Multilevel marketers draw greater scrutiny
Saturday , August 02, 2014 - 10:47 AM
Enrique Martinez didn’t like chocolate, but he was eating as many as 10 pieces a day, drinking chocolate protein shakes and rubbing a chocolate-based skin cream on his face. It was expensive chocolate, too. Martinez and his wife, Michelle, were going through $2,000 in chocolate a month.
The debt they accumulated this way — more than $100,000 over five years — is now with a consolidation company. Their credit is ruined. There is a crack in the driveway at their home in Albuquerque from a 14-wheeler that once delivered 12,000 cans of chocolate energy drinks to their garage.
The chocolate came from MXI Corp., which uses a controversial business model called multilevel marketing. MXI has more in common with Avon Products, Herbalife and Amway than with a conventional candymaker such as Hershey. These are companies without a sales force that recruit their customers to sell products, often in bulk to other customers, who might in turn sell to other customers, and so on.
Critics accuse multilevel marketers of using slick pitches to persuade the unwary to buy goods in bulk, promising them that they’ll make money by selling those products to others. In this way, the companies are paid upfront, and the rank and file bear a good deal of the financial risk.
Defenders of multilevel marketing say the business model makes sense. They say the customers are largely enthusiasts who initially join to buy their favorite products at wholesale prices, not to make money. They add that, in any industry, satisfied customers often make the best salespeople.
What’s more, companies such as MXI offer these customers, who are effectively their salespeople, refunds on unsold inventory and other protections so that they are never forced to remain part of the organization. That many do so anyway demonstrates that the products are genuinely popular both in themselves and as a source of income, according to the Direct Selling Association, multilevel marketing’s trade group.
“These people are making a life for themselves, or helping themselves, however modestly, by virtue of this activity,” said Joe Mariano, the association’s president. (MXI is not one of its 171 members.)
Yet industry analysts and investors say that in some companies, nearly all recruits will lose money. Former multilevel marketing distributors compare the groups to cults. For decades, the model also has drawn scrutiny from regulators. Late last month, a grand jury returned a fraud indictment against the owners of a multilevel marketer called TelexFree that sold telephone services.
Bill Ackman, the wealthy hedge-fund manager who reportedly bet $1 billion that Herbalife’s stock price would fall, has accused the company of fraud, most recently in a presentation to investors last month. The company sells powdered protein shakes and supplements in what Ackman calls a pyramid scheme. Wall Street has heatedly debated his claims.
Herbalife revealed in March that it is under investigation by the Federal Trade Commission. The company has stated that it complies with the law and that it will cooperate fully with the investigation.
Critics — including consumer advocates, trial lawyers and business professors — hope the probe into one of the industry’s best-known brands and other recent actions mean that regulators have begun to police the industry more aggressively. Herbalife is “just the first domino,” said Brent Wilkes, the director of the League of United Latin American Citizens. “The whole industry has been allowed to fester.” Wilkes said multilevel firms are especially popular among Hispanic immigrants who use their tightknit communities to move products.
Despite the controversy surrounding multilevel marketing, the industry is thriving. Herbalife reported a gross profit margin of 80 percent on $1.3 billion in worldwide sales last quarter, a margin that is typical of publicly traded firms in the sector. The share price of Nu Skin, another multilevel marketer, tripled in 2013. Roughly 16 million Americans are involved in multilevel marketing each year, a number that increased sharply after the 2007-08 financial crisis.
MXI is privately held and does not release information about its sales. In a 2010 court filing, the company stated that it had 50,000 salespeople in its network. The company, established in 2005, calls its products “healthy chocolate” and claims that they can improve digestion, sexual health and general well-being.
Calls placed to the company’s headquarters in Reno over several months were not returned. Messages submitted by way of an online form and to e-mail addresses listed for the company’s founders - Jeanette Brooks and Andrew Brooks, her son - received no reply. Messages left on phone numbers listed for the Brookses went unanswered, even though Martinez said he spoke with Jeanette Brooks and informed her of The Washington Post’s story.
A public records search did not reveal any lawsuits against MXI, and no formal law enforcement investigations into the company have been announced.
Martinez made most of his sales the usual way. He and his colleagues recruited salespeople, known as “distributors” or “direct sellers,” to sell chocolate in all forms — aphrodisiacs and probiotics, weight-loss shakes and shampoo. To bring them in, he told them just what he’d been led to believe: that the business was lucrative. They bought inventory and, in turn, sought recruits.
Martinez acknowledges that he made poor decisions. He’d misled recruits about making money. He should never have ordered that truckload of energy drinks.
He could have left MXI earlier. The hairstylist had dabbled with 16 other multilevel marketers over three decades, including Herbalife and Nu Skin. He lost a little bit of money every time, but he convinced himself that he just hadn’t put in the work. This time, he was committed.
On MXI’s promise of “increased income and lifestyle security,” he continued to borrow. He and the other salespeople deluded one another into thinking they were all on the point of becoming fabulously wealthy, he said.
“Eventually, you come to realize: There’s something really wrong here, and I just can’t keep lying to people,” Martinez said. “Everybody’s lying to each other.”
What is a pyramid scheme?
In the controversy over multilevel marketing, the central question is whether the companies are fraudulent pyramid schemes. There is no federal law defining a pyramid scheme, and courts have interpreted the concept in various ways.
“A significant percentage of MLMs could be pyramid schemes,” said Bill Keep, the dean of the School of Business at The College of New Jersey — and the man Wall Street turns to with questions on the matter. “We don’t know how much.”
Traditionally, pyramid schemes are organizations in which people pay some amount to join and then can profit by recruiting other people to buy into the organization. Bernard Madoff’s infamous swindle exploited new investors to pay off earlier investors. Such schemes, which have no products to sell and depend on new recruits for revenue, are widely recognized by the courts as fraudulent.
Multilevel marketing organizations are relatively ambiguous because of an unusual characteristic many of them share: Most of their customers are salespeople who also buy products for themselves. Many dissatisfied former distributors have stories, like Martinez’s, about gorging themselves on the companies’ products.
The industry’s defenders point to these customers as evidence that the companies are filling a demand in the market. In surveys commissioned by the trade association, more than half of distributors identify discounts on products as a reason they joined the ranks of multilevel marketers.
On the other hand, opponents of multilevel marketing contend that distributors buy inventory solely to establish and maintain their position in an organization, with the goal of making money. Bruce Craig, a retired assistant attorney general for Wisconsin who successfully prosecuted several multilevel networks, estimated that about 99 percent of recruits in major companies will take losses.
In any case, many distributors discover that the only way to find new buyers for products is to recruit new distributors. Whether these recruits want the products for themselves or are hoping to make money is generally not clear.
That fact makes it difficult to distinguish between a legitimate retailer that seeks to broaden its base of customers and a fraudulent pyramid scheme that relies on continual recruitment.
The trade association requires its members to offer distributors refunds on unsold inventory, arguing that refunds allow distributors to keep only the products that they want for themselves or can resell. “No pyramid scheme would ever be able to sustain such a policy,” said Mariano, the association president.
Yet advocacy organizations say that even when refunds are available, the emotional pressure of multilevel marketing and the close relationships that develop among distributors can lead them to consume or throw away unwanted products rather than return them. “These companies have some sort of magical hold over people,” said Wilkes, whose organization began collecting Latin Americans’ complaints about Herbalife and other multilevel marketers after discussions with Ackman, the hedge-fund manager.
Mariano called it “extraordinarily elitist” to suggest that so many people could be so easily brainwashed. He also accused Ackman of manipulating investors and journalists, impugning Herbalife, and multilevel marketing generally, for his clients’ financial gain.
“The real people that are direct sellers are somehow going to rely upon a Bill Ackman or a Washington Post reporter to represent them and protect their interest, and they can’t?” Mariano said. “I find that, on their behalf, so offensive.”
But without a clear standard for identifying pyramid schemes, critics argue, prosecuting even unambiguously fraudulent companies is difficult.
“Regulatory actions over the last 20 years have been insufficient to provide, I think, good consumer protection,” Keep said.
Products of the product
After five years in which Martinez and his wife dedicated their lives to selling healthy chocolate, he gave up on the business model.
Enrique and Michelle Martinez joined MXI during the financial crisis in 2008, worried that the economic downturn would reduce Enrique’s income from his hair salon in Santa Fe. It seemed ideal for them. Enrique describes himself as a natural salesman. ("I have the gift of gab,” he said.) Michelle has an MBA, and she got her start in business as a girl when she worked in her mother’s clothing store. She later became a part owner.
Multilevel marketing was a new kind of challenge for Michelle. She was busy from 8 a.m. until 8 p.m. on weekdays and sometimes later, running chocolate from the salon’s office while Enrique cut hair and talked up MXI’s products. (A small box of 84 squares, individually wrapped like Ghirardellis, cost $125.) On weekends, the pair would hold chocolate tastings. Along with their recruits, they moved as much as $4,000 in chocolate a week. They hid the fact that they were losing money.
It fell to Michelle to reassure recruits who felt that making money for MXI was not as easy as the couple had led them to believe. It was emotionally exhausting. “People would call up angry,” she said. “You were battling a lot of doubt in the industry.”
She was always on the phone. When she wasn’t advising recruits, she was discussing strategy with distributors above her in the organization. They talked about multilevel-marketing precepts such as “Be a product of the product.” In other words, to learn about their products, effective salespeople become avid consumers themselves.
“Knowledge on ice, ignorance on fire” was another maxim: Distributors should concentrate on selling and recruiting, not on learning about the industry. On these calls, the distributors maintained one another’s morale.
Michelle had doubts of her own, but multilevel marketing had become her world. She was constantly in touch with people who purported to believe absolutely that they would make money, including her husband and several distributors she counted among her closest friends.
“I was the one that was always encouraging her,” Enrique said.
While Michelle managed the business, Enrique was the promoter, always scouting prospective buyers. He’d cleared out all the hair products for sale on the shelves in the salon and replaced them with chocolates, telling clients that selling MXI products was more remunerative. And though he failed to find steady retail customers, he refused to admit that his pitch to recruits - that MXI was a profitable opportunity - might be misleading.
Instead, the chocolate to which he’d hitched his hopes of financial success took on an irrational importance for him. He had joined to make money, not for the chocolate, but his initial distaste for the products transformed into zeal. He started telling everyone he knew that MXI’s probiotic chocolate had cured his acid reflux.
“There’s something that happens to you, where you start to believe your own” sales pitch, he said, using an obscenity.
Along with the chocolate, however, Enrique did not stop taking the heartburn medication Prilosec.
He and Michelle advanced to the Platinum level in MXI’s hierarchy of distributors in April 2012. To qualify, the couple bought $113,459.88 in chocolate, paying with their credit cards. Their income as Platinums didn’t cover their debts. After about a year, they were forced to confront their complicity in what they now say was a business model driven by recruitment.
“Looking back on what I’ve done,” Enrique said, “I’ve had to do a lot of apologizing.”
He’s started seeing a therapist. Michelle couldn’t sleep all last summer. Awake at night, she filled a journal with entries like this one, from May 28, 2013: “I am so worried about the inventory we have. I don’t know what to do and am being pushed and encouraged to purchase more.”
The chocolate company is not a trade association member, but it is not clear that the policies mandated by the association’s code of ethics would have helped Enrique and Michelle.
As the association requires of its members, MXI refunds distributors for unsold inventory. Enrique and his wife had stored much of their chocolate for more than a year, and the repurchase policy had expired. They sold the last of the products online, for pennies on the dollar, a few months ago.
Even though their house was full of chocolate, the couple stopped using MXI’s products. They had convinced themselves of the health benefits of chocolate as a way to rationalize their investment in the business. Once they stopped believing in the model, they could no longer believe in the products.
“The reason I hyper-consumed was the promise for building a business,” Michelle said.
The more she and Enrique consumed the chocolate, she said, the more it consumed them. They became products of the product.
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