Direct sales companies should prepare for a new wave of regulatory actions
By: Brent Kugler, Guest Contributor
Companies should take the time to consider if their plans hit the guardrails laid out by the most recent statements and actions of regulators.
Like it or not, the legal requirements for multi-level-marketing (MLM) compensation structures have changed in recent years. Many existing comp plans used by direct selling companies for years may now, if challenged, be considered non-compliant by the Federal Trade Commission (FTC). Indeed, comp plans considered to be compliant as recently as two years ago may today run afoul of the FTC’s latest criteria for evaluating compensation structures.
In 2020, the FTC shifted its attention to COVID-19-related claims and issues. As the pandemic finally begins to recede and the agency returns to its previous focus, companies should be prepared for a new wave of regulatory enforcement actions at the federal and state level.
In the last quarter of 2019, the FTC filed two highly publicized enforcement actions against AdvoCare and Neora. These actions followed public statements by the FTC promising further aggressive enforcement activity against what it considers to be non-compliant direct selling practices. The FTC enforcement actions against these companies also signaled an increase in FTC scrutiny of MLM compensation structures.
In regard to this, the FTC announced new criteria for determining what is and is not a legally compliant MLM compensation plan. Speaking to a DSA audience in Fall 2018, the FTC’s Andrew Smith said the agency asks two preliminary questions when evaluating a MLM compensation plan: (i) does a compensation plan overly incentivize recruitment rather than product sales; and (ii) does the compensation plan create incentives for distributors to purchase more products than they actually need?
Further, Smith and others at the FTC have identified certain characteristics of MLM compensation structures that the FTC believes to be indicative of an illegal MLM compensation plan, including “threshold-based rewards” (rewards that begin or increase exponentially at specific thresholds); “convex rewards” (rewards where greater levels of expenditure by a program participant earn greater rewards); and “duplication-based rewards” (rewards that are available or increase only for participants with larger downlines).
In addition to the direct statements from FTC leadership, the FTC has relied on economic and academic reports to bolster its case. Publication of the research paper “The Alchemy of a Pyramid” in December 2019 provided further insight into the FTC’s views on MLM compensation structures. Co-authored by two FTC economists, “The Alchemy of a Pyramid” identifies an emphasis on recruiting other participants as a critical component in evaluating the legality of an MLM compensation plan. The paper suggests that an MLM compensation structure that requires, rewards or incentivizes recruitment of other participants is indicative of an illegal pyramid scheme.
While the FTC’s new criteria for defining what is and is not a compliant MLM compensation structure plan is seemingly at odds with established legal case precedent, and even the FTC’s 2018 Guidance to the MLM industry, the current regulatory climate means increased risk. This is especially so for established companies that continue to utilize antiquated compensation plan structures and concepts as well as startup companies that make the mistake of adopting an outdated compensation model.
Direct selling companies must therefore ensure that their compensation plans are able to withstand scrutiny under the FTC’s new criteria. This means removing any rewards or incentives that are tied to recruiting and ensuring that the compensation plan emphasizes rewards to participants based upon sales of products and services to non-participant customers.
As noted above, the FTC views any emphasis on recruiting in a company’s compensation plan to be indicative of an illegal pyramid scheme. In its complaint against AdvoCare, the FTC was critical of a “Rookie Bonus” implemented by AdvoCare, which rewarded distributors who recruited at least three new distributors and generated sales volume from the new recruits. The agency alleged that the Rookie Bonus was improper because it emphasized recruiting rather than retailing product.
This allegation is noteworthy because many companies have “fast-start” bonuses or similar programs that incentivize new participants to enroll new recruits. Though untested in court, it serves as a reminder that companies that offer rewards or bonuses for recruiting should not emphasize the recruitment of new participants in the program description.
Even further, these companies should, in fact, explicitly call out in the program materials that the reward is based on “new” verifiable retail sales volume (i.e., the volume can only be generated from retail sales made by a new program participant).
The compensation plan—in structure, terminology and practice—should emphasize that rewards to participants and commissions are primarily based on verifiable sales to end user retail customers.
Historically, compensation plans were written from the perspective of participants purchasing and reselling large quantities of products with commissions tied to distributor purchase volume. Many existing comp plans contain this legacy “cash-and-carry” language, even though a majority of their product revenue is generated from preferred customer and non-participant retail sales. Companies should update the terminology in their compensation plan so that it cannot be misconstrued as emphasizing rewards based on distributor purchases.
Similarly, participant purchase requirements for qualification or maintenance purposes should be set at minimal amounts or replaced entirely with retail sale requirements. The FTC has expressed concerns about MLM compensation plans that require minimum purchases by participants unrelated to consumer demand, because in many cases the requirements compel participants to purchase products for which there is no demand simply to qualify for a reward threshold.
Finally, make sure your company’s compensation plan is written in a way that makes it easy to understand. If not, it may be misconstrued. For example, if there are limits to the amount of “Personal Volume” or “PV” that can be used for calculating commissions, then make sure this limitation is clearly stated in the definition of PV or elsewhere in the compensation plan document. Otherwise, the comp plan may be misunderstood as rewarding unlimited participant purchases rather than verifiable retail sales to non-participants.
One thing is for certain, the FTC is actively taking measures to correct what they see as misleading compensation structures that, in their opinion, can harm consumers. Companies should take the time to consider if their plans hit the guardrails laid out by the most recent statements and actions of regulators.
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