Unpacking The Latest FTC Guidance On Multilevel Marketing

Law360

08.09.2024

Ensuring that direct sellers' income disclosure statements reliably and accurately reflect the actual experience of a typical distributor has long been the Federal Trade Commission requirement.

On April 30, the FTC published updated business guidance concerning multilevel marketers, or MLMs.^[1]

This 2024 guidance details the current principles and practices that the FTC claims to consider in its assessment of whether an MLM is offering an unlawful compensation structure and operating as a pyramid scheme.

While the FTC continues to emphasize that representations about income opportunities should reflect the earnings of a typical distributor^[2] and that any income claims must be based on reliable empirical evidence,^[3] the 2024 guidance outlines a number of other requirements regarding what constitutes deceptive earnings.

Below, we discuss from an economic standpoint the 2024 guidance with respect to several of the FTC's current perspectives on how MLMs should approach their income and earnings reports, which are typically in the form of income disclosure statements.

While an IDS is intended to be an accurate estimate of the earnings participants can generally expect by engaging with the MLM's business, we note that there is not a preferred disclosure for all consumers,^[4] and that each individual company's unique compensation structure will be reflected in its IDS.

We also recognize a potential tension between the IDS as a marketing tool, meant to attract potential participants, and the IDS as a risk management tool, which may require direct sellers to adopt conservative measures of participants' earnings and thus avoid regulatory scrutiny.

While retail sales are recognized as a potentially significant source of earnings for distributors, the IDSs typically do not report retail profits because direct sellers generally do not track distributors' sales to final customers. Including these retail profits in the IDS would not only improve their accuracy but also potentially make the IDS more attractive to potential participants.

Capturing Participants' Costs

Perhaps the most important requirement that the 2024 guidance repeatedly insists upon is that "[c]laims about earnings should take into account both what participants earn and what they spend."^[5]

In particular, expenses — such as costs for product purchases, tools, services, conference travel, and training — must be subtracted from any revenue earned to determine whether the participant has made a profit or lost money.^[6]

While the FTC insists that the IDS ought to account for all costs incurred by individuals pursuing a business, currently, an IDS generally does not disclose or quantify business expenses incurred by the typical distributor that reduce their net earnings.^[7]

These expenses fall into two broad categories: those observable in the companies' business intelligence, distributor-level data; and those that are generally unobservable.

The observable expenses include direct expenses — such as fees for registration and renewal, fees for distributor websites, marketing and sales aids — and expenses associated with enrollment and rank/eligibility maintenance.

Direct expenses can generally be assessed using companywide data or the data on distributor-level purchases — often referred to as order-line data.^[8]

Some typical and recurring expenses, such as general enrollment costs and costs to attend mandatory trainings or conferences, can be inferred from the companywide data.

However, these data usually cannot capture the disparity in costs incurred by individual participants — e.g., some may meet different enrollment requirements.

The order-line data on the other hand, can track participant-specific expenses associated with enrollment, including starter kits and any administrative fees, and eligibility maintenance, or minimum purchase requirements.

While these costs are relatively easy to identify in the data, their treatment is less clear because they generally provide the purchaser with some consumption value and incorporating them into the IDS could overstate distributors' expenses.

The examples of unobservable, distributor-specific expenses include cost of setting up and maintaining the business, as well as the cost of travel to conventions and other events. While the business intelligence data provides little information on these expenses, a well-designed and executed survey could shed some light on these costs.

Challenges Associated with Reporting Typical Earnings

The 2024 guidance explicitly states that "[t]he IDS should not misrepresent participant earnings, including by annualizing or projecting income that was not actually earned by a participant in the time period the IDS covers."^[9]

This requirement addresses the treatment of distributors who did not participate throughout the period covered by the IDS.

To understand this requirement, consider a simple example: A distributor joined a direct selling company in June and earned $25 in November and $75 in December for a total of $100.

Annualizing this distributor's earnings — i.e., stating that this distributor would have earned $200 — or using the distributor's average monthly earnings, $50, to impute this distributor's earnings for each month of the period covered by the IDS would likely be seen as deceptive by the FTC.^[10]

Consider also a scenario where distributor A earns $50 in the first six months and nothing afterward, and distributor B earns $50 in the last six months, and nothing in the first six months. If the average monthly earnings are calculated by ignoring the zero-earning months, the average monthly earnings would be $50 for each month, and the annual average earning of $600 — the sum of the average monthly earnings.

Essentially, the average monthly earning is extrapolated for the months where distributors A and B had no earnings, leading to a 100% overstatement of the annual average earnings.

The risk of misrepresenting the earnings of the distributors in the two scenarios above would likely be minimized by reporting monthly, instead of annual, earnings.

Further, the 2024 guidance explicitly states that "excluding the participants who lost money or earned no money, who failed to qualify for bonuses or commissions, or who are considered inactive because they didn't get any compensation or qualify for a certain type of compensation during a particular time period, is misleading."^[11]

To understand this requirement, consider the following example.

A distributor purchases every month, meets the minimum purchase requirement in 10 months, and earns in three months only.

The FTC would likely find that the IDS that calculates this distributor's earning over either 10 months in which the minimum purchase requirement was met, or three months when this distributor earned as an active distributor — those who by definition of the compensation plan are eligible to receive earnings — is deceptive.

Characterizing Distributor Earnings

The guidance states that if "the MLM or participant does not have a reasonable basis to know what the typical person in the group is likely to achieve in earnings, they should not make any earnings claims, including lifestyle claims."^[12]

In particular, it states that "[i]f they are atypical, then discussion of those atypical earnings must be accompanied, at a minimum, by a clear, prominent, and unavoidable presentation of the typical participant's revenue and expenses."^[13]

Further, the guidance also explicitly states that in order to make any claim of "modest or supplemental income," the MLM needs to obtain information on the typical net earnings of participants and establish the exact definition of what "modest and supplemental income" represent to consumers.^[14]

In essence, this requirement seems to ask that a direct seller conducts an annual survey that would establish the participants' perception of the terms "modest" and "supplemental" income.

However, given the FTC's general skepticism of survey evidence, it is unclear what type of analysis would be considered sufficient to establish the meaning of these two terms.

Measuring the Typical Distributor's Earnings

The 2024 guidance does not specify the correct metric for measuring the typical distributor's earnings. Because there may be wide variation in how much distributors earn within a rank, simply calculating the arithmetic mean tells potential distributors little about how much a typical distributor at that rank earned.

Median — or the value separating the higher half from the lower half of distributors in terms of their earnings — may more accurately capture the typical distributor's earnings and is less sensitive to extreme values.^[15]

Although the earnings and the rank of a single distributor may change dramatically within the period covered by the IDS, parsing their experience by the rank and ignoring their overall experience during the relevant period may not speak to the experience of a typical distributor.

Instead, the experience of distributors who may have held different ranks during the relevant period may be better captured by reporting the median earnings by the highest rank they achieved in that period.

In terms of presentation of the metric, the metric must be reported in a way that is not misleading in terms of what the typical distributor earns.

For example, if the earnings in the IDS are presented in a way that appears to highlight the experience of a small percentage of distributors who achieve high earnings, this may be considered misleading as it downplays the experience of a large percentage of distributors who earn relatively modest amounts, if anything at all.

Given the complexity associated with preparing an IDS that would meet the FTC's requirement, direct sellers may wonder whether to publish the IDS at all.

After all, the FTC states that "[i]f an MLM is not a 'Business Opportunity,'^[16] it is not required to give any information about earnings to potential participants, but any earnings information it does give must be truthful, substantiated, and non-misleading."^[17]

However, if direct sellers opt not to publish an IDS, their distributors cannot make any earnings claims at all — no matter how truthful.

Companies must balance the reality that distributors demand and need a voice to speak about their actual experience with the business versus the need to create a truthful and accurate IDS.

Branko Jovanovic is a partner and Monica Zhong is a principal consultant at Edgeworth Economics.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of their employer, 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.

CITATIONS

[1] FTC, "Business Guidance Concerning Multi-Level Marketing," April 30, 2024, available at https://www.ftc.gov/business-guidance/resources/business-guidance-concerning-multilevel-marketing.

[2] See The 2024 Guidance, question 13: "Any earnings claim should reflect what the typical person to whom the representation is directed is likely to achieve in income, profit, or appreciation."

[3] See The 2024 Guidance, question 13: "An MLM or participant making claims about MLM income must have a reasonable basis for the claims disseminated to current or prospective participants about the business opportunity at the time it makes the claims. A "reasonable basis" means reliable, empirical evidence that supports the claim, not subjective beliefs or personal anecdotes."

[4] See Miller, A. M., Snyder, S., Bosley, S. A., & Greenman, S. (2023). Income disclosure and consumer judgment in a multilevel marketing experiment. Journal of Consumer Affairs, 57(1), 92–120, at p. 95. See also Bosley, S. A., Greenman, S., & Snyder, S. (2020). Voluntary Disclosure and Earnings Expectations in Multi‐Level Marketing. Economic Inquiry, 58(4), 1643–1662.

[5] The 2024 Guidance, question 13. The Guidance further states that for any direct sellers deciding to publish an IDS, either because they elect to do so or because they offer a "Business Opportunity," the income and earnings information these direct sellers disclose to current or prospective participants should truthfully consider both participants' income and typical expenses. See The 2024 Guidance, question 24.

[6] See The 2024 Guidance, question 13. Note that the FTC's response to question 14 states that "[i[f an MLM or MLM participant does not have access to data showing what participants typically spend pursuing the business opportunity (e.g., product or service purchases, website fees, party costs, and training or conference expenses), they should refrain from making any earnings claims." In response to question 23, the FTC states that "If an MLM does not have evidence of the typical earnings of its participants (including any costs that its typical participants incur), it should refrain from making any earnings claims and ensure its participants do the same."

[7] Note that Noland Court observed that "[a]ffiliate witnesses did not carefully track (and, in some instances, did not even understand the difference between) revenues and profits." Order In Re Federal Trade Commission v. James D. Noland, Jr. et al., In the U.S. District Court for the District of Arizona, May 23, 2023, 17:26–18:1).

[8] Even the observable expenses can be challenging to assess, especially in instances where the expenses are not readily identifiable. For example, the assessment of costs associated with sales aids may require a thorough review of SKU description and associated price and volume points.

[9] The 2024 Guidance, question 24.

[10] The FTC provided the following example: "According to the complaint, when calculating a participant's annual income, if a participant worked one year — 24 pay periods — but only earned one paycheck for $100, AdvoCare multiplied the single $100 check by 24 pay periods to calculate the participant's "annual average income" as $2,400. The FTC alleged that AdvoCare's IDS, therefore, was deceptive in its portrayal of participant income."

[11] The 2024 Guidance, question 24. In addition, "participants should not be omitted from earnings statistics unless the MLM has evidence that they have affirmatively opted out of the income-earning opportunity, not merely failed to qualify for it or not merely exercised any inventory buy-back program." See The 2024 Guidance, question 24.

[12] The 2024 Guidance, question 18. The FTC repeatedly emphasizes the differentiation between typical and atypical earnings and considers it potentially deceptive if the earnings claims do not "reflect what the typical person to whom the representation is directed is likely to achieve," including the disclaimers that "results are not guaranteed" or similar statements. See The 2024 Guidance, questions 13 and 18.

[13] The 2024 Guidance, question 18.

[14] The 2024 Guidance, question 19.

[15] Consider, for example, a situation where 10 distributors earn nothing and one distributor earns $110. The arithmetic mean in this example is $11, which overstates the earnings of all but one distributor. The median equals zero, which more accurately reflects the experience of the majority of the participants.

[16] Business opportunity, as defined by the Business Opportunity Rule (see https://www.ecfr.gov/current/title-16/chapter-I/subchapter-D/part-437), means a commercial arrangement in which: (1) A seller solicits a prospective purchaser to enter into a new business; and (2) The prospective purchaser makes a required payment; and (3) The seller, expressly or by implication, orally or in writing, represents that the seller or one or more designated persons will: (i) Provide locations for the use or operation of equipment, displays, vending machines, or similar devices, owned, leased, controlled, or paid for by the purchaser; or (ii) Provide outlets, accounts, or customers, including, but not limited to, Internet outlets, accounts, or customers, for the purchaser's goods or services; or (iii) Buy back any or all of the goods or services that the purchaser makes, produces, fabricates, grows, breeds, modifies, or provides, including but not limited to providing payment for such services as, for example, stuffing envelopes from the purchaser's home.

[17] The 2024 Guidance, question 23