SEC: We Hate Pyramids
By Jeffrey A. Babener
|From time to time, rumors fly through the industry that
"the sky is falling." The topic of inquiry for many distributors and companies
most recently is a rumor that the SEC (Securities Exchange Commission) is about to shut
down the network marketing industry on the basis that network marketing constitutes a sale
of a security. The answer to this inquiry is that there is good news and there is good
The good news is that the SEC itself in response to such inquiries has confirmed that no enforcement policy changes are or have been in the works as to this industry. And the good news is that the SEC treats such matters on a case-by-case basis and, where the abusive behavior of a network marketing company transforms it into a pyramid scheme, the SEC will, as it has in the past, take action to stop the company. Why? Because for the SEC, as well as all courts and state regulatory agencies, a pyramid scheme is a security.
|Where it appears that a pyramid scheme has operated as and masqueraded as a network marketing opportunity, the SEC and other agencies have taken further action.||"... for the SEC ... a pyramid scheme is a security."|
In 1971, the SEC announced that in its opinion a multilevel marketing program could be transformed into a security. The 1971 SEC notice is not an indictment of the network marketing industry. Instead, it suggested that an MLM company that was more like a pyramid scheme in which the activity of a distributor was "passive" rather than "active" could trigger accusations of a passive investment scheme or security. In a pyramid scheme, rather than buying products to sell to consumers, distributors are instead buying into a position in a scheme. This is nothing new. In fact, the SEC and all state regulatory agencies have always taken the position that a pyramid scheme is by definition a security. The point is, however, that many criteria have developed over the years to differentiate a pyramid scheme from a network marketing business opportunity.
The most recent and substantial prosecution of an MLM company by the SEC in 1992 illustrates the fact that the SEC will in fact pursue a pyramid scheme which is masquerading as a network marketing company. In that case, the SEC convinced a federal court to shut down and freeze the assets of the ILN program.
The ILN program held itself out to the world as a consumer benefit service which also offered members and distributors opportunities for real estate investment. In reality, the program was probably driven by "the deal" and was a headhunting scheme. Potential recruits were invited to emotionally charged revival type meetings where they were encouraged to invest money in memberships and real estate, and make a fortune by getting others to do the same. Large amounts of money were invested with expectation of large returns. The federal courts accepted the SEC position that the ILN marketing program constituted an illegal pyramid scheme and the sale of securities.
Explaining securities law in layman's terms is not such an easy task. In layman's terms, a security is best thought of as a "passive investment", i.e. an investment of money with expectation of a return that is substantially caused by someone else than the investor. For instance, when you invest money in your own small business, that it is not a passive investment because the profit comes solely from your own work. Similarly, purchase of a franchise is an active investment. But the purchase of a share of stock in IBM is a passive investment. And so also is an investment in an MLM program which involves inventory loading and headhunting where distributors expect to make their money by merely introducing new distributor investors who also invest heavily, and where little money is made by selling product or service to the actual retail customer. The courts have continually held that a pyramid scheme constitutes the illegal sale of securities. In a pyramid scheme, participants are in reality investing in the marketing plan and counting on the marketing plan to bring them a return on their investment if they can find other investors.
In the ILN case, the court compared the ILN program to some of the abuses in famous programs, such as Dare to be Great, Koscot and "Challenge to America," all of which were accused of being pyramid schemes and thus securities.
The ILN program had elements of today's modern MLM programs, but it had much more in common with pyramid schemes of old. It's useful to contrast the ILN program from the elements of a legitimate program. According to the SEC and the court:
|In a pyramid scheme, participants are in reality investing in the marketing plan and counting on the marketing plan to bring them a return on their investment if they can find other investors.|
So, what is the answer to the many inquiries about the SEC and the MLM industry? The answer is that from an SEC standpoint, the network marketing industry has a future. Pyramids do not. MLM companies that tolerate front-end loading, garage qualifying, buy-in qualification, or who offer programs that are driven by "the deal" rather that the product or service, are all fair game. If you are recruited for such a program -- run fast in the opposite direction.
|The answer is that from an SEC standpoint, the
network marketing industry has a future.
Pyramids do not.
|Jeffrey A. Babener
Babener & Associates
121 SW Morrison, Suite 1020
Portland, OR 97204
|Jeffrey A. Babener, the principal attorney in the
Portland, Oregon law firm of Babener & Associates, represents many of the leading
direct selling companies in the United States and abroad.
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