Referral programs and pyramids: How do you determine legality?

In 2016, Herbalife agreed to pay $200 million in damages and change its business model after the US Federal Trade Commission (FTC) accused it of running a pyramid scheme. In 2008, Bernard Madoff's investment fund was recognized as the largest financial pyramid scheme in history, resulting in about $65 billion in losses. The founder himself was sentenced to 150 years in prison.

There are many other examples where companies aimed at attracting new customers and increasing sales by introducing referral programs. However, if the legal rules of development and implementation were not observed, these schemes unwittingly acquired the features of financial pyramids, the activities of which are prohibited in many countries.

If a company's referral program is classified as a pyramid scheme, it could result in criminal penalties, including fines and jail time for executives, civil lawsuits from program participants who suffer losses, loss of credibility, and negative media coverage.

First, let's define the terms:

A referral program is a marketing strategy in which existing customers attract new customers for a reward. It is a mutually beneficial cooperation in which the company receives new clients, and referents receive rewards for their recommendations.

A financial pyramid is a business model based on generating income primarily by attracting new participants to the system rather than through selling goods or services. In such schemes, the income of early participants is formed at the expense of contributions from subsequent ones, which ultimately leads to the collapse of the system and losses for the majority of its participants.

And now, the main aspects of the difference between these two business models:

1) Value Proposition: Referral programs focus on selling goods or services, while pyramid schemes often promise high returns without an explicit product or service proposition.

2) Reward: In referral programs, the reward is based on sales made through the referral. In financial pyramids, income often depends on the number of participants attracted.

3) Sustainability: referral programs are created for long-term business development, while financial pyramids are short-term and doomed to failure.

To avoid signs of a pyramid scheme in your referral program, the attorneys at Antwort Law offer the following recommendations:

1) Limit referral levels: Avoid creating multi-tier structures that may be associated with pyramid schemes. Limit the number of referral levels and ensure that the main reward is paid for actual sales.

2) Maintain transparency: Make sure the terms of the program are clearly stated and easily understood by participants.

3) Define the program's goal: clearly state what you want to achieve with the help of the referral program - increase sales, expand your customer base or increase brand awareness.

4) Evaluate the legislation: Study the local legislation and requirements for referral programs in your country. Make sure your program complies with all regulations and licensing requirements.

5) Risk Warning: Include a risk warning regarding the referral program on your website. It will help explain the potential risks to participants and caution them against investing large sums of money.

A referral program can be a powerful tool for growing your business abroad if designed and implemented correctly. Developing and implementing a referral program requires careful legal analysis, especially when doing business abroad. It is important to distinguish it from financial pyramids to avoid legal risks. Turning to professionals will help ensure the legal security of your referral program and facilitate its successful implementation.

Antwort Law lawyers specialize in drawing up referral programs, considering the specifics of local legislation and international standards. We will help you:

•     Identify legal risks and minimize them;
•     Draw up contracts and agreements that comply with the law;
•     Ensure compliance with privacy and data protection rules;
•     Prevent legal disputes related to accusations of creating a financial pyramid.

Lidia Ivanova

International lawyer
Antwort Law