Top-deck rejig: Bali to head Britannia global ops, Varun Berry India biz
Spectrum reframing issue will be placed before EGoM, says Sibal

Corporate May 28, 2013

Why Amway case is similar to a ponzi scheme

By Vivek Kaul

William S Pinckney, the chief executive officer of Amway India, was arrested yesterday by the crime branch of Kerala Police along with two other directors of the company.

A report in the Daily News and Analysis (DNA) quotes a top official of Economic Affairs Wing (EOW), Kerala as saying "With the call of easy money, they have been luring people to come and invest. And in turn, the new members had to get more people and this was leading to illegal money circulation. As a result, we had received several complaints against the company and we decided to arrest the officials."

The company is said to have been violating the Prize Chits and Money Circulation Schemes (Banning) Act. More specifically, Pinckney and the two other directors were arrested in connection with a case filed by a certain Visalakshi of Kozhikode. She claimed to have incurred losses of Rs 3 lakh in trying to sell the products of Amway through its multi-level marketing network.

A report in The Mint quotes P A Valsan of the EOW of Kerala Police as saying "They were charging 10 times the value of their product. For instance, they sold product priced at Rs 340 at anywhere between Rs 2,700 and Rs 3,400...Also, they were involved in money chain, which is prohibited under the Prize Chits and Money Circulation Schemes (Banning) Act 1978."

So there are multiple reasons behind the arrest. It is for the Police and the Courts to establish whether the products were being sold at many times their price. But the other part about whether Amway is a money circulation scheme or not, needs some discussion.

, an individual entering a legitimate MLM business at lower levels is likely to face losses and be unsuccessful at it.

, an individual entering a legitimate MLM business at lower levels is likely to face losses and be unsuccessful at it.

A money circulation scheme is essentially a Ponzi scheme. A Ponzi scheme is a fraudulent investment scheme where the money being brought in by newer investors is used to pay off older investors. The scheme offers high returns to lure investors in and it keeps running till the money being brought in by the newer investors is greater than the money needed to pay off the older investors whose investment is up for redemption. The moment this breaks, the scheme collapses.

Before we get into a detailed discussion on whether Amway is a Ponzi scheme or not, it is important to understand how Amway and other multi-level marketing(MLM) companies go about their business. An MLM company like Amway appoints independent distributors to sell its products. Amway sells products like diet supplements, toothpastes, shampoos, multi-purpose liquid cleaners, soaps, grooming products etc. These distributors are not employees of the company. They make money by selling Amway products.

As per the Amway Business Starter Guide there are three ways a distributor can make money. First and foremost he makes what the company calls the retail profit margin.

"Distributors buy Amway products at Distributor Acquisition Price (DAP) and may resell products at a retail price, not to exceed the maximum retail price, as published. In this case, the Distributor's income would be the difference between the DAP and retail price," the Business Starter Guide points out.

This is the way almost any distributor for any company makes money. He buys goods directly from the company at a certain price and then sells them at a higher price, which cannot be more than the maximum retail price.

The second way a distributor makes money is through what Amway calls the commission on personal purchases. "Distributor may earn commission on the volume of the Distributor's individual purchases of Amway products during the month," the Business Starter Guide points out.

The third way a distributor makes money is through earning commissions on group sales. "A Distributor may recruit a sales group and based on the success and productivity (as defined by product sales) of the sales group, a Distributor may earn commissions. It is important to note that a Distributor only earns commissions on the volume of Amway products actually sold," the Business Starter Guide points out.

So a distributor can sponsor other distributors and then make a certain commission on the amount of Amway goods sold by those distributors. The new distributors can appoint more distributors and so the chain grows. The original distributor gets a commission on all the products sold under his chain.

Prima facie this sounds like a perfectly legitimate though not a normal way of doing business. Amway products are not available in shops. If you want them, you have to buy them directly from Amway distributors.

There are many multi-level marketing companies in the market which claim to sell a certain product. These products include gold coins, holiday memberships and so on. These MLM companies appoint distributors who in turn appoint new distributors, with the idea of selling the product of the company.

The catch here is that the product is just a faade. Nobody is really interested in selling the product. The money is made by distributors by appointing new distributors who are charged a certain commission for joining the MLM scheme. The new distributors in turn appoint newer distributors and so the chain continues.

The return to the upper levels comes from creating new levels rather than the sale of the product. The wealth gained by participants at the higher levels is the wealth lost by participants at lower levels. So these MLM schemes are essentially Ponzi schemes where money being brought in by newer distributors is paid off to older distributors. There is no legitimate business activity going on.

The Federal Trade Commission in the United States looked at Amway in the 1970s and tried to answer the question whether Amway was a legitimate business or a Ponzi scheme?

The Commission held that, although Amway had made false and misleading earnings claims when recruiting new distributors the company's sales plan was not an illegal pyramid scheme (another name for a Ponzi scheme).

"Amway differed in several ways from pyramid schemes that the Commission had challenged. It did not charge an up-front "head hunting" or large investment fee from new recruits, nor did it promote "inventory loading" by requiring distributors to buy large volumes of nonreturnable inventory," said Debra A Valentine, a general counsel for the FTC, in a seminar organised by the International Monetary Fund in May 1998.

So that's another point in favour of Amway not being a Ponzi scheme.

But there is one thing that we need to understand here. Like in an MLM scheme which is a Ponzi scheme, the business that an Amway distributor does, depends on finding new distributors and then hoping that these new distributors sell Amway products and at the same time are able to appoint newer distributors. If a distributor is successful at this he makes more and more money. The trouble is that we go along it becomes more difficult to appoint new distributors. Lets try and understand this through an example. Lets say the first distributor that a genuine MLM company appoints, in turn appoints five distributors.

Table explains the number of distributors.

Table explains the number of distributors.

These five distributors now appoint five distributors each. So we now have 25 distributors at the second level. Each of these distributors now in turn appoints five distributors. So we now have 125 distributors at the third level. If the chain continues, at the 12th level we will have around 24.45 crore distributors. This is equal to around 20% of India's population. The total number of distributors will be around 30.51 crore.

What this simple example tells us is that it is difficult to keep appointing more and more distributors. This is similar to a Ponzi scheme, where for the scheme to keep going more and more newer investors need to keep coming in, so that the older investors whose money is falling due can be paid off. The trouble of course is that that the number of people is not infinite, as the above example shows us.

The problem for Amway distributors (or any other genuine MLM company) entering the game late is that it is difficult for them to sponsor new distributors. It is also difficult for them to sell Amway products given that there are so many distributors already operating in the market and they have selling relationships in place. Also, products sold by MLM companies typically tend to be more expensive than similar products being sold in the open market, making it more difficult to get customers willing to buy.

Hence, even in a legitimate MLM business like Amway, it is important to enter early. Those entering the business at the lower levels, find it difficult to get on new distributors and also end up with a lot of unsold inventory, thus leading to losses. Amway requires its distributors to buy back unsold inventory from the new distributors that they sponsor. But that is easier said than done.

To conclude, an individual entering a legitimate MLM business at lower levels is likely to face losses and be unsuccessful at it. To that extent, even legitimate MLM businesses are similar to Ponzi schemes, where it is important to enter the scheme early. Also, like Ponzi schemes even legitimate MLM businesses project the prospect of unrealistically high returns while soliciting new distributors.

(Vivek Kaul is a writer. He tweets @kaul_vivek)

by Vivek Kaul

Related Stories.