How to Avoid Civil Investigative Demand (CID)
The recent FTC actions against Advocare and Neora underscore how critically important it is for direct selling to avoid becoming ensnared in an FTC investigation
Neora’s recent lawsuit challenging the FTC’s enforcement authority is a welcome and needed response to what appears to be increasing regulatory overreach and efforts by the FTC to improperly legislate changes in the network marketing industry through enforcement proceedings.
But it will likely be several years before a final ruling is issued in Neora v. FTC. In the meantime, an emboldened FTC has vowed to “aggressively” prosecute enforcement actions against what it views as non-compliant network marketing companies operating in the U.S. As with the prior FTC enforcement actions against Herbalife and Vemma, the recent FTC actions against AdvoCare and Neora underscore how critically important it is for companies in our channel to avoid becoming ensnared in an FTC investigation.
Three Outcomes Of A CID
A CID, or Civil Investigative Demand, is a request from the FTC for information (similar to a subpoena) about various aspects of a company’s business operations. A company’s receipt of a CID is usually the first notice to the company that it is the subject of an FTC investigation. It is also a seminal event because receipt of a CID irreversibly alters a company’s business operations for years to come. Unfortunately, three things are a virtual certainty when a company receives a CID:
- There is a zero percent chance that the target company will be able to convince the FTC that it operates lawfully;
- The target company will receive no credit for corrective action taken following its receipt of the CID; and
- The target company is going to be forced to spend millions, possibly hundreds of millions of dollars, either in litigation with the FTC or in paying a stiff restitution fine to resolve the enforcement action. [The restitution orders entered against Herbalife, Vemma and AdvoCare were for $250 million, $238 million and $150 million, respectively].
So how does a direct selling company avoid a CID and the catastrophic consequences that almost always follow?
Get Serious (Really Serious) About Policing Earnings Claims
First and foremost, a company must take whatever steps are necessary to eliminate unsubstantiated earnings claims by the company and its distributors. Improper earnings claims are typically what put a company on the FTC’s radar. Companies that do not have issues with improper earnings claims are much less likely to attract FTC scrutiny.
The logical starting point is to ensure that the company itself is not publishing improper earnings claims. In the Complaint filed against AdvoCare, the FTC listed numerous examples of improper earnings claims made at AdvoCaresponsored events and on company-created social media posts and webinars.
Companies need to ensure that their marketing personnel are properly trained on what is and is not a permissible earnings claim. Controls must be in place to ensure legal/compliance review of all company publications and promotional materials. Companies must also police what is said from the stage or in video presentations made at company events. These are not new or novel concepts, yet a number of direct selling companies continue to publish unsubstantiated earnings claims on social media and at company events.
Just as importantly, companies must publish accurate data reflecting the earnings of all program participants. An income claim is considered deceptive unless information is disclosed showing what program participants can typically expect to earn. This makes a company’s Income Disclosure Statement a critical document.
The FTC was critical of AdvoCare’s Income Disclosure Statement because it only reported earnings data for “active” distributors. “Active” distributors were defined by AdvoCare as participants who earned income in the previous year. The FTC alleged the AdvoCare IDS was deceptive because less than 30 percent of all AdvoCare distributors earned income.
By disclosing on its IDS only the earnings data for “active” distributors, the FTC alleged that the IDS was misleading because it failed to include earnings data for more than 70 percent of AdvoCare distributors.
“…it is imperative that direct selling companies examine their business practices and take every possible precaution to avoid being the next recipient of a CID.”
Full & Transparent Disclosure Of All Participant Earnings
The IDS can be an important insurance policy for direct selling companies. A full and transparent disclosure of all participant earnings will significantly reduce a company’s exposure to regulatory scrutiny. On the other hand, an incomplete or misleading IDS can be the evidence the FTC relies on in concluding that a company has made deceptive earnings representations in violation of Section 5 of the FTC Act.
The biggest challenge a company faces in reducing exposure for improper earnings claims is in policing claims made by members of its sales force. In a presentation at the DSA Legal and Regulatory Conference in October, FTC’s Andrew Smith unequivocally stated that the FTC intends to hold direct selling companies responsible for improper earnings claims made by their distributors. This means that companies must do much, much more than simply have policies in place that prohibit distributors from making improper earnings claims and occasionally enforce those policies.
In today’s regulatory climate, it is essential that companies implement a training program and train distributors on what is and is not a permissible earnings claim. Companies must also commit to terminating distributors at any level or rank who persist in making improper earnings claims. Companies must also actively monitor distributor social media posts and compel the removal of social media posts that contain improper earnings claims.
In sum, companies must be able to demonstrate a robust training, compliance and enforcement program. Even a ten-fold increase in a company’s compliance and policy enforcement budget is a drop in the bucket compared to the astronomical cost and expense a company faces following receipt of a CID.
Take A Fresh Look At Your Company’s Compensation Plan
Just as critically, ensure that your company’s compensation plan—in structure, terminology and practice—is primarily based on rewarding distributors for sales to non-distributor retail customers. Conversely, ensure that your compensation plan does not overly incentivize purchases by distributors or emphasize recruitment of new distributors. Companies should be able to demonstrate that a majority of product revenue is generated from verifiable retail sales to non-distributors. Distributor purchase requirements for qualification or maintenance purposes should be set at minimal amounts or replaced entirely with retail sale requirements.
Keep in mind that optics matter. A company’s compensation plan will likely be one of the very first documents reviewed by an FTC investigator. Make sure your company’s compensation plan is easy to understand. If it’s not, then it’s capable of being misunderstood. Similarly, update the terms and definitions to reflect an emphasis on retail sales to non-distributor customers. Historically, multi-level compensation` plans were written from the perspective of distributors purchasing and reselling large quantities of products with commissions tied to distributor purchase volume. Many existing compensation plans contain this legacy “cash and carry” language even though a majority of product revenues are generated from preferred customer and non-distributor retail sales.
Update the terminology in your company’s compensation plan so that it cannot be misconstrued as emphasizing rewards based on distributor purchases. Finally, because optics matter, incorporate Amway policies (70% rule, etc.) and Herbalife and Vemma limitations on rewardable personal consumption into the compensation plan document itself rather than in a separate Policies & Procedures document. A company’s compensation plan, from beginning to end, should reflect a compensation program based on rewarding distributors primarily for sales to non-distributor consumers.
What Do Your Company’s Financials Reveal?
Finally, take a look at your company’s financial statements. The FTC alleged that AdvoCare operated as an illegal pyramid based, in part, on the fact that more than 80 percent of AdvoCare’s product revenue was generated from distributor purchases. In most cases, a company’s financial statements provide compelling evidence proving or disproving that the company operates as an illegal pyramid scheme. The financials of a compliant multi-level program should reflect that product revenues are generated primarily from retail sales to preferred customers and non-participant consumers. Similarly, a company’s financials should not reflect a significant percentage of revenues generated from the sale of enrollment kits, high-priced enrollment bundles or mandatory purchases or payments by distributors. A company should be able to use its financial statements to demonstrate that there is strong retail demand for the company’s products or services.
FTC Making Good On Its Promise
By filing two enforcement actions against direct selling companies in less than a month, the FTC appears to be making good on its promise of further aggressive enforcement activity against what it considers to be non-compliant direct selling companies. Neora’s lawsuit challenging the FTC’s enforcement authority offers a ray of hope that the FTC may eventually be required to act in accordance with published guidance and enforcement standards rather than a constantly changing internal agency interpretation of what constitutes an illegal pyramid scheme. It is imperative that direct selling companies examine their business practices and take every possible precaution to avoid being the next recipient of a CID.
Brent Kugler is a partner with Scheef & Stone in Dallas, Texas. Brent is a prominent attorney is a direct selling industry with extensive experience in representing direct sales, multilevel and network marketing companies in lawsuits, arbitrations regularities matter across the untied states.
