Reese Introduction What is a Binary Compensation Plan? The Legal Framework Governing Binary Compensation Plans The Bottom Line Endnotes Binary compensation plans have become the darling of startup multilevel marketing companies. They are relatively simple to understand and offer fast-paced growth opportunities. Companies find them attractive for the same reasons. In addition, several companies utilizing binary plans have recently entered the market and generated eye-popping sales and profits. This, of course, has led to an influx of programs modeled after the highly successful plans. Unfortunately, not all that glitters is gold. In the last 24 months, the multilevel marketing industry has seen a dramatic increase in regulatory actions. These actions have come in the form of joint plan between the states and the Federal Trade Commission notably Project TeleSweep in and Project Missed Fortune inas well as numerous individual and joint state actions. Companies utilizing binary compensation plans marketing been hit particularly hard in these actions. As a result, those companies that have been hit have had stringent limitations placed on their programs. These limitations oftentimes strike at the heart of their method of doing business and require significant changes to their marketing approach So what is the problem with binary plans? Why have states attacked them with so much more vigor than companies utilizing other compensation plans? Yes, they can be designed to operate legally, but in addition to proper design, companies must properly implement their programs so that they accurately follow the design. Several relatively new MLMs that entered the industry using binary plans simply failed to adhere to the legal principals governing the MLM industry in implementing their plans. Unfortunately, these companies were quite visible, and consequently there have been highly publicized actions brought against them. Naturally flowing from these actions is a great deal of bad press that has tarnished the image of binary plans, including those that are operating legitimately. Fortunately, solutions are available, but they require companies to carefully analyze their programs and make some painstaking changes. This article will discuss several key areas of law applicable to the multilevel marketing industry and apply these legal principles to the operation of binary compensation plans. In conducting the analysis, it will focus on a common binary format utilized by companies selling prepaid long distance telephone cards. Although not all binary plans follow this format, it is a blueprint that has been frequently copied by new companies entering the marketplace. Moreover, since companies selling prepaid plan cards utilizing this format have been among the hardest hit by regulatory agencies, these plans provide an ideal case study for legal analysis. Bear in mind however, that the principles apply to all binary programs regardless of the product or service that is being offered. The plans used by marketing prepaid telephone card companies are simply an illustration of problems that can arise in any program What is a Binary Compensation Plan? A binary plan is a multilevel marketing compensation plan which allows distributors to have only two front-line distributors. When a distributor enrolls, he is automatically assigned his first business center. The distributor may then purchase additional business centers and place the centers at strategic locations within his downline organization. Each business center must independently meet their two person enrollment requirements. Historically, Distributors have been allowed to purchase up to seven business centers, but the current trend is to allow only three centers. A common component to binary plans is a three phase sales and compensation cycle. One business center is placed on his right downline leg and the other on the left leg. After business centers have been enrolled i. Fifty sales completes the first phase of the compensation plan. This completes phase two. In addition to phase three income, the programs usually allow distributors to participate in phases one and two concurrently with phase three. Multilevel pre-paid telephone card companies have adopted the binary plan as the program of choice. Until recently, most programs were strikingly similar to one another, right down to the prices charged for the products. Recently, companies have begun lowering their prices as they have recognized the necessity of becoming more price competitive. Return to Contents The Legal Framework Governing Binary Compensation Plans Amid the confusion and concern over the legality of binary plans, many people have lost sight of the fact that binary plans operate under the same laws that govern other multilevel compensation plans. There is no law stating that operation of a binary compensation plan constitutes a consumer fraud, or a company using a binary plan is a pyramid. Thus, so long as the implementation of a binary plan complies with the laws governing the operation of multilevel business, it will be legal. However, because of their structure, binary plans have unique challenges to implementing their programs within that legal framework. Four principal areas of law governing the multilevel marketing industry are anti-pyramid laws; 2 business opportunity laws; 3 securities laws; and 4 lottery laws. A comprehensive discussion of each of these areas of law is properly the subject matter of its own article. However, a brief overview will assist us in examining which aspects of a binary plan present the greatest risk of running into legal problems. Pyramids are illegal in every state as well as under federal law. It would be convenient if these laws were uniform and cohesive; unfortunately, the industry is not so lucky. The application and enforcement of the laws varies from state to state, so the best we can do in the limited space of this article is generalize about what actions will cause a company to violate pyramid laws. This rule appears straightforward, but its application can be difficult because most pyramid operators are not so foolish as to blatantly pay a commission based on recruitment of other participants. Rather, they typically disguise the program as a legitimate multilevel marketing business by offering a product or service that the distributors can sell. Law enforcement officials have, however, seized upon dicta contained in the recent Ninth Circuit Court of Appeals decision in Webster v. If the products or services are being purchased and used primarily by individuals who are participating in the compensation plan, or who are purchasing in order to qualify for compensation, they contend that the sale is not a true retail sale. Following this line of reasoning, they have attacked programs not just binary plans as pyramids. If, on the other hand, distributors are retailing the goods or services to persons who are not involved in, or trying to become involved in, the compensation plan, regulators consider a legitimate retail sale exists. Since actual distributor surveys presenting data on retail sales levels are generally not available at the investigatory stage, there are several factors which regulatory officials consider evidence that a program is not offering a true retail sales opportunity. Principal among these are excessive inventory requirements; overpriced products; 3 a primary emphasis on recruiting rather than product sales. A court or regulatory body will look skeptically on programs that generate sales through excessive inventory requirements. These purchases, whether a front-end load or a monthly maintenance requirement, will be viewed simply as a participation fee from which commissions are paid. Of course, it is common for multilevel companies to require monthly production quotas of their sales force, so the mere fact that a maintenance requirement exists does not prove that no true retail opportunity exists. The amount distributors must spend must also be binary into consideration. Programs with high mandatory purchase requirements will be scrutinized much more closely than programs with modest requirements. Although there is no magic number as to what constitutes a monthly maintenance quota that is too high, a strong dose of common sense is in order. Binary plans are closely watched by law enforcement officials because they plan significant investment in inventory as distributors progress through the phases of the program. This danger is magnified even further if the distributor operates multiple business centers. Clearly, the danger that a distributor will be loaded with unsaleable merchandise is significant under this scenario. Because retail sales are so important in the eyes of regulators, multilevel companies must ensure their products are priced competitively. Distributors simply will not be able to retail goods and services that are too expensive. Regulators recognize this, and therefore those programs whose products and services are excessively priced will be subject to greater regulatory scrutiny. In this case, regulators and courts will consider the product simply a disguised recruiting fee. Many companies operating binary plans have found themselves under the regulatory microscope partially as a result of excessively priced products. This is dramatically higher than the price of phone cards offered through retail channels, which typically range from 20 to 50 per minute. Based on the difference in price between the retail cards and those offered through binary plans, there is no reason for a consumer to purchase a phone card through a binary plan other than to participate in the compensation plan. Thus, the likelihood of these goods being retailed by distributors is slim to none. Because excessive prices precluded any meaningful retail sales opportunities, distributors often simply gave away excess cards as a means of garnering the interest of prospects. Whether or not this was done at the urging of company officials will be disputed. Regardless of the source, however, the practice cast a negative shadow on those programs that engaged in it. Regulators take the view that if a product must be given away, it has little or no legitimate economic value. Absent any inherent economic value attached to the product, the price paid by distributors is simply a masked head-hunting fee, and the program will collapse without a constant supply of new recruits. If a program primarily focuses on recruiting new distributors rather than sales of products or services, law enforcement officials will attack it as a head-hunting operation. Legitimate programs are driven by the sales of products and services, not by recruitment of new people. This is plan to say that companies should not train distributors in recruitment techniques, for clearly, recruitment is an essential component to building a multilevel business. However, companies must strike a balance between emphasizing recruitment and product sales. On this point, there is no magic formula to determine whether excessive emphasis is placed on recruitment, as this is a very subjective determination. Companies should be advised, however, that attorney generals will attend their meetings incognito, and will literally put a stopwatch to the duration of the product discussion and the compensation plan discussion. This is oftentimes an unfair practice, as a compensation plan may be much more difficult to explain than is a product or service, but it is nonetheless a common practice. The design of binary plans arguably focus on enrollments rather than sales in two key ways. This problem is easily resolved by requiring distributors marketing balance the sales volume in each of their legs rather than to balance the number of enrollments in each leg. If for example a program required distributors to have at least one-third of their total sales volume in each leg to qualify for commissions, the direct relationship between enrollments and commissions is diluted. The second design aspect of binary plans which results in an emphasis on recruiting over sales arises from the practice of marketing multiple business centers. The Federal Trade Commission and many of the states regulate the offering of business opportunities. Therefore, if classified as a business opportunity, the promoter must make detailed disclosures about the program, its finances, the history of the business, the personal history of the promoters, the identities of other distributors, and binary detailed information. In some states this information must simply be filed with the state, whereas other states require the promoter to provide each prospective distributor with a copy of the disclosure statement ten days before the distributor can be enrolled in the program. In addition, some states require the promoter to secure a surety bond before doing business in the state. These onerous requirements will suffocate any multilevel marketing opportunity. The drafters of business opportunity statutes recognize that not every investment of money constitutes a significant sum which requires regulatory intervention. Prudent multilevel companies seek to avoid being classified as business opportunities by keeping required purchases below the initial investment threshold limits. Close analysis of many MLM programs reveals that although distributors must meet monthly quotas, these quotas can usually be satisfied by purchases made by their direct retail customers. Under this approach, a modest monthly quota can result in the institution of an investigation or enforcement action. To date, states have had success in negotiating settlements based on this argument. Regardless that these purchases are optional, if the company or its field force place an emphasis on the purchase of multiple centers, regulators will argue that these purchases are in reality required initial investments. Moreover, mandatory inventory purchases will also be added to the total. Selling an unregistered investment contract security is strategy serious issue for multilevel companies, for there are significant criminal and civil penalties that can be imposed. Neither the Securities Act of nor the Securities and Exchange Act of define an investment contract. Rather, the definition has been supplied by a series of United States Supreme Court and Circuit Court of Appeals decisions. These decisions have established a three part test to determine if an investment contract exists. These elements include an investment of money; 2 in a common enterprise; and 3 the investor is lead to anticipate profits primarily from the efforts of the promoter or some third party. Of these three elements, courts and regulators focus most keenly on the third element. While this is not a technically correct application of the law, you are probably getting the idea by now that in the real world, the law is not always applied in a technically correct fashion, particularly at the administrative investigation stage. While all multilevel companies must be careful to avoid promoting their programs as securities, binary plans must be especially cautious due to the inherently rapid spillover rate which results from each distributor having only strategy front-line positions. Unfortunately, since the spillover is one of the most attractive features to binary plans from a marketing standpoint, companies have been anything but bashful about trumpeting the downline building power of the system. The message is that all a distributor need do is enroll two people. In any event, the managerial efforts which a distributor must put forth to be successful are minimal, and therefore the income stream is largely a passive investment because it is generated primarily from the efforts of strategy. To avoid this pitfall, distributors must engage in true managerial activities to build their businesses and promote sales. Strategy companies have a policy that requires distributors to continue to train, supervise, and motivate their downline, as well as ongoing sales requirements. These policies should be taken seriously as they impose ongoing managerial requirements on distributors so that their income is not primarily dependent on the efforts of others. Lottery issues always follow on the heels of securities issues. A lottery exists when an individual pays consideration i. If a distributor need only get two enrollees, law enforcement officials will argue they must be relying heavily on luck that a productive downline will be developed below them because the distributors are putting forth only minimal effort to personally contribute to its success. Companies must remove the element of chance from their programs to avoid falling prey to lottery laws. As with the securities analysis, this is done by requiring participants to engage in bona fide management responsibilities and ongoing sales and marketing efforts. Again, how much is enough will be determined on a case-by-case basis as individual programs are analyzed. In addition, the mandatory purchase of product to activate a business center and to re-enter a phase provides ample support for the position that the consideration element of the lottery test is satisfied. By removing all mandatory purchase requirements from a program, companies will be able to argue that the consideration element is not satisfied The Bottom Line Binary plans definitely have their place among multilevel compensation plans. There is no question that they can be designed and operated legally. However, companies using the plans have had more than their fair share of law enforcement actions brought against them. But the battles that have been fought are teaching the industry a lesson, and industry is listening. We are seeing companies that have been attacked by regulators changing their plans to diminish the potential for inventory loading and to increase the ability of distributors to engage in bona fide retail sales of merchandise. Similarly, new companies that adopt binary plans are not all following the standard format of the prepaid phone card companies that have run into so much resistance from regulators. The current trend is to allow only three business centers rather than seven, to balance legs based on sales volume rather than enrollments of new business centers, and to require distributors to engage in retail sales activities before allowing them to collect commissions or cycle into subsequent commission phases. Is it too little too late? Certainly binary plans have been tainted in the eyes of many regulators, and they are now viewed skeptically. The negative press that follows a regulatory investigation is sufficient to cause serious problems for a company. To address this problem, it is up to the companies using binary plans to teach regulators how they differ from plans that have been attacked in the past. Those companies that cling to the old ways of the binary plan may prosper in the short term. However, given the recent barrage of regulatory action we have seen against companies using this format, it is a safe bet that those who do not voluntarily change will have changes forced upon them through regulatory action. Return to Contents Endnotes Spencer Reese is a partner in the law firm of Reese, Poyfair, Richards PLLC. He is a graduate of the Washington University School of law and binary a member of the Idaho, Missouri and Colorado bars. He was formerly in-house counsel for Melaleuca, Inc. Reese can be contacted at Some well recognized companies appear on the list of those attacked by regulatory agencies. On February 4, the Arizona Attorney General entered into a settlement agreement with Tele-Sales, Inc. More importantly, however, the Arizona A. On February 28,the Alameda County Prosecutor and the California Attorney General entered the offices of Destiny Telecom and seized business binary to be used in actions against the company. InStrategic Telecom Systems, Inc. Code One company, Travel Max, recently did take this issue to court in Kentucky. The state requested that the court impose a temporary restraining order on Travel Max operations based on the arguments that Travel Max was operating a pyramid and an unregistered business opportunity. Before using the information found on this site, please see our disclaimer Home About Us Attorneys Spencer M. Richards Practice Areas Additional Services Our Clients What Our Clients Say Articles Law Library Guides and Reference Materials Articles Cases Statutes and Regulations Events Blog Contact Us Contact Spencer Reese Contact D. Poyfair Contact Steven Richards Binary Compensation Plans Double Trouble!! This, of course, has led to an influx of programs modeled after the highly successful plans Unfortunately, not all that glitters is gold. Naturally flowing from these actions is a great deal of bad press that has tarnished the image of binary plans, including those that are operating legitimately Fortunately, solutions are available, but they require companies to carefully analyze their programs and make some painstaking changes. The plans used by the prepaid telephone card companies are simply an illustration of problems that can arise in any program Return to Contents What is a Binary Compensation Plan? They offer Oxyfresh different views, options and perspectives on age-old legal problems. They are available 24 hours a day during crisis situations and have treated us like we were their only clients. It has prevented Oxyfresh from making costly mistakes and assisted us in correcting potential problems. The attorneys at the firm have such a thorough understanding and grasp of the legal issues facing the dietary supplement and cosmetics industries and the multilevel marketing channels of distribution, as well as the operations of our company, that they are able to respond to our questions and issues in a manner that is quick, thorough, extremely competent and highly economical. As a result of working with them, we got a glowing letter of praise from FDA. Poyfair East Fort Union Boulevard, Suite 115, Cottonwood Heights, UT Tel Email Spencer Reese Email Steven A. The Legal Framework Governing Binary Compensation Plans The Bottom Line Endnotes.
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