American Greed

Legit business opportunity — or pyramid scheme? Six signs to watch out for if you’re presented with a multilevel marketing job

Pyramid scheme
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Fortune Hi-Tech Marketing in Lexington, Kentucky, promoted itself as a way for "average people to make substantial income and achieve financial independence." Participants sold Dish Network packages, mobile phone plans, hair products and nutritional supplements. Members were told they'd get commissions on the products they sold, as well as bonuses for recruiting new representatives.

But the Federal Trade Commission found that over a four-year period, 98 percent of people who bought into the program as salespeople lost more money than they ever made. 88 percent did not even recoup the enrollment fees. And at least 94 percent did not renew their membership after the initial year. Alleging the program was a "pyramid scheme," the FTC shut it down in 2013.

The vast majority of people lose money in pyramid schemes — which the FTC defines as programs that "promise consumers or investors large profits based primarily on recruiting others." Douglas Brooks, an attorney who represents victims of deceptive schemes, says getting caught up in one can be devastating. "People get in, they work at it for a few months, or maybe even a year or two, and then they realize that they've maxed out their credit cards, taken out second mortgages, and had disruptive relationships with family and friends," he said.

Some multilevel marketing programs — where participants earn commissions for their sales and the sales of those in their "downline" — are legitimate. But it can be difficult for consumers, and even for government regulators and lawyers, to determine if the program is valid or not. Brooks says even if a plan isn't technically a pyramid scheme, it still may not be a viable business opportunity. Here are some red flags to watch out for if you're approached about getting involved in a multilevel marketing program.

There's not a lot of emphasis on selling products

As mentioned, illegal "pyramid schemes" generate money from recruiting new members rather than selling goods. This past March, James Merrill was sentenced to six years in prison for his role in the Massachusetts-based pyramid scheme TelexFree, which cost investors $3 billion. Merrill, the company's former president, pleaded guilty last October. TelexFree, which went bankrupt in 2014, claimed to sell cheap internet phone service and recruited "promoters" to get paid to post ads for the product online. But according to the Justice Department, TelexFree supported its ongoing operations not with product sales but with new investors' sign-up fees. Merrill and his partner also allegedly paid themselves millions of dollars from investors.

In a pyramid scheme, there's a small group of investors at the top that require a large base to support the scheme — hence the name "pyramid." Money from new participants is used to pay commissions to other participants. The people at the top hold most of the money, and those at the bottom usually lose out. These schemes are likely to fail because members' success is dependent on their ability to bring in investors, and there are a finite number of people in any community. Brooks advises asking other members, "Do you make your money by selling this product or are you making most of your money by commissions based on people you've recruited and people that those people have recruited?"

There are cheaper, comparable products already on the market

If consumers can get products similar to the ones you'll be selling cheaper somewhere else, you'll probably have trouble getting enough people to buy from you. Get samples of the products and head to a store that sells items like the ones you'll be selling. Do a side-by-side comparison of the labels and the prices. Brooks says people too often don't take the time to do this type of analysis. "They don't find out until after they're involved in it that they really can't make money retailing it, that the products are priced too high," he said. "You can always make a first sale to a friend or a family member, but you're not going to be able to consistently sell the products."

They're putting a lot of pressure on you to sign up at the meeting

If someone is trying to pressure you into signing up at an initial meeting, that's a major red flag — especially if he or she brushes off your concerns. "The way a lot of these companies operate, is they have very carefully crafted meetings, and they're designed to get people to lower their guards and to get all excited about this business," said Brooks.

Instead, treat this like any other business opportunity, and carefully consider whether getting involved is the right decision for you. Resist the urge to jump right in without having all the information. Go home and study the literature you were given at the meeting. Go online and research what others are saying about the company. Look into the people who spoke at the meeting. Think about whether you're really interested in or suited for selling products. "There's a serious push to get you to sign up because they know, most of the time, if people think about things in the sober light of the morning, we'll think, you know what, this is not going to work for me," Brooks said.

Members make big claims about how your life will change

Watch out for people who get up on stage at meetings and claim to be making tremendous amounts of money. "Human nature is such that if you see someone talk about that kind of success, and they don't seem to be particularly smart or talented, you think, well, I could do that," said Brooks. Take their words with a grain of salt. Brooks says many participants take a "fake it til you make it" approach, exaggerating their successes in order to lure others in. This is especially the case if their success is dependent on how many people they recruit into the program. "They give little techniques for sort of glossing over the fact that you're not actually making money at it yet, but you think you will," Brooks said.

There are lots of additional costs

Ask other members how much it's actually going to cost you to run the distributorship. Participating in one of these plans often requires buying large amounts of inventory that you're expected to sell. Ask others if they've actually been able to sell all of the products they've bought, or if they're now stuck with items they don't need. Besides buying inventory, you also may have to spend money going to meetings, buying mailing lists, leads, or sales materials. Some programs even require you to rent spaces.

"The claim is the opportunity costs are so low that no one can really lose money at this. That's just not true. I've seen people lose tens of thousands, and sometimes even over $100,000 at these things," Brooks said.

The company has a confusing compensation plan

Are you having a hard time understanding how you would actually make money? "The compensation plans are very complicated, and there's a reason for that," said Brooks. Compensation plans often have provisions involving "breakage." Breakage is sales volume generated by you or someone in your downline for which you don't receive compensation. The money, instead, goes to the company. This typically occurs when a distributor hasn't qualified to earn a commission yet, often because they haven't met their inventory targets. Make sure you ask enough questions to thoroughly understand the payment structure and to understand the exact steps you need to take as a distributor to earn commission.

If you've been approached by a friend, neighbor, or family member you trust, you may not want to decline their offer to participate in the program. But if you're skeptical or confused about how the plan works, be cautious. "You've got to be your own advocate and do your own work in trying to figure out the truth here," Brooks said. "If you don't understand it, you shouldn't feel stupid. If you don't understand it, you shouldn't join the business."

CNBC's "American Greed" looks at the dark side of the American Dream. "American Greed" returns with all new episodes Monday, June 19 at 10 p.m. ET/PT.