Direct Selling vs. Pyramid Schemes: What Makes a Business Model Legal in Canada?

Broadly speaking, pyramid schemes focus on the recruitment of people, and direct selling/multi-level marketing focuses on the sale of product. While this seems simple at first, you enter the weeds quickly. This blog post will examine how even well-intentioned direct selling businesses can inadvertently operate as pyramid schemes in Canada, and what you can do to make sure your business is legal in Canada.

What is a multi-level marketing plan under Canadian law?

Section 55 of the Competition Act starts off by setting out what an MLM is. Simply put, an MLM is a distribution model in which payment is made to upline distributors when a downline distributor sells goods. Section 55 then continues to set out rules for all MLM participants. In particular, all MLM participants must provide an income disclosure statement when making income or lifestyle claims. Failure to do so may result in a criminal conviction or fine.

Section 55 continues to explain that a pyramid scheme, by definition, is an MLM that goes on to commit different infractions. This is worth repeating: a pyramid scheme is an MLM that breaks the rules set out in the legislation. This begs the question, which rules must MLMs make sure not to break?

What Activities May Turn Your MLM Into a Pyramid Scheme in Canada?

Now that you are familiar with Section 55 of the Competition Act, let’s walk through some of the most common activities that risk your MLM being recognized as a pyramid scheme.

Payment For Recruitment and Binary Compensation Plans

Does your MLM directly pay for recruitment? If yes, then your MLM is likely a pyramid scheme. The analysis becomes more complex when you start to consider if your compensation plan indirectly pays for recruitment. Take, for example, is your compensation plan a binary plan that requires recruitment to level up? This is the number one risk factor that direct selling companies face in Canada: binary compensation plans without proper modification will be considered a pyramid scheme in Canada.

Requirement To Purchase Starter Kits Not At Cost

In Canada, mandatory starter kits must be sold at cost. What is considered “at-cost” must have accounting evidence to back up this claim. As an example, if you sell a starter kit for $50, your company will have to show how $30 goes to the cost of the product, $20 goes to shipping, and how $10 goes to any customer service afterwords.

Inventory Loading

MLMs cannot sell more products to their participants than what is commercially reasonable. With the advent of drop shipping, this risk is not as common. However, some participants may try and “buy” their way to promotion of rank, and could still trigger this. MLMs should have systems in place to make sure that bulk buying is always done in a commercially reasonable manner.

Buyback Guarantees

MLMs must also have a reasonable buyback guarantee. If they do not, then they will be considered a pyramid scheme. What is reasonable, depends on the circumstances. Things can get tricky when considering non-refundable sales or seasonal products. Lastly, all participants should be made aware of these guarantees.

Conclusion

Denis Healey, former UK Chancellor of the Exchequer (the British equivalent to the United States Secretary of the Treasury), once said that “The difference between tax avoidance and tax evasion is the thickness of a prison wall.” The same can be said for the difference between MLMs and pyramid schemes. The difference can be very small, almost imperceptible, and it can at times take a trained eye, ie a lawyer, to tell the difference between the two. Given the potential for mistakes and significant legal risk, it is highly advised that anyone operating an MLM seek specialty legal advice. If you are looking for more guidance or just general peace of mind, feel free to get in touch for a free consultation.