Proactive engagement now can significantly minimize legal risks later
The FTC has made it a “top enforcement priority” to protect “hard-working consumers from losing money to illegal pyramid schemes or other business opportunities that make deceptive earnings claims.” If not careful, your company, like AdvoCare, Neora, and Success by Health, could become the FTC’s next target and face warning letters, injunctions, lengthy court battles, and millions of dollars in legal fees. Senior management could also be personally liable for perceived bad acts.
In this environment, executives must proactively work with their company’s legal department to ensure their organization’s operative agreements, compensation plan, and compliance department have measures in place to minimize legal exposure. Your proactive engagement now can significantly minimize legal risks later if you focus on the five key elements below.
It All Begins with Your Operative Agreements
Your operative agreements define the relationship between the company and its distributors. When drafting and revising these agreements, you must pay particular attention to provisions regarding modification of the agreements, class action waivers, and dispute resolution. These provisions are often the focus of legal challenges.
For example, you must ensure that the arbitration and modification provisions are drafted so as not to render the class action waiver unenforceable. Often, a company’s operative agreements allow the company to unilaterally modify them. Plaintiffs’ lawyers love to exploit these modification provisions to argue that the contract is illusory, and thus the arbitration and class action waiver provisions are invalid. You must, therefore, diligently review the operative agreements to ensure they include a fully enforceable arbitration and class action waiver that complies with the law of the state that governs the agreements.
As another example, you must review modification and dispute resolution provisions in each operative agreement to ensure they do not contain any differences—no matter how seemingly small—that would conflict in a way that makes them unenforceable. Litigants will use these inconsistencies to invalidate otherwise sound arbitration and class action waiver provisions, subjecting the direct seller to expensive and protracted class-action litigation in the court system. So, consistency is key.
Look at How Your Compensation Plan is Structured
While operative agreements define the relationship between the company and its distributors, it is the compensation plan that often faces the most scrutiny, at least from the FTC. In fact, the FTC reminded all direct sellers during a panel at the 2021 MLM Conference that it continues to focus on compensation plan structure to determine whether it believes that a company is a pyramid scheme.
Notably, the FTC is becoming increasingly focused on how distributors boost their commissions through products purchased by other distributors and not product sales to end users. This arrangement is the hallmark of a pyramid scheme. Direct Sellers, however, can minimize the risks associated.
First, if your compensation plan allows self-purchases by the distributor or purchases by other distributors to count toward rank advancement and commissions, decrease the amount of product that counts toward such incentives. This will also minimize inventory loading and a distributor’s ability to manipulate the compensation plan by purchasing product themselves or increasing their downline solely to capture the purchases made by other distributors.
Second, direct sellers must have a fully operational and easy to use “undo option,” which allows distributors to return products if the business opportunity fails. By implementing an “undo option,” a company can easily demonstrate to the FTC or a court that there is an appropriate mechanism to allow unhappy distributors to easily part ways with the company and get their investment back.
There are, of course, other compensation plan red flags that direct sellers must look out for, such as threshold rewards that require a distributor to purchase a certain amount of product every month to engage in the business opportunity. And, luckily, there are quite a few ways to modify compensation plans to eliminate these red flags without causing too much pain to the company’s bottom line. In sum, direct sellers need to take a hard look at their compensation plan to ensure they have eliminated the red flags that will bring the FTC knocking.
Have A Preferred Customer Program
Another key business element that all direct selling companies must have is a preferred customer program that encourages sales to, and greatly rewards distributors for, sales to preferred customers.
Some individuals sign up as distributors for the sole purpose of receiving the volume discount with no intention of growing a business. To the FTC, the lack of business growth suggests that these individuals were tricked into a business opportunity with no exit strategy. By implementing a preferred customer program, individuals who would otherwise sign up for the business opportunity for the discount alone can self-identify as a preferred customer instead and reap the benefits of the discount without the need to become a distributor.
Without a preferred customer program, the company would be forced to reverse engineer its data to prove to the FTC which business opportunity participants are actually “end-user” consumers and have not been duped by the system. This backward approach will only expose the company to additional scrutiny. Thus, implementing a preferred customer program allows the company to clearly differentiate between end-user consumers and business opportunity participants and prove the value of their product/services through significant end-user sales.
Every Company Must Have a Robust Field Education Program
Fourth, direct selling companies should also be implementing a company-sponsored training program that educates the field on the company’s policies and procedures, and preferably, the training program will happen at registration for the business opportunity.
The education program must discuss, among other things, how to properly promote the business opportunity without making improper income and product claims. Defining improper claims is not enough. Rather, this training should provide multiple examples for distributors to learn how to identify improper claims and to explain the proper way for describing the company’s products and the business opportunity to others.
Often, distributors make improper claims unknowingly because they do not understand the implications of their statements or how they are viewed by the FTC. For example, a distributor might make a truthful claim about his or her business results but fail to include the required income disclosure statement explaining the typical results of a distributor. The FTC views this as a misleading claim even if the distributor’s statement was based on his or her personal results. This is critical for top-level distributors, as many FTC investigations are initiated because of improper income and product claims made by top-level individuals.
Importantly, this training should come from the company itself at the beginning of its relationship with the distributor, and the company should maintain records showing completion of the program. The company should not, however, require its distributor base to engage in any recruitment training or support as such a requirement would be used by litigants to argue that the company’s distributors are actually employees.
Must Have a High-Functioning Compliance Program
Finally, a functioning compliance program that is supported by company executives is critical to defending your company against FTC scrutiny and litigants.
Once you have well-drafted policies in place that clearly outline prohibited conduct, your focus should be on the strength of your compliance program. It is not enough to have a compliance department. Instead, you must ensure that your compliance department is adequately staffed, is identifying distributor violations of the policies, and is imposing corrective measures when necessary. Additionally, your compliance department must be well-versed in the policies to ensure that it is consistently communicating and applying them to all distributors.
Your compliance department’s documentation and evidence against distributors for policy violations will be key evidence in an FTC enforcement action or litigation. Thus, consistency is critical to show that no distributor, including high earners, is above reproach. You want to show that you and the company take violations of the policies seriously, especially with respect to compensation plan manipulation and improper claims. Even more important is that your company can show that distributors who violate these policies are actually punished for their actions.
Minimizing legal risks requires attention and diligence from all stakeholders, including top executives. These five elements are the perfect starting point to making changes that will better protect you and your brand. The work you proactively put in now will minimize the need to face an FTC investigation or litigation later.
John C.C. Sanders, Jr. is the Founding Partner/Dallas and Katrina G. Eash is a Partner at Winston & Strawn. Winston represents dozens of direct selling companies in a wide range of disputes and consulting matters.
From the September 2021 issue of Direct Selling News magazine.