Interpretive Release Multi-level Distributorships and Pyramid Sales Plans 33-5211

36 F.R. 	23289-91
Rules 	Cm.d 	Regulations
23289
/ Title '
17-COMMODITY AND
SECURITIES ExCHANGES·• . 	I 	.
Chapter 11-Securitles and -Exchange
Commission 	·
(Reteauea Nos. 38-8211, 34-8381)
PART 	231-INTERPRETATIVE 	RE
LEASES RELATING TO THE SECURI
TIES ACT OF 1933 AND GENERAL
- 	il.JLES AND REGULATIONS THERE
UNDER
PART 	. 241-INTERPRETATIVE 	RE
'LEASES RELATING TO THE SECURI
TIES EXCHANGE ACT OF 19;14 AND
GENERAL 	RULES 	AND 	REGULA
TIONS THEREUNDER
Multi-level Distributorships and
Pyramid Sale~ Plans
The Securities- and Exchange Com
mission has considered- the appUcabllity
of the securities laws to multilevel dis
tributorship and other business opportu
nities that are being offered to prospec
tive participants throuarh"pyram:td sales
plans. The Coinmisslon belleves that the
operation of. such plans -often Involves
the offering of an "Investment contract"
or a "participation in a profit-sharing
agreement," which are. securities within
the meaning of section 2(1) of the Secu- .
rites Act of. 1933. In such cases the secu
rity involved-the agreement between
the offering company and the Investor
must be registered with the commission
unless an exemption is available. In tho
absence of registration or an exemption,
sales of these securities violate section 5
of the Securities Act.
Moreover, any person who partlcipa~s
in the distribution of these securities may
be a broker as defined In section 3(a) (4)
of the Securities Exchange Act of 1934
and, unless an exemption Is available,
would be · required to register . as such.
pursuant to section 15 (a) m .of that Act.
For example, this might include, among
others, persons who, foJ.: a tinder's fee,
conunlsslon, bonus or other compensa
tion, induce others to become partici- .
pants In the plans for the purpose of
recruiting still other participants.
In addition, where deceptive acts ·and
practices. are co~tted in connection
with the offer or sale of these securities,
those responsible violate the antifraud
provlslons or section 17Ca) of the Secur
Ities Act and sections 10(b) and 16<c> (1)
of the Securities Exchange Act and Rules
10b-5 and 15cl-2 under that Act.
The common element of the various
forms of pyramid ·promotions is a sales
plt.ch which stresses the amount of
money a participant can make on the
recruitment. of others to participate in
the plan. This may serve to obscure the
nature of the basic relationship -being
created between participants in the PliPl
and the offering company. A discussion
of two of the more prominent forms of
promotionS follows. · The description of
these programs shoUld no\ be taken to
indicate that promotions taking dltrerent
forms may not also be within the pur
view of the following discussion.
In the typical form of multllevel.,dlstrl
butorshlp 	that 	has 	been 	establlshed
through pyramid promotions,· the com
pany represents that It Intends to man
ufacture, or to sell un<f&r .its own trade
name, a Une of products and it purports
to be offering franchises for the distribu
tion of those products which appear to
follow establlshed forms of franchise
distributorships. Normally· several types
of distributorship agreements are said
to be avallable to the public which are.
described more or less as follows. At the
lowest level for a relatively small fee the
participant is provided with a •sample
inventorY and will be authorized only to
make retail sales to the publlc. For a
larger fee, the participant is supposed
to receive a wholesale Inventory that he
in tum supplies to salesmen whom he
supervises. This participant may also be
authorized to make retail sales of his
.own. For an even larger fee, a more
·substantial wholesale inventory Is ob
tained and responslbtllty Is assumed for
supervision of lower-level participants.
At the highest level of distribution, for
a very substantial fee, a purported,rtght
to be the link between the company and
· the distribution chain is acquired. U the
distribution program should actually go
into effect, under such plans, In ac
cordance with a predetermined schedule,
bach distributor would pay less for prod
ucts to those from whom he gets them
than he woUld receive when he passes the
products on through distribution chan
nels to the consumer. Where in these
circumstances prospective pa.rttclpants
are led to belleve that they may profit
froin participation in these distribution
programs without actually assuming the
signlficant 	functional 	responslbWties
that normally attend the operation of a
franchise, in the ·commission's opinion
there Is the otrer of a security. Even
where a specific offer is not made, if In
the actual operation of a distributorship
program profits are shared with or other
forms of remuneration are given to per
sons who have provided funds to the
enterprise-purportedly for a franchise
or other form of Ucense-but those per
sons do not in fact perform the functions
of a franchise, there would appear to
be an investment contract. 	•
It must be emphaSized that the as
signment of nominal or limited respon
siblllties to the participant does not neg
ative the existence of an investment con
tract: where the duties assigned are so
narrowly circumscribed as to involve lit
tle real choice of action or where the
duties assigned would in any event have
little direct efl'cct upon receipt by the
participant or· tho benefits promised by
the promoters, a security may be fbund
to exist. As the SUPreme Court has held,
-empba8is must be placed upon economic
reality. Bee Securities and Exchange
ConunlSston v. W. J. Howey Co., 328 U.S.
293 <1946). While the Commission has
not taken the position that a franchise
arrangement necessarlly in'Volves the of
fer and sale of a security, In the Com
mission's view a security Is ofl'ered or sold
where the franchisee ls not required to
·make significant efforts tn the operation
of the franchise in order to obtain the
promised return. 	.
A dltrerent program that has fre
quently employed a pyramid sales pro
motion Involves the soUcltatlon of capi
tal from a limlted number or "founders" ·
to construct a local retail store that will
be owned and operated by the promoters.
Under these plans the "founders" typi
cally make a payment of money to the
promoters Cwhich may nominally involve
the purchase of some product> and the
"founders" are provided with some form
of Identification card that they are re
quired to distribute to prospective cuS
tOmers of the store in adva.ilce of the
store's opening. Orice the store ls in
operation the "founder" ls to receive a
"commission" on sales made to those per
sons having the ldentlftcation cards that
the "founder" has provided. In the Com
mission's view, these programs involve·
the ofl'er and sale of investment con
tracts. The basic promotional efforts that
"founders" are required to make ln ad
vance of the store's opening-distribu
tion of cards to prospective customers
even if required to contln ue after the
store's opening, do not Involve the kind
or degree of participation In the man
agamont of an enterprise that might
negate the inference of an investment
relationship.
In Securities and Exchange Commis
sion v. C. M. Joiner Leasing Corp., 320
U.S. 344, 351 (1943>, the Supreme court
observed that the nature of securities
that are subject to the Federal securities
laws does not stop with the obvious and
commonplace: "Novel, uncoinmon, or ir
regular devices, whatever they appear to
be, are· also reached if it be proved as
matter of fact ·that they were widely·
offered or dealt In under terms or courses
of dealing which establlshed their char
acter In commerce as 'Investment con
tracts,' or as 'any interest or Instrument
commonly known as a 	"security" •."
simllarly in Securities and Exchange
Commission v. W. J. Howey Co., 328 u.s.
293, 301 C1946) the court described the
purported sales or orange groves as a
kind of investment contract. In that con
text it stated: "The test is whether the
scheme involves an Investment of money
1n a common enterprise with profits to
come solely from the efl'orts of others."
It has been contended that, since it Is
an element of some promotions or the
kind here considered that the prospective
Investor must make some efforts himself,
the contracts do·not fall within that de
finition. But In the Commlssl.on's view
a failure to consider the klnd and degree
of 	efl'orts 	required of 	the 	Investors
ignores the equally significant teachings

RULES 'AND .REGULAnoNs
of Howey, ld. at 299, that form Ia to be
disregarded for substance and that the
.Jnves~ent-contraet concept.
1£mbodles a flexible rather tlui.n a static
prtnclple, one that Is capable of adaptation
to moot the countless aDd variable schemes
devtsecl by thoso who BOOk the uao of the
money or others on the promise of prollts ..
These words COmPel the conclusion that
the Howey decision itself should not be
permJtted to become a "static principle"
easily '&Voided by tnrentously-devlsed
variations In .form from the particular
type of Investment relationship described
In that case.
The term "security" must be defined
. in a manner adeqwi.te to ~rie the pur
P9S8 of protecting investors. The exist
ence of a security must depend in signif
Icant ''"llli!lsure lJpon 	the 	degree 	of
managerial authority over the investor's
funcla retB!fned or rtven: and perform
ance by an Investor of duties related to
the enterprise, even 1f .financially sfgnlf
lcant and plainly contributing to the
success of the venture; may be irrele
vant to the existence of a security if the
investor does not control the use of hts
funds to a stgntflcant·<legree. The "efforts
. of others" refen-ed to In Howey are
limited, therefore, .to those types of es
. sentlal managerial ei!orts but for which·
anticipated return could not be produced.
Nor 1s lt s1gnlficant that the return
PrOmiSed for the use of an investor's
money may be -somethlng other than a
·· share of. the pl'Qflts of the enterprise.
The court in Howey described an in
vestment contract provldlng the Inves
tor with an equity Interest In the common
enterprise: where the Interest oi!ered ls
of a different nature the promised return
wlll necessa.rUy·vary. Thus. for example,
market-price appreciation In value--not
profits in a commercial sense-was slg
nlficmt in the Investment contracts rec
ognized by the Supreme Court In secu
rities 	and 	Exchange 	commlsslon 	v.
Variable Annuity Life Ins. Co., 359 u.s.
65 (1959> and Securities and Exehange
Commfss.lon v. Ui.Uted Benefit, 387 U.S.
202 (1967>. The· -expecta.tton of "com..
mlsB1ons"tor the U.se of Investor's money,
when not linked to services of the kind
or degree for which commissions arc
normally paid In nontnvestment con
texts, 1s. also consistent with .the exist
ence of an Investment contract.
In a recent decision, ·the Supreme
Court of Bawa.ll llliB considered tho
meantnt of the term "Investment con
tract" as used Jn a Slate-statute deflnl
tion of the term "security" tha.t 1s sub
stantially similar to the definitions con
tained In the Federal securities laws.
·State v. Hawall Market.'Center, Inc., 485
P. 2d 105 <1971>. The Hawa.ll Market
Center tlirough a pyramid promotion had
oi!ered partlc1patton In a retail-store en
terprise of the kind described above;
Whlle embraclng Interpretive principles
of the kind laid down by the u.s. su
preme Court In Howey and Joiner, the
Hawa.ll court reJeeted a Hteral adherence
to the language that the Supreme Court
found approprJate in deGcrlblng the
specific type of investment contract that
was before It In Howey, where profits
were, Indeed, to ~me "solely from the ef
forts" of others. In doing so, that court
noted the ~er that "courts Cmightl
become entrapped 1n polemics over the
meaning of the word 'solely' and fall to
consider the more fUndamental question
whether the statutory policy of ailordlng
broad protection to investors should be
applled even .to those situations where
an Investor 1s not Inactive, but partici
pates to a. Umlted degree In the opera.;.
tlon of the business," Id. at 108 <foot~
note omitted) . For purposes of the Ha.
wa.ll Securities Act, therefore, the court
held <ld. at 109) that an Investment con
tract exists where: .
(1) An offeree furnishes Initial value to an
offeror, aDd
(2) A portion of thla lnltlal value Is sub
Jected to the risks of the enterprise, 11nd
(8) The furnishing of the Initial value Ia
Induced by the otreror!s promises or represcn
·- ta.tlons Whlch give rise to a reasonable under
standing that a valuable benefit o1' some
kind, over and llbove the lnltlal value, will
accrue to the offeree as a rDSul t of the opera
tion of tho enterprise, and
(4) The offeree does not recolve tho right
to exerotse praotloal aDd actual control over
the managerial decisions of tho enterprise•
The COmmission belleves that the
court's analysis of the Investment-con
tract concept In the Sawall Market Cen
ter case 1s equally appllcable under the
Federal securities laws. While the con
clusion of the Hawaii court encompasses
types of· investment contracts that the
Supreme Court of the United States has
not yet specifically considered, the Com
mission believes that lts conclusion 1s
fully consistent wlth the remedial· ap
proach repeatedly stated by the Supreme
Court to be appropriate In interpreting
the Federal sec:urltles laws. See Tcherep- ·
n1n v. Knight, 389 u.s. 322 (1967) <Se
Curities Exchange Act> : Securities and
Exchange Commission v. Capital Gains
Research Bureau, 375 U.S. 180 (1963)
<Investment Company Act> : Securities
and Exchange Commission v. W. J. How
ey Co., 328 u.s. 293 (1946> (Securities
Act> : Securities and Exchange Commis
sion v. C. M. Joiner Leasing Corp., 320
U.S. 344 (1943) <Securittea Act>. 	·
It further a.ppears to the commission
that the pyramid sales promotions that
are often employed ln connection With
the sale of securities of the types de
scribed above may be Inherently fraudu
lent. Under these programs, various cash
fees and percentage incentives· are of
fered to those willing to participate as
an Inducement for the recruitment of
additional participants. This aspect of
the promotion Ia often glven great em~·
phasla at "opportunity meetings" at
which movies may be shown and speeches
made concentrating on the allegedly un
limited ·potential to make money in a
. relatively· short period of time by recruit
ing others Into the program. Since there
are a flnlte number of prospective partic
ipants In any area, however, those In
duced to participate at later stages have
llttle or no opportunity for recruitment
of further persons. It 1s patently fraud
ulent to fall to disclose these factors
.
to prospective Investors. Even wh~re
some dlsclosure of these practicalltles 1s
made, moreover. it may be .made ln. a
manner. that misleadingly· falls to note
the signlflcance to the participants of
the facts dlaclosed. In the COnunlsslon's
view; use of this Inherently fraudulent
device to Induce Investment 1n any en~
terprise oilerlng securities to the publlc
1s a violation of the antlfra.ud provisions
of the securities laws.
By the Commission.
[SEAL] 	RONALD F. HUNT,
Secretar1/.
NovEMBER 30, 1~71.
lFR Doc.71-17921 Piled 12-7-71:8:61 am)
FEDERAL REGISTEI!. VOL. 36, NO. 236-WEDNESD~Y, DECEMBER 8, 1971