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Why Spotting a Pyramid Scheme Isn't So Easy

You know the companies—Amway, Herbalife, NuSkin, Mary Kay— even newcomers like Visalus. They promote the opportunity to strike it rich, or even just make a little extra money

But are they pyramid schemes? (Read More: From High Energy Clubs to Dashed Dreams: Herbalife Tales.)

That's the question that has followed the multi-level marketing industry for years. These companies, which offer the opportunity to make money by selling products and recruiting other distributors, insist they're not pyramid schemes.

The trouble, according to Joe Mariano, president of the Direct Selling Association, the industry's trade group, is that "there are a lot of pyramid schemes that like to disguise themselves as legitimate direct-selling companies. That creates an environment where there can be confusion."

But even if they're not pyramid schemes, the chances of making any money with multi-level marketing—let alone striking it rich—appear to be remote. (Read More: 'Don't Call Me a Multi-Level Marketer'.)

First, a primer: Multi-level marketing is a form of direct selling. In traditional direct selling, a salesperson sells a product (the classics are vacuum cleaners and encyclopedias) directly to a customer—and gets a good chunk of the profit.

With multi-level marketing—often involving nutritional supplements, weight loss products, cleaning products and various types of housewares—products are sold through a network of distributors. They earn income from the sales they make themselves as well as from people they've recruited to become distributors–otherwise known as their "down-line." (Read More: How Multi-Level Marketers Dodged a Bullet.)

The Federal Trade Commission, which regulates multi-level marketers, warns in a recently revised "consumer protection" page on its website:

Don Bayley | E+ | Getty Images

Not all multilevel marketing plans are legitimate. If the money you make is based on your sales to the public, it may be a legitimate multilevel marketing plan. If the money you make is based on the number of people you recruit and your sales to them, it's not. It's a pyramid scheme. Pyramid schemes are illegal, and the vast majority of participants lose money.

Determining whether a multi-level marketer is a pyramid scheme is difficult, however.

"Identifying a pyramid scheme masquerading as an multi-level marketer requires a fact-intensive inquiry," the FTC said in one report. It "entails a complex economic analysis including an in-depth examination of the compensation structure and the actual manner in which compensation flows within an organization."

The Direct Selling Association downplays concerns about pyramid schemes and even losses from those who participate in mulit-level marketing. On its website, the trade group says a random survey in 2002 shows more than half of all "direct sellers report their net income from direct selling, after taxes and expenses, is positive."

The group also says its surveys show that from 2001 to 2003, the average annual turnover rate in direct sales was 56 percent. (Read More: Multi-Level Marketing Critic: Beware 'Main Street Bubble'.)

But plenty of critics, including Robert Fitzpatrick, who operates the website Pyramid Scheme Alert, insist that more than 99 percent lose money, with the turnover rate at some companies exceeding 90 percent every year.

"If you have to recruit—then the ones you recruit have to recruit," Fitzpatrick said. "Now you're in a chain letter. And on a chain letter, most people are going to lose. Most being 90 percent to 99 percent."

Perhaps nothing is more important than understanding the company's compensation plan. However, it's often easier said than done, because most plans contain complex payout formulas.

"Opaque" is the way Davidson & Co. analyst Tim Ramey, a fan of multi-level marketer Herbalife, describes Herbalife's plan. (Read More: Activist Investor Dan Loeb Takes 8% Stake in Herbalife.)

"They do make available their documents and you can go through them," Ramey said in a CNBC interview. "It's a couple-hundred-page long document."

And therein lies the problem: So many of these businesses, legal or not, are simply too complicated.

While there is no easy way to spot a pyramid, among the things to consider:

• Just because a company says it sells a product, doesn't guarantee it's legit. The FTC warns that some schemes can simply use claims of product sales to hide their pyramid structure.

• Don't be fooled by the claims it's not a pyramid because you don't have to spend a lot of money up front. CNBC's investigation found that many companies try to get customers so excited about the product that they want to join the "business opportunity."

• Qualifying for certain levels of bonuses requires various levels of product purchases and other associated costs. Not all companies require a bona-fide customer order before a distributor purchases product.

And that gets to a more difficult question: How many sales are typically to customers not associated with the company? It's an important and highly nuanced question any distributor should ask.

Direct-seller Melaleuca, for example, which insists it is not a multi-level marketing firm, says "all commissions and bonuses are based on sales to end consumers."

Melaleuca says that every month 62.2 percent of sales come from customers who are not and have never been distributors. Another 23 percent who were once distributors continue to buy the product for personal use.

Herbalife doesn't distinguish between end customers and distributors and says it doesn't track that number. (Read More: Reasons to Worry About Herbalife: Greenberg.)

In an interview with CNBC, David Vladeck, until recently the director of the bureau of enforcement at the FTC, said—without referring to any company in particular—that it would be a "red flag" if an multi-level marketer couldn't say how much of its sales went to end customers. (Read More: Herbalife Disputes Ackman's Claim of 'Pyramid Scheme'.)

As for party plans, like Tupperware, Fitzpatrick sees them as the least problematic "because they do, in theory at least, have a retail sales model—parties. The parties are potentially viable, at least a few would be, perhaps enough to get back initial investments or not lose much."

What's a potential recruit to do?

The FTC advises consumers who are considering joining an multi-level marketer to ask as many questions as possible. (Read More: Before You Join: Six Questions to Ask.)

Its list includes: "What's the company's track record? What products does it sell? How does it back up claims it makes about its product? Is the product competitively priced? Is it likely to appeal to a large customer base? What up-front investment do you have to make to join the plan? Are you committed to making a minimum level of sales each month? Will you be required to recruit new distributors to be successful in the plan?"

And if you start recruiting new distributors, keep this in mind: The FTC warns that you're responsible for any claims you make about a distributor's earnings potential. "Avoid making unrealistic promises. If those promises fall through, remember that you could be held liable," cautions the regulator.

This final tip: Just because a company says it trades on the New York Stock Exchange, or any exchange, doesn't mean it is better or worse than one that doesn't. Trading on the NYSE is not the equivalent of a Good Housekeeping Seal of Approval. It only means the company met certain requirements to be listed there.

By CNBC's Herb Greenberg and Karina Frayter; Follow Herb on Twitter @herbgreenberg; Follow Karina on Twitter @kfrayter

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  • Herb Greenberg is the editor of Herb Greenberg’s Reality Check, a subscription newsletter for investors focused on risk.