By JDSR Staff

Concern about pyramid schemes is rightly focused on the victimization of consumers. It is also important to recognize that pyramid schemes damage legitimate businesses, which further harms consumers.

Pyramid fraud works like the classic chain letter scheme where an individual is asked to send money to the sender of a letter, and then forwards the letter to others asking for money from them. The scheme eventually collapses when the last recipient of the letter cannot find new recipients willing to send him or her their money.

So, too, with pyramid schemes, are financial transactions not based on the transfer of goods and services of commensurate value, but rather mostly or exclusively on recruiting members into the scheme. Not only do they facilitate the transfer of wealth from one person to another without the consumption of products, and ultimately collapse when no other willing recruits can be found, they create nothing of social value in the process. Worse, they can injure retail enterprises that do not operate in traditional brick-and-mortar stores by undermining consumer confidence in their legitimacy.

The retail channel most vulnerable to consumer doubts sown by pyramid frauds is direct selling. Direct selling is a decentralized form of retail selling in which companies engage a salesforce of independent contractors to sell their good and services to customers they locate, usually in person and sometimes in the customer’s home.

Part of direct selling’s appeal to the parent company are the lower overhead costs of the operation, bypassing, as it does, the costs of shelf space and advertising to compete with established brands, and the expense of employing a salesforce rather than contracting with independent salespeople, who decide for themselves the extent to which they are willing to be involved in the enterprise.

That flexibility is, along with the low start-up costs involved, the main appeal of the enterprise to most independent direct sellers, who are, in effect, running their own small businesses according to a business plan and schedule they designed in accordance with their financial, social and family needs. Most direct sellers work part time to supplement their families’ incomes modestly.

There are direct sellers who aspire to build bigger businesses by recruiting a network of salespeople and share a percentage of their sales, what’s known as multilevel marketing. Lastly, there are individuals who are involved in direct selling solely or mostly because they enjoy the product and want to purchase it at a discounted price for themselves or their family and friends.

Internal consumption is a perfectly reasonable purpose for involvement in direct selling and constitutes a legitimate sale, no different in kind than a salesperson in a brick-and-mortar store who enjoys the products she sells and uses her employee discount to purchase them.

What distinguishes pyramid schemes from legitimate retail enterprises, including direct selling, is how compensation is earned. Compensation in pyramid fraud is mostly or exclusively earned by recruiting others to the scheme. Direct selling compensates distributors for sales of a good or service to ultimate users, who can be the distributors themselves as long as they are actually using the product. Direct selling companies allow unsold inventory to be returned to the parent company for a 90% or more refund.

Internal consumption is recognized as a valid retail sale in state and federal case law, particularly Federal Trade Commission v. BurnLounge (2014). It is exempted from proscribed activities in model anti-pyramid scheme laws in eighteen states, which were based on the recommendations of the Council of State Governments.

Editor’s note: Read full study by Dr. Chetan Sanghvi and his colleagues at NERA Economic Consulting: “An Economic Analysis of the Criteria Used to Distinguish Legitimate Direct Sellers from Pyramid Schemes,” an insightfully relevant study for policymakers today as they seek to protect consumers and legitimate businesses from bad actors masquerading as direct sellers.