Op-Ed in Law 360 by Chetan Sanghvi: We Need A Law To Recognize And Combat Pyramid Schemes

Concern about pyramid schemes has focused on the victimization of consumers. This is as it should be. But it should also be recognized that pyramid schemes damage legitimate businesses, which further damages consumers. The prevalence of fraud can create a fog of uncertainty and doubt that leads individuals to demur from participating in legitimate businesses. The antidote is to provide clarity and assurance. Establishing clear guidelines in law on what constitutes pyramid fraud, and promulgating safeguards against fraudulent practices, can help to clear the fog, prevent fraud and stimulate economic activity.

At its core, pyramid fraud is simply a chain letter scheme wherein an individual transmits money to the sender of a letter, and then forwards the letter to others asking them to send him money. The scheme eventually, and inevitably, collapses when the final recipients of the letter cannot find new recipients who are willing to send them money.

Transfers of funds underlying a chain letter yield absolutely no incremental value to society. Similarly, the transactions defining pyramid schemes are not based on the provision of valued goods and services, but are simply transfers from recruits to incumbents unrelated to the realization of incremental value.

Nor are these transfers simply benign. The doubt that pyramid schemes inject into the marketplace tends to chill beneficial economic activity. Direct selling is particularly susceptible to this because pyramid fraudsters have mimicked and abused the mechanics of legitimate direct selling.

We care about the chilling impact that fraud has on direct selling because direct selling can represent the optimal means of distribution for companies with products that require long sales cycles and personal engagement, who have to contend with well-heeled incumbents — e.g., long-established brands built over years with large advertising budgets, or face the prospect of having to pay substantial slotting allowances to get onto retail shelves.

Individual direct sellers, in turn, benefit from access to an entrepreneurial opportunity in a manner that fits their financial, social and family needs. Some will aspire to build businesses that will ultimately include a network of salespeople beneath them. Others are attracted to direct selling because they simply value the product and want to purchase it at a discounted price for themselves or their family and friends.

The social benefits of legitimate direct selling can be preserved by making it more difficult for fraudsters to mimic legitimate activity. Pyramid schemes can seek to camouflage the transfer of payments by taking advantage of the mechanics of legitimate direct selling (in particular, mimicking the payments that direct selling companies appropriately make to direct sellers based on the legitimate profits that are generated by their recruits). Ensuring that payments are based ultimately on the sale of product, rather than merely recruitment, can alleviate this concern.

Many direct sellers value, purchase and consume the products they sell. It is common sense that as long as the purchaser values and consumes the product, it constitutes a legitimate sale. Bona fide “internal consumption” is a hallmark of legitimate direct selling, and for this reason, courts have recognized that it represents valid retail sales (most recently in Federal Trade Commission v. BurnLounge, 2014).

The problem here is that fraudsters can devise bogus products, or otherwise cover up the simple transfer of funds that characterizes a pyramid scheme by shipping products to direct sellers that are never actually consumed (a practice referred to as “inventory loading”).

In the past, “internal consumption” has been characterized summarily as illegitimate. This is simply incorrect. Whether a particular instance of claimed “internal consumption” constitutes a legitimate business transaction is an empirical question. Do the facts show that internal consumption consisted of legitimate sales to end users? Or do they show that it was simply inventory loading designed to cover the transfer payments that lie at the heart of a chain letter? This empirical question should be at the center of any concern regarding “internal consumption” and pyramid fraud.

A federal statute that defines pyramid schemes and spells out the criteria that should be used to identify fraud, as well as distinguish fraudulent from legitimate activity, would be beneficial to society. A well-crafted law would recognize the social costs of “false positives” while nevertheless interdicting real fraud, and would codify safeguards against abusive and fraudulent practices. Reps. Marsha Blackburn, R-Tenn., and Marc Veasey, D-Texas, have introduced a bill into the U.S. Congress: H.R. 3409, the Anti-Pyramid Promotional Scheme Act of 2017, which aims to accomplish these goals.

The Blackburn-Veasey bill defines a pyramid scheme for the first time in federal statute; makes it clear that evidence of a pyramid scheme exists when participants are compensated primarily for recruiting other participants, as opposed to retail sales; protects individual sellers from financial risk by requiring all direct selling companies to repurchase unused, marketable inventory at 90 percent of the original net cost; and recognizes bona fide internal consumption as a legitimate economic activity. The bill has received support from a number of individuals, including current and former state attorneys general who interdicted consumer fraud and recognize the positive impact that similar legislation had in their states. (See “Learning from the states: Feds should adopt anti-pyramid scheme law” and “H.R. 3409 Provides a Long-Needed Federal Definition of a Pyramid Scheme“.)

Similar language will be debated as part of the fiscal year 2018 spending package in January. In July 2017, Rep. John Moolenaar, R-Mich., offered an amendment to the Financial Services and General Government Appropriations bill. The language passed out of committee by a voice vote and was passed as part of the appropriations package by the House of Representatives in September. The Senate should support the House position and accept this provision as part of a final spending package.

Society will benefit from the passage of a law that facilitates the interdiction of true fraud, mitigating injury to consumers and legitimate businesses while also alleviating the false positives that can impose a dead-weight loss to society.

Dr. Chetan Sanghvi is the managing director of NERA Economic Consulting in Washington, D.C., a global firm dedicated to applying economic, finance and quantitative principles to complex business and legal challenges. Sanghvi is an expert in industrial organization and antitrust economics, specializing in the analysis of incentives, liability and damages in the context of competition and trade policy matters as well as commercial litigation.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

Direct Selling Association

Direct Selling Association

Direct Selling Association (DSA) is the national trade association for companies that manufacture and distribute goods and services sold directly to consumers.