Sales Referral Laws:
Watershed Decision for MLM

By Jeffrey A. Babener

© 2005

Multilevel marketing has always been closely regulated. MLM programs are scrutinized and evaluated on an ongoing basis by state attorneys general. The attitude of regulatory officials toward all MLM programs is a by product of the abuses of the late 1960's. Cases involving Glen Turner's Dare To Be Great Company, Koscot Inter planetary and Holiday Magic unleashed a wave of public indignation and legislators in every state responded to this hue and cry by enacting and adopting laws prohibiting pyramid and chain distribution schemes. In addition, several states enacted laws specifically to regulate multilevel marketing.

This regulatory reaction and aggressive prosecution of MLM programs threatened the existence of the legitimate MLM industry in the 1970's. The industry perhaps reached a turning point in 1979 when the FTC decided that the Amway program was not an illegal pyramid scheme. In the Amway case, the FTC carefully distinguished Amway's program from a pyramid scheme, and the decision has served as a beacon for entrepreneurs desiring to sell products through multilevel marketing. Recently, in another watershed case involving American Professional Marketing Inc., the Iowa Supreme Court used the Amway decision as a guide in rejecting the Iowa Attorney General's contention that, any marketing plan providing a purchaser of a product with an economic incentive for recruiting new participants, is illegal as a matter of law under that state's pyramid or referral sales statute. This case is of considerable importance to multi level marketers nationwide because the Iowa Attorney General was attempting to use the statute to ban all multilevel marketing in Iowa, regard less of whether or not the economic incentive for bringing in new participants was directly related to sales of the end product. Other states have asserted similar positions on sales referral laws. If the Attorney General had succeeded, the future of multilevel marketing would have been bleak in Iowa. The Iowa Supreme Court rejected the Attorney General's interpretation of the law.

The Court described the APMI program as follows: APMI is a national multilevel marketer of various products, however, the primary product in its Iowa marketing plan was a gasoline additive. Participants entered the program as "product representatives" by attending a sales meeting and purchasing a sales kit from the company for $38. Sponsors received no part of the $38 purchase price. Product representatives purchased the gasoline additive from their sponsors at 25% off the suggested retail price, and there was a maximum two case limit on the initial order. A product representative was not allowed to sponsor participants or buy the product directly until he or she became a supervisor or director. To become a supervisor, a product representative must have sold or consumed 75% of the initial two cases in two consecutive months.

A supervisor purchases the additive from APMI at 30% off the retail price and sells at retail or resells to sponsored product representatives. In addition to profits on sales at retail and to product reps, a supervisor earns a bonus based on sales to first generation supervisors and a volume bonus on sales to later generation supervisors.

A supervisor becomes a director by selling 120 cases in a 6 month period and filing a retail sales report. Directors earn bonuses based on purchases by their first five generations and profit sharing based on the director's organization sales compared to national sales.

The Iowa Attorney General filed a suit in district court in which he sought an injunction prohibiting APMI from selling its products through its MLM plan. The court granted the injunction and AMPI took an appeal to the Iowa Supreme Court.

The Attorney General contended that the AMPI plan violated Iowa Code Section 714.16 (2)(b) which makes it unlawful to sell . . . "any merchandise at a price or with a rebate or payment or other consideration to the purchaser which is contingent upon the procurement of prospective customers provided by the purchaser . . . or the procurement of sales . . . to persons suggested by the purchaser." In an earlier case, the Iowa court found that this statute made referral or pyramid sales arrangements illegal by their very nature, so the court examined the APMI plans to determine if they were pyramid or referral plans and therefore illegal.

The court first addressed the issue of whether APMI's plans were pyramid sales arrangements. There is no definition of pyramids in Iowa laws, therefore, the court applied a definition that the state and defendant agreed upon. The parties and the court adopted the FTC definition of pyramid selling:

"Pyramid selling as defined by the Federal Trade Commission involves 'inventory loading' and 'headhunting fees.' Companies which engage in pyramid selling have a large inventory requirement for a new distributor and reward distributors for bringing into the business a new distributor, unrelated to the sale of the product. The result emphasizes recruiting of new distributors rather than selling the products to consumers. Typically, these companies require new recruits to buy $2,000 to $5,000 in inventory with as much as half of that amount going to the recruiting distributor. Such schemes are often characterized by the payment by participants by money to the company in return for which they receive (a) the right to sell the product and (b) the right to receive, in return for recruiting other participants into the program, rewards which are unrelated to the sale of the product to ultimate users."

The court found that APMI was not engaged in pyramid selling because there was no "headhunting fee" paid to supervisors or directors, and no "inventory loading" because of the two case initial purchase limit and the requirement that the participant must sell 75% of the first two cases before reordering. Furthermore, bonuses paid to supervisors and directors are directly related to product sales.

The court also found that APMI was not engaged in marketing under an unlawful referral sales plan. The APMI purchaser did not furnish names of prospects to the seller with an eye toward commissions or rebates. Also, the state failed to present evidence that the price of the product was inflated to disguise a referral fee.

The most disturbing of the Attorney General's contentions in this case was that "any marketing plan that provides the purchaser of the product an economic incentive for the recruitment of new participants is illegal" under the Iowa statute. That the Attorney General was trying to stamp out multilevel marketing in Iowa once and for all is apparent in this quote from the state's brief to the court . . . "without a complete ban [of these types of schemes], the state would be put to the burden of conducting massive investigations and proving difficult factual issues on whether the scheme is good or bad all the while the scheme proliferates." Clearly, the Attorney General believed that the only good MLM plan is one that operates out of state.

The Iowa Supreme Court completely rejected this contention that any program offering economic incentives for recruiting is unlawful. First, the court found that product representatives received no consideration for referring new participants to their supervisors, and their profits were obtained solely by sales of the product at retail. As to the supervisors and directors, the bonus and profit arrangements would render the plan unlawful only if the profits were derived primarily from recruitment and were not based on retailing the product.

Comparing the APMI plan to the Amway program, the court found that APMI's buy back rule, the rule requiring a product representative to sell 75% before reordering, and the small amount of inventory needed to start, all serve to prevent inventory loading and encourage retail sales. Therefore, the state failed to prove that APMI's plan yielded profits based primarily on recruiting and unrelated to the sale of products.

In rejecting the blanket ban of MLM programs, the court stated that marketing programs would be examined on their merits and according to the facts of each case. So long as the program primarily ties profits to products and not people, and the program avoids the dangers of inventory loading and headhunting fees, the MLM program will likely pass muster in Iowa. Substantial credit for the outcome of this case is due to the Direct Selling Association and the Amway legal department who filed persuasive "amicus", friend of the court, legal briefs.

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