Multi-Level Marketing (MLM) and Pyramid Scheme

Multi-Level Marketing (MLM), also known as network marketing or referral marketing, is a form of direct sales strategy where the company encourages its distributors to recruit further distributors for the sale of the company’s product or service. The focus of MLM is to reach to the end consumer on a large scale by providing quality product or service. MLM only encourages the distributors to recruit more distributors, however, the focus is on the sale of the product/service to the end consumer.

According to Peter Vander Nat, Senior Economist at Federal Trade Commission (FTC), “An organisation is deemed to be a pyramid scheme if the participants obtain their monetary benefits primarily from recruitment rather than the sale of goods and services to consumers.”

Pyramid Scheme in simple terms can be defined as a company which, under the name of MLM, is only concerned with promoting the distributor recruitment for expanding the distribution chain to earn substantial profits. The focus is not on the selling of the product or the service to the end consumer but on earning through commissions received by the distributors in the chain.

For example: I am the founder of company A. I have 2 distributors selected for my product, say bottles. I sell a lot of 100 bottles to each distributer at the rate of Rs. 10 per bottle. Hence, I receive Rs. 2000 on the sale of my product. Additionally, I encourage my distributors to recruit more distributors under them. In return, I ask them for a percentage of the profit they earn by recruiting the distributors as my commission. I push the two distributors to do the same to their recruited distributors as well. And the chain goes on and on till exhausted. I, as company A, earn the maximum profit because of I get my Sales Price for every lot purchased by every distributor in the chain along with a percentage of commission on the profits earned by them. However, the distributors on the lowest end of the chain fail to earn such a substantial amount because of the costs involved, including the commission to be paid. I, as company A, do not bother to see if my bottle has reached my consumer. As long as I am selling my bottle to the distributor in the chain, I am earning.

It is difficult to identify a company having a genuine MLM strategy vs a Pyramid Scheme. The reason why it becomes so difficult is because of the level of sophistication with which pyramid schemes function. Hence, its legislation also faces a lot of issues. MLM in India is legal. However, the government has managed to identify certain businesses that may be a pyramid scheme. Usually, the businesses where the product or service does not reach the end consumer is termed pyramid scheme. The Direct Selling Guidelines 2016 and Price Chits & Money Circulation Schemes (Banning) Act 1978 lists down the businesses where MLM is considered illegal in India.

Case Studies

Herbalife – USA

Bill Ackman, the head of the hedge fund Pershing Square Capital Management, short-sold the stocks of Herbalife and even expected it to go to zero once he announced (in 2012) the answer to “why?” for his position in.

Herbalife is a dieting supplement sales company working under the MLM strategy. It had a chain of distributors who bought lots of Herbalife’s products. Instead of selling those products directly to the consumers, they were motivated to build their own network of distributors by recruiting more and more people. Initially, the model seemed quite promising and the distributors also managed to earn huge products. At a point, Herbalife was one of the most profitable businesses in Los Angeles. There were presentations held by distributors to recruit more distributors. A typical presentation of a Herbalife distributor would be of the “rags to the riches” type. The company also held award functions to reward the best performing distributors. In an attempt to recruit more distributors and earn substantial profits, some distributors set up Herbalife centres (most of them hidden and illegal according to the company norms) that involved huge costs. However, once the chain expanded, the distributors at the lower end of the chain (the larger portion of the pyramid) faced issues in both, selling the products as well as recruiting more distributors. Some of them had also availed debt to start their Herbalife distributor journey. It all went down in 2012 after Bill Ackman’s accusation of Herbalife being a pyramid scheme.

At the end in 2016, the FTC did not tag Herbalife to be a pyramid scheme. A fine of $200 million was charged along with changes to the company’s policies and way of conducting the business. However, Herbalife has gone under the investigation of the SEC and US Department of Justice on accusations of corruption in China and many other conspiracies in 2019 which it settled by paying fines of $20 million and $40 million.

Amway – India

Amway is a cosmetics and allied products selling company that functions like a similar MLM mentioned above. Amway has faced a class action lawsuit in US and China where it has managed to not fall under the definition of a pyramid scheme. However, one must not forget that it does form a kind of pyramid shape in its structure that may seem to be a scheme. Unlike Herbalife, Amway positions its distributors as Independent Business Owners (IBOs) of its products. These IBOs re free to decide whether they want to sell the products directly to the end consumers or want to recruit more IBOs under them. This distinction positions them as a structure slightly different from a pyramid scheme. Time and again in India, Amway’s distributors have been accused of running a pyramid scheme. Cases were filed against Amway distributors at various regions in 2006, 2011, 2013 and 2017 but it won all the cases (some cases at least to some extent). However, it still runs its business in India as a legal entity and is not regarded as a pyramid scheme.

MSc Finance graduate from the London School of Economics and Political Science (LSE)
Avatar for Ria Vaghela

Ria V Vaghela is an M&A Executive at RSM UK and an MSc Finance graduate from the London School of Economics and Political Science (LSE). She has worked at Jefferies, Dial Partners and 7i Capital prior to RSM UK gaining an experience of about 1.5 years. She has also worked as an Editor and Content Writer for The Representative Media. Apart from finance, she is interested in reading books on psychology and economics and also likes to paint and play lawn tennis

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