Thursday, January 30, 2014

MLM Dictionary: Omnitrition Case

The term "Omnitrition Case" refers to "Webster vs. Omnitrition" class action lawsuit that was argued in 9th Circuit Court (of Appeals) in 1996.

Explaining the Case

(editor's note: I am not a lawyer, so you can read the full case, and summaries by several MLM attorneys and MLM critics near the end.)

Omnitrition was started by Roger Daley, who had previously worked at Herbalife in the 1980's, and may have known Mark Hughes, founder of Herbalife, quite well. When Herbalife hit a rough patch, Daley went off on his own with a few close Herbalife fellow sellers and created OmniLife 4, a liquid supplement formula that became the foundation of Omnitrition International. Later, when Omnitrition hit a rough patch,  in the 1990's, he was served with multiple lawsuits, including the Webster vs. Omnitrition.

Shaun Webster and Robert Ligon worked for Omnitrition until they, in 1992, decided to sue Omnitrition International, a MLM selling vitamins and such supplements, charging it as a pyramid scheme. The case gained "class action' status, as it sought relief for all similar reps who had allegedly been cheated by Omnitrition. Webster also charged Omnitrition with violations of securities law as well as violations of California's "endless chain" (pyramid scheme) laws, as well as various other laws such as RICO (racketeering), wire and mail fraud, etc.

At the time, Omnitrition's comp plan has distributors (no multi-level commssion), and various ranks of supervisor. Lowest rank, "bronze supervisor" requires $2000 order in one month, or $1000 orders over two consecutive months. The order goes to Omnitrition.  (Omnitrition's comp plan is very similar to Herbalife's comp plan, because Daley used to work at Herbalife)

Omnitrition's defense is that it had followed Amway Safeguard Rules and thus it cannot be a pyramid scheme if Amway was ruled not a pyramid scheme by the FTC (per FTC vs. Amway).

District Court ruled in Omnitrition's favor in 1994, granting it a summary judgement ("Not pyramid scheme") and thus essentially dismissing the lawsuit. Webster appealed.

The 9th Circuit Court of Appeals reviewed the case in 1996 and found that the district court have ruled the summary judgement in error in not considering sufficient evidence. However, it had also ruled that some additional charges brought against Omnitrition's lawyers and such are not valid and the summary judgement issued by lower court for those are affirmed.

The Omnitrition Defense

Omnitrition's defense at the 9th Circuit court centered on 3 themes:

1) Omnitrition does not charge money to become a distributor (lowest rank), therefore it does not meet test 1 of the Koscot Test (see Koscot test at end)

Court rejected this defense, because distributor is only a small portion of Omnitrition's affiliate ranks. If one must purchase a large order to get "full benefits" of the program, i.e. "rank of supervisor" for several thousand dollars, then "free" rank with limited benefits is of little to no consequence. Test 1 is indeed met.

Furthermore, since the commission is based on what the downline purchased from Omnitrition, rather than the amount SOLD by the downline (i.e. retail), it is NOT related to sales, and thus meets "test 4" of the Koscot test.

2) Omnitrition claimed Webster did not submit sufficient evidence that proves Omnitrition is a pyramid scheme.

Court also rejected this defense, pointing out that the way the compensation plan is structured, would encourage members to jump in and buy a large order ("start off as supervisor!") and thus profit the upline, thus people are encouraged to sell the opportunity, not the products, and that is a pyramid scheme.

3) Omnitrition claimed that it has adopted the Amway Safeguard Rules, which is sufficient to prove it is not a pyramid scheme.

Court rejected this defense, pointing out that pseudo-compliance does not ensure the company is not a pyramid scheme. Omnitrition's version of Amway Safeguard rules are actually WEAKER than Amway's own, and Amway's defense was only accepted after a full trial and audit of retail which proved that no inventory loading had occurred. Thus, mere aping Amway Safeguard rules is not sufficient defense.

Furthermore, Omnitrition only produced evidence of "Ten Customer Rule". Omnitrition produced no evidence that the 70% (recorder) rule was followed, merely distributors "self-certifying" that they will not order until they have retailed (or consumed) 70% of their inventory. Furthermore, Webster have produced proof that "self-consumption" (i.e. no retail sales) is enough to satisfy the 70% rule. The court ruled: " If Koscot is to have any teeth, such a sale (for self-consumption?) cannot satisfy the requirement that sales be to 'ultimate users' of a product. "  Indeed, distributors who 'self-consume' are treated differently from retail customers, who enjoy a 30-day money back guarantee. Distributors have to accept the 90% refund (up to 3 months).

Court also found that the 90% refund for only 3 months is substantially weaker than Amway's buy-back.

There are a LOT of other technical details regarding a LOT of the other claims, like racketeering, securities fraud, and so on.

Notable Takeaways of the Ruling

a) The Court wrote: "The mere structure of the scheme suggests that Omnitrition's focus was in promoting the program rather than selling the products... The promise of lucrative rewards for recruiting others tends to induce participants to focus on the recruitment side of the business at the expense of their retail marketing efforts, making it unlikely that meaningful opportunities for retail sales will occur."

In other words, whether the compensation plan focuses on promoting retail vs. promoting the opportunity itself, determines whether the plan is a pyramid scheme. If a compensation plan is tilted toward recruiting, then it is probably a pyramid scheme as it is unlikely there will be any "meaningful retail sales".

Please also keep in mind that this is in ADDITION to the "Koscot Test", which the court also used in this decision.

This is interesting as this basically shows that the court knows about "product-based pyramid scheme" where "fake retail" was used to disguise the pyramid scheme from the Koscot Test. Basically, the court understands that if the plan encourages people to "buy products" just to participate in the compensation plan, and not for retail, it is a pyramid scheme.

b) The Court wrote: " If Koscot (test) is to have any teeth, such a sale cannot satisfy the requirement that sales be to 'ultimate users' of a product."

The sale aforementioned is the distributor claiming that s/he 'self-consumed' the products purchased "wholesale", thus acting as his/her own retail customer, and sold the inventory to him/her-self, to satisfy the 70% rule. This has several interpretations.

The "strict" interpretation, usually held by critics of MLM, is that this outlaws any "self-consumption" as "cheating" the Koscot test.

The "loose" interpretation, usually held by DSA, is that this irrelevant, since a self-consumer *is* an ultimate consumer.

However, this statement cannot be evaluated in isolation. This part is closing a loophole in understanding A and Koscot Test. It is possible for a scheme to adopt products as a disguise. Unless there is clear retail and the purpose for the wholesale purchase is to retail (and not merely to qualify oneself), the scheme is likely to be a pyramid scheme. Furthermore, you can't have a loophole that allows the distributor to "self-consume" the products, thus creating confusion on what is the real intent of the purchase. Is it for resale... or is it just to participate, i.e. "pay into the program"?

It really makes no sense for a distributor to consume his/her inventory any way. It's against any sound business principle. You can't sell what you consumed.

c) The Court also gave a new definition of inventory loading, "'Inventory loading' occurs when distributors make the minimum required purchases to receive recruitment-based bonuses without reselling the products to consumers."  This definition is different from the Amway decision where FTC defined it as non-returnable purchases downline makes to enrich their uplines.

This definition is more applicable product-based pyramid schemes where distributors are simply encouraged to buy inventory, but not for actual retail sales. Furthermore, while the inventory can be returned, there is no incentive to actually do so, even if it results in financial loss, because it would undermine their plan to benefit from recruiting additional participants who were also encouraged to buy inventory (but not retail them).

d) The court, in analyzing comp plan, ruled that paying upline commission based on downline's purchase FROM Omnitrition satisfies Koscot Test item 4, commission is de facto based on recruitment, and NOT based on (retail) sales. Consider that Omnitrition highly encourages distributors to go for at least "supervisor", i.e. minimum purchase to pay full share of commission the commission is based on how many people they can recruit who also buy in at full share.

Aftermath of the Case

Omnitrition suffered a resounding loss in the case by the 9th Circuit Court. The case is sent back to the lower court to be retried. Before the district court can retry the case Omnitrition settled with the Webster, et. al. for undisclosed amounts.

DSA tried their best to minimize the impact of Omnitrition case. Their "virtual museum" does mention Omnitrition, but in a completely irrelevant manner, and in a single sentence that said nothing about its impact on the direct selling industry. Since then, it has basically ignored Omnitrition case altogether, mainly by claiming that the 9th Circuit Court had blundered, that why does MLM have to prove it is NOT a pyramid scheme over and over again. This type of view is best explained by MLM Attorney Jeff Babener in his view on Omnitrition (see reference for link):
The ninth circuit's approach is a serious threat to the direct selling industry because it creates a presumption of illegality of a multilevel marketing plan. The approach is inconsistent with the realities of the direct selling industry because it denies the ability of a multilevel marketing program to count personal or family use by distributors as "sales to the ultimate user." Almost all leading direct selling companies pay commissions based on the wholesale movement of product, and, recognize personal and family use by distributors as legitimate retail sales. Despite paying commissions on wholesale movement of product, the direct selling industry has protected its distributors from the abuses of inventory loading pyramid schemes by well-established buyback policies and the 70 percent rule.
The problem with Mr. Babener's explanation is "but everybody else does it too" is not a valid defense. Indeed, are there any "direct sales" companies where sales people are encouraged to sell to themselves? The self-consumption problem is unique to MLM.

Mr. Babener can't seem to recognize that he's trying to refight the last battle, the FTC vs. Amway battle back in 1979, in 1996. Comp plans change. Pyramid schemes evolve.  What worked as a defense back in 1979 may not work in 1996.

Furthermore, DSA has sought to end-run takeaway (b) above by asking various countries around the world, such as Canada, as well as several US states, to pass anti-pyramid laws that specifically exempted "self-consumption" to defining "retail sales" as both sales to public and sales to distributor him- or herself and his/her family.

FTC itself has issued somewhat contradictory advisories since the Omnitrition case. In 2004 staff advisory opinion, it has refused to issued "hard" guidelines like "if >=X percent of sales is retail, then it's not a pyramid scheme". Their explanation is that the crooks will go right up to the edge and use other disguises to go past it. Instead, they prefer to analyze the comp plan itself and determine what is the intent of the distributors when they purchased inventory from the company?

In other words, just like takeaway (a) in the Omnitrition case above.

FTC's 2004 advisory opinion also explained that they understand modern pyramid schemes often *do* involve products and seemingly valid sales.

Why haven't there been more prosecutions?

One MLM critic explained that FTC is debating whether to take on Herbalife or any big MLM because FTC's resources are limited, and a fight with Herbalife, with couple billion in sales, would basically means they can't prosecute other cases for a while, and given the amount of resources Herbalife can dedicate to the fight (hire a legion of lawyers, PR campaign, etc.) the outcome is far from certain. And FTC, like all lawyers, hates to lose, as it would not be optimal spending of its limited resources. Same for all the other big MLMs.

Perhaps FTC is adopting the "kill a chicken to warn the monkey" approach...  But will the monkey listen? or adopt a "I'm too big to fail" attitude?

Current Situation

Omnitrition was not really mentioned in public media regarding prosecution of Burnlounge and FHTM (I haven't read all the court documents, but I would not be surprised if it's mentioned there).

Omnitrition was temporarily made popular in December 2012 when Bill Ackman started his epic short on Herbalife. However, it has again faded from public media since.

Omnitrition the company is still active today, albeit somewhat less visible in the US. It appears that it is now owned by Jorge Vergara of Mexico, who also had his start with Herbalife.

References About the Case

Full text of the trial from FindLaw

Analysis by Grimes and Reese, LLC, MLM Attorneys

Analysis by Robert Fitzpatrick, MLM Critic

Analysis by Jeff Babener, MLM attorneys

Analysis by Dr. Jon Taylor, MLM Critic
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  1. Isn't this pretty much happening in every MLM out there? Xango, Herbalife, NuSkin, Vemma...

    The Webster vs. Omnitrition case could pretty much destroy the entire MLM industry... Could it?

    1. Which is why earlier I wrote that MLM has LOST its will to retail. It's much like that American song "You've lost that lovely feeling..." (The Righteous Brothers, I think).