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The Murky Line between a Pyramid Scheme and a Multilevel Marketing Scheme

The classic definition of a pyramid scheme is a business model which attempts to make money solely by recruiting new participants into the program. Pyramid schemes usually promise astronomical returns within a short period of time. Members are generally required to hand over money at the initial sign-up stage. In return, members receive the opportunity to participate in the system. Participating members can recruit other members and are awarded commissions or bonuses based on the number of recruits they bring into the scheme. Pyramid scheme business models are unfair and illegal because the pyramid will eventually collapse, e.g., at a certain point there will be no new recruits.

There is no specific federal statute addressing pyramid schemes. However, the Federal Trade Commission (FTC) can prosecute companies running these schemes under fraud, deceptive trade, or unfair practices statutes. In reality, the majority of enforcement occurs at the state level. Indeed, every state has laws specifically targeting pyramid schemes. The California Endless Chain Statute makes pyramid schemes illegal and describes an “endless chain” as “any scheme for the disposal or distribution of property whereby a participant pays a valuable consideration for the chance to receive compensation for introducing one or more additional persons into participation in the scheme or for the chance to receive compensation when a person introduced by the participant introduces a new participant.”1

The definition of a multi-level marketing (MLM) scheme, sometimes referred to as direct selling, is a business model where members recruit other members and receive compensation for total generated sales. At first glance this seems like a pyramid scheme. In both schemes revenue is derived from customers pushing the product or “participation” on other customers, who in turn push “participation” further.

Georgia, Wyoming, Massachusetts, and a few other states have enacted laws which specifically regulate multilevel marketing companies. These states define an MLM company as a business which for consideration sells, distributes or supplies, goods or services through independent agents, at different levels wherein participants in the marketing program may recruit other participants, and wherein commissions, bonuses, discounts, or other considerations in the program may be paid as a result of the sale of such goods and services or the recruitment of additional participants.2

These statutes do not make MLM’s illegal, but place restrictions on their activities. One of the most important of these restrictions is the buyback requirement. Under this requirement a member seller has the right to cancel participation at any time for any reason and requires the company to repurchase unsold inventory from the distributor at a price not less than 90% of the distributor’s original cost and refund member fees.3

What is the exact difference between pyramid schemes and multi-level marketing schemes? What makes one illegal and the other legitimate? Generally, the pyramid and endless chain statutes are understood to prohibit the payment of a consideration for the right to recruit others for economic gain where the compensation is unrelated to the sale of products or services. An MLM scheme can be considered an illegal pyramid, but can also be legitimate if members receive compensation related to sales.4

However, not all regulators and officials have the same definitions. MLM companies offer new recruits training, services, and discounts as a way of hiding the true nature of the “investment.” The best way to think about legally is to ask a question. Why are people signing up? Are they only buying the product to gain the opportunity of recruiting others or are they signing up for the product itself? From a legal perspective the problem with a pyramid scheme is the inevitable “running out of recruits.” If customers are only participating for the ability to recruit others the scheme only works because of new recruits and is illegal. If customers are participating because of the product the scheme is legal.

On December 20, 2012 Bill Ackman, founder of Pershing Square Capital Management, accused Herbalife, a Los Angeles based company selling weight-loss products, as being a pyramid scheme. Ackman made a $1 billion bet against Herbalife by shorting the stock. In an attempt to shine a spotlight on Herbalife, Ackman released a 334 page presentation explaining why Herbalife is an illegal pyramid scheme.5 The accusations boiled down to the fact that participants “obtain their monetary benefits primarily from recruitment rather than the sale of goods and services,” and Herbalife “inflates the suggested retail price of its products and overstates retail sales in its public filings to conceal the fact that recruiting awards earned by distributors are substantially greater than the profit they generate.”6

Herbalife Chairman and CEO Michael O. Johnson discredited Ackman and responded saying “the allegation that Herbalife is a pyramid scheme is bogus. Make no mistake: Today’s announcement isn’t about Herbalife’s business model. It’s about Bill Ackman’s business model.”7 Herbalife released another statement saying “[w]e urge the SEC to investigate these series of events to protect the rights of investors. This appears to be yet another attempt to illegally manipulate the market by overzealous short-sellers . . . . We don’t pay to recruit distributors.8

Historically, the FTC has not been overly active in pursuing illegal pyramid schemes. However, there has been a recent public push to stop these illegal practices. In January of this year, the FTC and several state attorney’s general did bring an action against Fortune Hi-Tech Marketing (FHTM), claiming that the FHTM MLM scheme was illegal. 9 The FTC and the state attorney’s general alleged that Fortune falsely claimed consumers would earn significant income for selling company products and services. The FTC also claimed that nearly all consumers who signed up with the scheme lost more money than they ever made, 85% of consumer payouts were for recruiting other consumers, and only minimal compensation was paid for sales to non-participants. The complaint alleged that the marketing scheme granted larger rewards for recruiting people than for selling products. In May 2014, a court order shut Fortune’s MLM scheme down.10

If regulators do decide to sue Herbalife the case will likely turn on our earlier question. Why do consumers sign up to participate in Herbalife’s MLM scheme? Is it for the products and discounts (Herbalife’s claim), or is it for the opportunity to sign up other members and receive commissions?

The Herbalife – Ackman saga has received extensive national coverage. The public push for more scrutiny and involvement by regulators has never been stronger. It will be interesting to see if the FTC uses Herbalife as a springboard to start cracking down on MLM companies and their unfair practices.

  1. Cal. Penal Code § 327. 

  2. E.g., Ga. Code Ann. § 10-1-410(6); Wyo. Stat. Ann. § 40-3-102(a); Mass. Gen. Laws Ann. ch. 93, § 69. 

  3. E.g., Wyo. Stat. Ann. § 40-3-105. 


  5. Pershing Square Capital Management, Who Wants to be a Millionaire, 

  6. Id. at 63. 

  7. Herbalife (Dec. 19, 2012), 

  8. Herbalife (Dec. 20, 2012), 

  9. Federal Trade Commission (January 28, 2014), 

  10. Federal Trade Commission (Mat 13, 2013),