FTC Proposed Business Opportunity Rule
Analysis by Jeffrey Babener
A Regulatory Update for MLM,Direct Selling, Network Marketing, Direct Sales, Party Plan Independent Distributors and Companies
Information that Every MLM, Direct Sales, Direct Selling, Network Marketing and Party Plan Distributor and Company Should Know About the FTC Proposed Business Opportunity Rule
Despite rumors to the contrary, "nothing" will happen immediately. ... There will be plenty of time for debate and suggested modification on the Proposed Rule.
In April 2006, the Federal Trade Commission issued a proposed rule that will have the effect of extending the FTC Business Opportunity Rule to virtually all MLM programs. Despite rumors to the contrary, "nothing" will happen immediately. The process for adoption of a final rule is estimated by industry experts to take about 18 months to three years following extensive hearings, workshops and the political process. There will be plenty of time for debate and suggested modification of the Proposed Rule during that time. Most importantly, it should be noted that this is not the specific problem of any one company, but rather, it is a potential challenge to the entire community of all direct selling companies.
In particular, the FTC Proposed Business Opportunity Rule is problematic for the direct selling industry because the proposed rule:
- Erases the $500 threshold exemption of applicability and all companies must comply,
- Requires extensive disclosures to recruits and requires a seven-day waiting period before a prospect recruit may sign up with the MLM company,
- Requires the company to notify the prospect of ten purchasers of the opportunity closest to the prospect's home, or in the alternative, a list of all new distributors in the last three years,
- Requires furnishing detailed substantiation regarding any earnings claims,
- Requires that the seller of a business opportunity provide a "disclosure statement" which would include information outlining legal action involving the company, such as previous lawsuits, the number of direct sellers who cancel within two years and a list of "references." i.e. purchases of the opportunity in the previous three years;
- Requires the maintenance of onerous detailed records of the company, including a 10-year record of legal actions against the company and any of its officers, directors, etc.
FTC'S PROPOSED BUSINESS OPPORTUNITY RULE:
Why is the FTC Proposed Business Rule of such concern to the industry?
DETAILED ANALYSIS of Problematic Provisions
On April 12, 2006, the Federal Trade Commission published its Notice of Proposed Rulemaking, and its proposed Business Opportunity Rule. 71 Fed. Reg. 19,053, (April 12, 2006), (to be codified at 16 C.F.R. § 437).
This rule will markedly expand the FTC's regulation of sellers of business opportunities, and as currently written, it will mean that all network marketing/MLM companies are subject to its provisions. The original FTC Business Opportunity Rule is narrowly drawn, and excluded many ventures that should have been considered business opportunities from its scope. With the proposed rule, in its current form, the FTC has gone in the other direction, expanding its net of regulation to basically all persons who solicit another to enter into a new business. There will be no more $500 minimum payment requirements to trigger application of the rule.
Under the new rule, a business opportunity is defined as an arrangement where a seller solicits a purchaser to enter into a new business where the purchaser makes a payment to the seller, and the seller, either expressly or impliedly; (1) makes an earnings claim, or (2) promises to provide business assistance. Business assistance is defined as promising to find locations to operate the business; providing outlets for products or customers for the purchaser's goods or services; promising to buy back any of the products or services; tracking or paying, or purporting to track or pay commissions or other compensation based on the purchaser's sale of goods or services, or recruitment of other persons to sell goods or services; and otherwise advising a purchaser in the management or operation of a new business.
It is clear that the FTC is specifically targeting network marketing businesses through the business assistance definition that includes the tracking of commissions based upon sales of product and/or recruiting. It appears from the Commission's comments that the FTC is chiefly concerned with fraudulent earnings representations. The FTC also claims that pyramid schemes often induce new recruits with the promise of an ongoing commercial relationship, including assistance in finding recruits, promotional assistance and that some offer training. These promises are sometimes not fulfilled.
The FTC feels that, in light of the number of complaints regarding pyramid schemes and misrepresentations involved with such schemes, pre-sale disclosures and conduct prohibitions are necessary. 71 Fed. Reg. at 19060-61. However, as currently written, the proposed rule has a number of provisions and effects that are extremely problematic for legitimate network marketing companies, and some provisions that are probably not workable in a network marketing setting.
Basically, if the rule applies to a transaction, the seller must supply all prospects with a one-page disclosure document setting out a number of categories of information. The seller must set out a seller's identifying information, and five substantive disclosures relating to:
- whether or not the seller makes earnings claims;
- the existence of criminal or civil legal actions;
- an explanation of any cancellation or refund policy;
- cancellation or refund request history for a rolling two-year period; and
- reference lists.
The first three of the disclosure items are "yes" or "no" items. Any "yes" answer with respect to earnings claims, legal actions and the existence of a cancellation or refund policy must be explained and/or supported with other documentation. For example, earnings claims are allowed provided the seller has a reasonable basis for making the claim and can substantiate the claim. If the seller has been involved in legal actions, details of the actions must be set out in a separate document.
This is an important issue to every company and many companies and trade groups, including the Direct Selling Association, and leading industry legal and marketing experts are actively involved in responding to the proposed rules. Much of the participation is through various tasks forces, legal and government relations committees of direct selling trade organizations. (Babener and Associates and www.mlmlegal.com, through Jeffrey Babener, is an active participant). The proposed rule has been the subject of multiple communication opportunities in which interested industry representatives have outlined a number of very problematic provisions and unanswered questions. One concern is with respect to the identifying information, and specifically, the definition of a seller under the rule. While it would seem obvious that the company is the seller, in the explanation of the disclosure documents, it is mandated that, in addition to identifying information relating to the seller, the name of the "salesperson" offering the opportunity should be set out. It is unclear whether or not this means every distributor. The definition of a seller also impacts the disclosures that must be made in the section of the disclosure document relating to legal actions, and this is not clear. It could be that the duty to disclose litigation will also extend to any "affiliate or prior business of the seller," or any of its officers, directors or high ranking executives.
The disclosure document rule also states that the company must maintain and disclose its cancellation and refund history. The seller will be required to keep a two-year rolling history of all cancellation and refund requests, and must provide the numbers to prospective distributors. Not only do industry experts believe this would be a logistical nightmare, concern has also been expressed that the nature of the MLM industry is such that cancellation and refund request numbers would not give a true picture of the value of a company.
However, the most troublesome item in the proposed disclosure document is the item relating to references that must be provided to all prospective distributors. The company has a choice with respect to providing these references. It can either provide the names of the 10 prior purchasers who are nearest to the prospect geographically, or provide the prospect with a national list of all purchasers. The companies would be required to provide a reference's name, city and state, and telephone number. This item of disclosure raises serious issues with respect to proprietary and trade secret information, and a distributor's privacy rights. On the latter point, the FTC suggests that the company should get written permission from all new distributors to be contacted in the future as references. However, this might have the effect of discouraging some prospects from becoming distributors.
In addition, the providing of the 10 latest customer's identities that are nearest to the prospect's address would also be a logistical problem. It was suggested that perhaps a company could set up a program using Mapquest-like software for identifying local references. In any event, complying with this facet of the rule would be extremely difficult. The FTC, in its proposed rule explanation, suggested that companies could establish a web page containing the names, cities, states and telephone numbers of all people who have purchased the opportunity in the last three years. Obviously, this approach is not workable from a competitive standpoint.
A final area of concern with respect to the disclosure documents, which is the subject of industry discussion, relates to the requirement that the disclosure document be provided to each prospect seven days before the company could enter into a contract with that prospect, or do business with the prospect other than as a retail customer. This provision would be a significant problem, given the immediate nature of network marketing.
INDUSTRY AND COMPANY RESPONSE AND ACTIONS.
This is the initial proposed rule from the FTC, and it is expected that it will be 18 months to three years before there is a final rule. The FTC will be taking written comments until June 16, 2006, and the members of the direct selling industry and the DSA will be preparing extensive comments.
Is the proposed rule a major threat to the direct selling industry? All experts and knowledgeable industry observers agree that this is one of the most significant threats to the industry since the FTC unsuccessfully challenged Amway as a pyramid scheme in 1975. Most industry experts believe that, at the end of the process, some compromises will be reached to preserve the existing direct selling opportunity because the alternative would be to impact significant damage on an industry that generates $30 billion in sales and involves 14 million individual distributors and tens of thousands of employees.
Legal and governmental relations representatives of major leading companies have convened to develop a short and long term regulatory and legislative policy, as well as to garner support and informed status of companies. For the most part, the joint strategy discussions are occurring through auspices of DSA subcommittees, such as the task force on the FTC Proposed Business Opportunity Rule, Lawyers' Council, Government Relations Committee and interface with companies. Included in the current plans for addressing this issue are the following:
- With the support of its task force, committee members and company input, the DSA is submitting a position paper to the FTC.
- During the next two to three years, the FTC will host multiple workshops and/or comment hearings on the proposed rule and has requested participation by the direct selling industry. Again, although the current expectation is that this process will take 18 months to three years, the industry was actually surprised that the proposed rule was released this spring and it could be surprised again as there is no guarantee on this time period.
- The industry and DSA and other industry trade associations continue direct discussions with staff members of the FTC who are responsible for the drafting of the proposed rule.
- The DSA and other industry trade groups are commissioning statistical and economic impact studies to prepare a statistical analysis of the impact of the proposed rule on the industry. The FTC is most interested in such studies.
- Representatives of major companies and the DSA and industry trade groups have begun a lobbying and information initiative with key members of Congress. The request is for Congressional staff to make themselves heard to FTC staff. In addition, if an unsatisfactory rule is adopted by the FTC, draft legislation would be introduced to neutralize the effects of the FTC Rule, or at least to raise the triggering threshold from zero to $500 or possibly $1,000. The model might be the sort of initiative carried out by the health products industry to enact DSHEA, protecting discussion of health benefits of dietary supplements, which was a response to overreaching rules and enforcement and policy positions by the FDA on dietary supplements. In fact, such a model might build on the direct selling industry supported Congressional bill, H.R. 1220, earlier introduced to address confusion on the "personal use" issue occasioned by FTC consent decrees and position statements issued since the mid 1990's.
- Law firms in Washington D.C., that include former FTC commissioners and staff, are being sought to exert future informational campaigns, and, if necessary, lobbying for relief from the proposed rule.
- Press initiatives by industry trade groups will be undertaken to demonstrate the adverse consequences of formal adoption of the rule.
- Ultimately, a grassroots initiative by distributors of direct selling companies will be encouraged.
- Companies will be encouraged to explain this issue to their distributors in a calm and deliberate fashion and to encourage various levels of distributor participation in the process. This issue will be on the minds of distributors for some time, and it will be important to treat this subject honestly and with their understanding that the company is standing behind them on this particular issue.