The Latin doctrine of caveat emptor advises the buyer to be aware of the products he buys. After micro-finance, it is the turn of direct selling and multi-level marketing companies to expect a regulator soon.

The controversy over the online survey-and-reward company, Speak Asia (SA), is forcing protestors to ask the Ministry of Commerce to regulate the sector.

Multi-level marketing (MLM) is a marketing strategy in which the sales force, who need not necessarily be employees, are compensated not only for sales they personally generate, but also for the sales of others they refer, creating a stream of distributors and a hierarchy of multiple levels of compensation. Few entities have been in business in India for decades.

Bangladesh law

Bangladesh has taken a lead to draft and attempt to enact a Multi-level Marketing (Control) Act, 2011. Bangladesh had about 62 MLMs registered with the Registrar of Joint Stock Companies and Firms. A MLM enticingly named Destiny 2000 had about 4.5 million clients. A premier bank in Bangladesh warned the people against investing in MLM companies that offer abnormal profits in a short span of time.

Business Model

The business model of MLMs probably necessitates a separate legislation. Many of these are registered abroad and conduct their business through their Web site.

In case they have a branch or representative office in India, the Reserve Bank of India (RBI) directions require that it should at least be made aware of their existence. In case the business is conducted through a joint-venture with an Indian entity, the Registrar of Companies (Roc) would be in the know in case the joint venture opts for the company model.

Many of these MLMs would not meet the parameters laid down by the RBI to register themselves as non-banking finance companies since they identify themselves as marketing companies, and not finance companies.

The model adopted by SA was to charge a subscription fee for an online magazine, encourage subscribers to participate in surveys and pay them a fixed fee for that and a variable fee for the number of referrals made.

While this seems to be a perfectly legitimate business, investors would need to look at the relationship between the online magazine and the surveys they are taking as one is paying for a magazine and getting paid for a survey. They would also need to look at the long-term sustainability of this model, including the possibility of cash burnout if the incentives exceed the subscriptions - a theoretical possibility.

In a legitimate MLM company, commissions are earned only on sales of the company's products or services. No money may be earned from recruiting alone (‘sign-up fees').

One must analyse the compensation plan to determine whether participants are paid from actual sales to customers, and not from money received from new recruits. If participants are paid primarily from money received from new recruits, then one can be sure that a pyramid scheme is operating as Madoff proved last year.

On the part of the MLM entity, it would probably be appropriate to make some disclosures about its business model, financials and risk management practices as these could anyways be information that could be sought under the Right to Information Act.

The proposed regulator should, inter-alia, mandate publishing the financial statements and cash flows on the Web site along with all necessary disclosures.

US rulings

In a 1979 ruling in the case of a marquee MLM company Amway, the US Federal Trade Commission ruled that it was not a an illegal pyramid scheme, but ordered Amway to cease price fixing and cease misrepresenting the apparent success achieved by the average distributor. Seven years later, it had to pay up $ 100,000 in a consent decree for violating the 1979 ruling, after Amway placed ads that represented higher-than-average distributor earnings without stating the actual average results or percentage of distributors who actually met the represented claims.

Caveat Investor could well be the new mantra.

(The author is a Bangalore-based chartered accountant.)

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