H.R. 3409 Provides a Long-Needed Federal Definition of a Pyramid Scheme

I served as attorney general for the state of Washington from 2005 to 2013. I used my time in office to fight for the security of Washington families and consumers and vigorously prosecuted cases of identity theft, internet fraud and child pornography.

I helped lead cases brought by the National Association of Attorneys General against subprime lenders who contributed to the destruction of the housing market in 2007, which resulted in some of the largest settlements in the history of consumer protection.

The priority my office placed on protecting consumers included a focus on fighting a pernicious form of fraud known as pyramid promotional schemes. Pyramid schemes persuade their victims to pay high upfront costs ostensibly to sell a product. But they do not offer compensation for selling the product, only for recruiting others into the scheme.

All 50 states have anti-pyramid scheme laws. Twenty-one states have laws based on model legislation proposed by one of the nation’s pre-eminent nonpartisan policy organizations, the Council of State Government. However, when I came into office, the state of Washington did not have effective legislation to protect consumers and honest businesses against pyramid schemes.

In 2006, we worked with Washington legislators to unanimously pass an anti-pyramid scheme bill based on the CSG recommendations. Those recommendations included, among other things, that internal consumption of the product in the direct selling retail channel should be recognized as a legitimate transaction so long as those sales were made by people who wanted and used the products they purchased.

Inexplicably, there is no federal statute defining pyramid fraud. But Reps. Marsha Blackburn (R-Tenn.) and Marc Veasey (D-Texas) are trying to remedy that oversight, and they should be strongly commended for their effort. They recently introduced H.R. 3409, Anti-Pyramid Promotional Scheme Act, based on provisions of the model legislation Washington and 21 other states have adopted.

The Blackburn-Veasey bill would strengthen the prosecution of pyramid schemes by providing a sanctioned definition that exposes the fraudulent imitation of legitimate businesses without wrongly tarring with the same brush direct sellers who purchase and use their company’s products.

Direct selling companies that contract with independent distributors to sell goods and services are particularly vulnerable to unfair association with pyramid schemes, which deliberately impersonate attributes of their industry. Unlike pyramid schemes, direct sellers compensate their salespeople for selling actual products to actual users of the products. Those end users might be salespeople themselves, and there is nothing wrong with that as long as they actually want the products and aren’t compelled to purchase them because they were saddled with inventory they couldn’t sell.

People get involved in direct selling for different reasons. Some direct sellers are entrepreneurs building a small business using a network of salespeople they recruit. Many more have less ambitious reasons, selling only part time to supplement family incomes or because they enjoy the social aspect of direct selling. Many others are involved simply because they enjoy a company’s goods or services and wish to associate with the company to buy its products at a discount. All are legitimate enterprises and deserve to be recognized in the law and protected from fraud and mistaken identification with pyramid schemes.

The Blackburn-Veasey bill includes an additional provision to ensure that internal consumption is legitimate. It mandates that direct selling companies offer to repurchase unsold inventory from their distributors for at least 90 percent of the original cost. Such a guarantee will protect honest salespeople from being stuck with inventory they don’t want and can’t sell.

The bill also closely follows extensive state and federal case law on pyramid schemes. And nothing in the bill would interfere with the ability of federal regulators to police the direct selling industry.

It is long past time that the federal government followed state governments and the courts by clearly defining pyramid fraud to facilitate its successful prosecution and protect consumers, honest businesses and entrepreneurs from serious harm.

Robert McKenna, a partner in Orrick’s Seattle and Washington offices, is co-head of the firm’s Public Policy Group and co-founder of Orrick’s Cyber Security & Data Privacy Group.

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