are facially
unrelated to sales to the ultimate user but are based on purchases made from Equinox by
the distributor and his downline. In short, distributors rewards are received by
purchasing product and recruiting others to do the same.
*
* *
Equinox
argues that its formal adoption of policies similar to Amway's was sufficient to prevent a
finding that it was a pyramid scheme as a matter of law.
In
Omnitrition, however, the Ninth Circuit held that the implementation of policies that
would prevent a program from being a pyramid scheme do not insulate the program unless the
polices are enforced and actually serve to deter inventory loading (making purchase quotas
solely to receive the bonuses and rebates without reselling the product to an end user)
and encourage retail sales. 79 F.3d at 783. The policies adopted by Equinox are not
adequately enforced and do not have the required effect. Often, distributors are not even
aware of Equinox's policies. Policies that are attached to representative agreements that
distributors are required to sign are removed before the distributor signs the agreement.
Distributors are also discouraged from reading the Equinox Manual which contain Equinox's
policies and only use the manual as a reference guide.
Equinox
requires distributors to certify that 70% of the previously purchased product has been
sold or consumed before allowing distributors to purchase more product. Equinox, however,
does not enforce this rule. Evidence presented at the hearing indicated that distributors
are allowed to make orders by phone directly from Equinox without any mention of
certification. When a distributor orders additional product, Equinox merely infers that
the distributor is certifying that 70% previous product purchased had been sold. Evidence
also indicted that Equinox, despite its written policies to the contrary, allowed and/or
encouraged distributors to falsify or forge at least some of the written certifications
that were made. Because Equinox's 70% Rule is not effectively enforced, it does not
actually serve to prevent inventory loading.
Additionally,
distributors can satisfy the 70% Rule by consuming the product themselves or by selling
the product to their own downline.
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[CASE
NO.5]
Schrader
v. State, 517 A.2d 1139 (Md. App. 1986).
The
General Assembly enacted Article 27, § 233D by Chapter 507 of the Acts of 1984, which
took effect on July 1, 1984. Section 233D(a)(4) defines a "pyramid promotional
scheme" as
'any
plan or operation by which a participant gives consideration for the opportunity to
receive compensation to be derived primarily from any person's introduction of other
persons into participation in the plan or operation rather than from the sale of goods,
services, or other intangible property by the participant or other persons introduced into
the plan or operation.'
Subsection
(b) states that "[ a] person may not establish, operate, advertise, or promote a
pyramid promotional scheme." Violation of that prohibition renders a person guilty of
a misdemeanor punishable by fine and/or imprisonment. Article 27, § 233D(c).
Pyramiding
is a type of multi-level marketing operation which theoretically serves as a method of
distributing a company's products to the public. Annot., 54 A.L.R.3d 217, 219 (1973).
Participants in the operation are spread out over various distribution levels through
which products are resold until they reach the consumer. Id. However, because "one
profits merely by being a link in the product distribution chain, the emphasis is on
recruiting more investor-distributors rather than on retailing products." Note,
Pyramid Schemes: Dare to be Regulated, 61 Georgetown L.J. 1257, 1259 (1973).
A
participant's recruitment of others into the pyramid operation results in creation of that
participant's "downline," consisting of those persons recruited by the
participant himself and by the participant's recruits. The downline is created by
recruiting a preestablished number of individuals into the first level of the operation,
each of whom then recruits an equal number of additional persons. The original participant
moves up to the next level of the operation each time the bottom level of recruits in his
downline is completed, with the process ideally continuing until the original
participant's downline reaches a maximum figure determined by the number of levels in the
pyramid. A participant may earn commissions from the sale of products to the distributors
within his downline, but commissions are also received from entry fees paid by new
recruits into one's downline.
The
type of pyramid operation with which § 233D is concerned is one in which a participant's
compensation is "derived primarily" from the participant's recruitment of others
into the operation rather than from the sale of goods or services. With that consideration
in mind, we now review the evidence in this case.
On
February 4, 1985, the Montgomery County Police Department received a complaint concerning
C.I. Systems ("CIS"), which was owned and operated by the appellant. Initiating
an investigation into the company, Montgomery County Vice and Intelligence Officer John
Sheridan called a telephone number obtained from a CIS flyer and heard a recorded message
to the effect that "C.I. Systems would act as a consultant for a person that became
involved. One could earn $ 300 to $ 700 a month in approximately three months. This amount
could double every six to nine months." The recording further advised that "[n]o
selling was involved, and four to six hours per week is all that it would be necessary to
work." Two additional telephone numbers, one in Virginia and the other in Maryland,
were then provided. Officer Sheridan called the Maryland number and heard another
recording, this one giving directions to CIS meetings at an office located in Bethesda,
Maryland and requesting that callers leave their names and the date of the meeting they
would attend. Officer Sheridan gave an undercover name and stated that he would attend the
meeting on February 6, 1985.
On
February 6, Officer Sheridan attended a meeting at the address indicated in the second
recorded message. Conducting the meeting was one Robert Schaffer, who identified himself
as a member of CIS's board of directors. n1 Mr. Schaffer informed those gathered at the
meeting that an initial payment of $ 45 could result in earnings of $ 300 to $ 700 a month
within 3-6 months and of $ 2,000 a month within 6-12 months, without any selling required.
He also advised that Erik Schrader was the founder and head of CIS.
Eight
days later, on February 14, 1985, Officer Sheridan attended a second meeting at the same
location. The meeting was again conducted by Robert Schaffer, who this time explained the
various recruiting methods used by CIS. Among the methods discussed were flyers, tear-off
slips, advertisements in newspapers and magazines, and the wearing of buttons to prompt
inquiries from others. Mr. Schaffer stated that a $ 65 fee was required to join CIS, at
which time flyers could be purchased at a special initial rate of $ 25 per 1,000. He then
explained in further detail the overall nature of the operation, which involved the
recruitment of others into the enterprise at different "levels." n2 According to
Officer Sheridan's testimony at the appellant's trial, recruitment was emphasized as the
focus of the operation; selling and the product line were incidental. To the extent
products were involved, participants in the programs were generally buyers rather than
sellers. n3
* *
*
As
defined in § 233D(a)(4), a pyramid promotional scheme is an operation in which a
participant's compensation is "to be derived primarily from" recruitment of
other participants into the operation rather than from the sale of goods or services. The
word at issue in the statute is "primarily." The Court of Appeals in Bowers
explained that "[a] statute is not vague when the meaning of the words in controversy
can be fairly ascertained by reference to judicial determinations, the common law,
dictionaries, treatises or even the words themselves, if they possess a common and
generally accepted meaning." Id. at 125, 389 A.2d 341. We believe the word
"primarily," as used in § 233D(a)(4), possesses a common and generally accepted
meaning. Webster's New World Dictionary (2d College ed. 1982) defines
"primarily" as "mainly; principally. In quantifiable terms,
"primarily" is commonly understood to suggest a figure representing more than 50
percent. Thus, the definition of "pyramid promotional scheme" in § 233D(a)(4)
imposes a standard requiring that participants in a pyramid operation derive more than 50
percent of their compensation from recruitment for the operation to fall within the
definition. We find nothing ambiguous about the term "primarily" as used in that
definition.
An
Illinois anti-pyramid statute using the word "primarily" survived a similar
attack based on vagueness grounds. The Illinois statute defined a "pyramid sales
scheme" to include
any
plan or operation whereby a person in exchange for money or other thing of value acquires
the opportunity to receive a benefit or thing of value, which is primarily based upon the
inducement of additional persons, by himself or others, regardless of number, to
participate in the same plan or operation and is not primarily contingent on the volume or
quantity of goods, services, or other property sold or distributed or to be sold or
distributed to persons for purposes of resale to consumers.
Ill.Rev.Stat.
(1983), Ch. 121 1/2, Par. 261(g) (emphasis added). In People ex rel. Hartigan v. Dynasty
System Corp., 128 Ill.App.3d 874, 83 Ill.Dec. 937, 471 N.E.2d 236 (1984), that statute was
challenged as void for vagueness on grounds that "the word 'primarily' does not
inform a person of reasonable intelligence of what conduct is prohibited by the Act."
Id. 83 Ill.Dec. at 942, 471 N.E.2d at 241. Rejecting that argument, the Illinois court
reasoned that "'[p]rimarily' means 'pre-eminently' or 'fundamentally'" and that
the term "is certainly less broad than other terms contained in the Act which have
withstood void for vagueness challenges." Id. The Court held that "the term
'primarily' provides fair notice to those who are subject to the act of the schemes and
ventures which are prohibited." Id. 83 Ill.Dec. at 943, 471 N.E.2d at 242.
In
1983, the Utah legislature, apparently in an effort to cure potential vagueness problems
in that state's 1973 anti-pyramid law, added the word "primarily" to the
definition of a pyramid scheme. Utah Code (1953, 1983 Supp.), § 76-6a-2(4).
.
. . [T]he Act attempts to cure potential problems of constitutional vagueness by defining
a pyramid scheme as "any sales device or plan" in which a person provides
consideration "for compensation or the right to receive compensation which is derived
primarily from the introduction of other persons into the sales device or plan rather than
from the sale of goods, services or other property." Thus, even if a multilevel plan
involves a product that profitably may be sold to the consumer, it is still an illegal
pyramid if the promised profits are derived primarily from recruitment. That definition
does not appear to be unconstitutionally vague because it distinguishes more clearly than
the 1973 law between genuine multilevel marketing plans and pyramid schemes by requiring
that compensation be derived primarily from introduction of others into the scheme, rather
than including organizations that pay any compensation derived from introduction of others
into the scheme.
Utah
Legislative Survey, 1984 Utah L.Rev. 115, 215-16 (footnotes omitted) (emphasis in
original).
The
word "primarily," as used in the definition of "pyramid promotional
scheme" in § 233D(a)(4), has a sufficiently definite meaning to afford a person of
ordinary intelligence and experience a reasonable opportunity to know what is prohibited
by the statute. We therefore hold that § 233D provides adequate notice of the type of
pyramid operations which are prohibited.
* *
*
We
believe the evidence was sufficient. The boxes of documentary evidence seized from the CIS
offices in Maryland and Virginia demonstrate that the business was essentially nothing
more than a recruitment scheme. The testimony of both Officer Sheridan and Mr. Retta
indicated that participants were told they did not have to concern themselves with selling
anything; rather, they could earn money by recruiting others into the operation. In the
opinion of the State's expert witness, the appellant's operation was one primarily for
recruiting people into the pyramid and not for selling products. According to the expert,
the individual programs promoted by CIS, even if separate business entities, were used by
CIS "to facilitate the down liner system or programs." We conclude that there
was ample evidence to support the finding of the trial judge that the appellant was guilty
of conspiring to violate Article 27, § 233D.
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[CASE
NO.6]
State
ex. rel. Webster v. Membership Marketing, 766 S.W.2d 654 (Mo.App. 1989):
It
is irrelevant to the disposition of this case to determine whether, as respondents argue,
the Amway exemption should apply not only to tangible goods such as cosmetics, but also to
a service which 5-Star purports to furnish. The prospect sales representatives have to
receive pecuniary benefits from MMI is not dependent on the resale of the membership the
representative has bought but upon his ability to induce others to join the plan and
recruit added sales representatives. The quoted exemption in the statute is not applicable
here irrespective of the fact that respondents purport to offer a service in place of
tangible goods.
Returning
to the definition of a pyramid scheme as set out in the statute, the foremost attribute of
such an activity is the concept that by joining the venture, the participant has an
opportunity to realize a pecuniary benefit, not from the sale of goods or services, but
based on his ability to induce others to join the enterprise. The prospective return from
participation under such a concept realistically declines in an inverse ratio as the
number of participants increases because the possibility of recruiting new participants
eventually is exhausted. A position at the apex of the pyramid offers the greater
opportunity for gain. Those entering the venture last usually have little or no genuine
opportunity for benefits from the addition of new participants.
In
the present case, certain aspects of the 5-Star Plus venture meet the definition of a
pyramid scheme and some do not. This is attributable to the options of participants to be
5-Star Plus members or sales representatives or both. Certainly from the standpoint of
MMI, the primary objective and source of profit lie in the sale of 5-Star Plus memberships
and if a sales representative engages only in that activity without attempting to recruit
new sales representatives, there is no basis to charge a violation of the pyramid scheme
law. As was noted earlier, attainment of the highest level of membership sales and
commission benefits is not dependent on enlistment of subordinate sales representatives. A
salesman could reach that level of compensation if he sold 29,520 memberships, even though
none of those persons agreed to become a sales representative.
The
aspect of the activity which does subject respondents to the prohibition of the statute is
the device of the "downline matrix" which offers participants the opportunity to
earn commissions and free automobiles in return for recruitment of successive levels of
salesmen. The statute condemns a scheme wherein the opportunity to receive a pecuniary
benefit is based upon the inducement of other persons to participate in the same plan. The
downline matrix concept is precisely that, a plan whereby the person initiating the matrix
stands at the apex of the pyramid and earns the right to commissions, not on the basis of
his own sales of 5-Star Plus memberships, but on the proliferating recruitment in groups
of three of sales representatives in declining order to the base of the pyramid.
Respondents
offer several arguments to demonstrate that the sales arrangements for 5-Star Plus do not
constitute a pyramid scheme. They first point out that the element of consideration paid
by a participant must be shown before the statute becomes applicable. In the 5-Star Plus
concept, a sales representative may enter the matrix and be eligible to earn commissions
without buying a membership and, according to respondents, this precludes a finding that
this essential element was proved.
A
consideration may consist of some right, interest, profit or benefit accruing to one
party, or some forbearance, loss or responsibility given, suffered or undertaken by the
other. Charles F. Curry and Co. v. Hedrick, 378 S.W.2d 522, 533 (Mo. 1964). A
consideration within the contemplation of § 407.400(5) therefore is not limited to a
payment of money, nor is the term "paid" used in the statute.
According
to respondent MMI's statement of its practices, a sales representative for 5-Star Plus
memberships enters into a contract with MMI wherein the representative agrees to abide by
the marketing policies of MMI and, in turn, acquires the right to be paid commissions and
bonuses for membership sales. The consideration sufficient to meet the condition of §
407.400(5) is the responsibility to MMI which the sales representative assumes by his
agreement and the concurrent benefit of commissions to be earned. The fact that a sales
representative may or may not also become a 5-Star Plus member by payment of dues is
irrelevant to the question of consideration.
Respondents
also argue that they should be judged based on the Amway exemption because commissions to
sales representatives are based on the quantity of memberships sold. They also say they
should not be subject to the prohibition of the pyramid law merely because the product
they offer is a service rather than soap, cosmetics or food supplements. This argument
cannot overcome the fact that under the matrix scheme, assuming sales representatives are
engaged in selling memberships and recruiting new sales representatives, there is no
resale of the product outside the matrix. The sales representative acquires nothing for
resale to an ultimate consumer because the plan depends on that consumer becoming a
salesperson himself and, in turn, persuading others to join and participate in the same
way. The Amway exemption simply does not apply.
Respondents
also undertake to demonstrate that a membership in 5-Star Plus has a value in that members
have the opportunity to purchase goods and services at substantial discounts. The argument
is presumably intended to dispel any suggestion that purchasers of memberships are being
victimized. The value of a 5-Star Plus membership is not an aspect of this case or of
appellant's charge. Respondents have not been accused of an unlawful merchandising
practice under § 407.020, only with operating a pyramid sales scheme. Whether
respondents' product has value or is worthless is irrelevant to the issues in this
case."
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[CASE
NO.7]
Webster
v. Omnitrition, United States Court of Appeals, Ninth Circuit:
On
its face, Omnitrition's program appears to be a pyramid scheme. Omnitrition cannot save
itself simply by pointing to the fact that it makes some retail sales. See In re
Ger-Ro-Mar, Inc., 84 F.T.C. 95, 148-49 (1974) (that some retail sales occur does not
mitigate the unlawful nature of pyramid schemes), rev'd on other grounds, 518 F.2d 33 (2d
Cir. 1975). The promise of lucrative rewards for recruiting others tends to induce
participants to focus on the recruitment side of the business at the expense of their
retail marketing efforts, making it unlikely that meaningful opportunities for retail
sales will occur. Koscot, 86 F.T.C. at 1181. The danger of such "recruitment
focus" is present in Omnitrition's program. For example, Webster testified that
Omnitrition encouraged him to "get to supervisor as quick as [he] could." Ligon
states:
"The
product sales are driven by enrolling people. In other words, the people buy exorbitant
amounts of products that normally would not be sold in an average market by virtue of the
fact that they enroll, get caught up in the process, in the enthusiasm, the words of
people like Charlie Ragus, president, by buying exorbitant amounts of products, giving
products away and getting involved in their proven plan of success, their marketing plan.
It has nothing to do with the normal supply and demand in this world. It has to do with
getting people enrolled, enrolling people, getting them on the bandwagon and getting them
to sell product.
* *
*
To
rebut the pyramid allegations, Omnitrition relies heavily on In re Amway Corp., 93 F.T.C.
618 (1979), in which the FTC found Amway was not a pyramid scheme because its policies
prevented inventory loading and encouraged retail sales. Id. at 715-16. Omnitrition argues
that its formal adoption of [*783] policies similar to Amway's was sufficient to support
summary judgment. We disagree.
The
policies adopted by Amway were as follows: (1) participants were required to buy back from
any person they recruited any saleable, unsold inventory upon the recruit's leaving Amway,
(2) every participant was required to sell at wholesale or retail at least 70% of the
products bought in a given month in order to receive a bonus for that month, and (3) in
order to receive a bonus in a month, each participant was required to submit proof of
retail sales made to ten different consumers. Id. at 716.
* *
*
Omnitrition
has distribution rules modeled on Amway's. However, the existence and enforcement of rules
like Amway's is only the first step in the pyramid scheme inquiry. Where, as here, a
distribution program appears to meet the Koscot definition of a pyramid scheme, there must
be evidence that the program's safeguards are enforced and actually serve to deter
inventory loading and encourage retail sales. In Amway, the ALJ made that crucial finding
of fact, after a full trial. See id. at 631. Our review of the record does not reveal
sufficient evidence to establish as a matter of law that Omnitrition's rules actually
work.
Further,
Omnitrition's rules, while carefully crafted to appear like those in Amway, are weaker in
operation. The key to any anti-pyramiding rule in a program like Omnitrition's, 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. Only in this way can
the second Koscot factor be defeated. Omnitrition has failed to prove that as a matter of
law its rules operate in that manner.
First,
Omnitrition produced evidence of enforcement only for its ten customer rule. Even assuming
that Omnitrition's enforcement measures are effective, it is not clear that these measures
serve to tie the amount of "Royalty Overrides" to retail sales. The overrides
are paid based on purchases by supervisors. In order to be a supervisor, one must purchase
several thousand dollars worth of product each month. That some amount of product was sold
by each supervisor to only ten consumers each month does not insure that overrides are
being paid as a result of actual retail sales.
Second,
Omnitrition produced no evidence of enforcement of its 70% rule. It merely states that, in
order to place further orders IMAs must "certify" that they have sold 70% of the
product they previously ordered. There is no evidence that this "certification"
requirement actually serves to deter inventory loading. Importantly, the requirement can
be satisfied by non-retail sales to a supervisor's own downline IMAs. This makes it less
likely that the rule will effectively tie royalty overrides to sales to ultimate users, as
Koscot requires.
In
addition, plaintiffs have produced evidence that the 70% rule can be satisfied by a
distributor's personal use of the products. If Koscot is to have any teeth, such a sale
cannot satisfy the requirement that sales be to "ultimate users" of a product.
Third,
Omnitrition has not shown that it enforces its buy-back rule, or the extent to which
Omnitrition has actually repurchased product from disappointed IMAs. In addition, by
Omnitrition's own terms, the rule is weaker than Amway's in two particulars: (1)
Omnitrition only refunds 90% of the price of the product and (2) Omnitrition will only
repurchase consumable products (the majority of what it sells) if they are less than three
months old. The latter fact is very significant. The buy-back rule is only effective if it
can reduce or eliminate the possibility of inventory loading by insuring that program
participants do not find themselves <b>saddled with thousands of dollars worth of
unsaleable products. Omnitrition's rule potentially would not achieve this goal for any
person who participated in the program for more than three months."