By Mark Schaub and David Hong  King & Wood Mallesons’ Corporate & Securities group

US network marketing companies like Herbalife, Nu Skin and Usana Health Sciences have been brutally reminded that a successful China story can quickly move from being a strength to a vulnerability depending upon the mood that prevails in China.

The recent multi-level marketing (“MLM”) crackdown in China coupled with a joint announcement by several PRC authorities launching a number of investigations which have led to a tailspin in the share price of major international MLM companies that have a large exposure to China.

What Happened?

In short, the PRC authorities are taking strong action against pyramid schemes.

Serious misconduct on the part of a number of Chinese MLM companies has led to social unrest that in turn has spurred the PRC State Administration for Industry and Commerce, Ministry of Education, Ministry of Public Security and Ministry of Human Resources and Social Security to launch on 10 August 2017 a three-month national campaign to crackdown on illegal pyramid schemes in China (“Campaign”).

Why?

The PRC authorities are very concerned about social stability generally but cult-like activities arouse particularly strong reactions.

The Campaign was triggered by very public gatherings by protesters against Shan Xin Hui (a Chinese pyramid scheme) in July. These protests were held in the heart of the nation’s capital coupled which heightened interest on the part of the authorities. Media outrage had also been building due to a number of separate cases in which college graduates died in suspicious pyramid scheme related circumstances. In addition there had also been a material uptick in unscrupulous MLM organizations collecting membership fees for organizations that provided no benefit or sold non-existent products.

Shan Xin Hui, which means “kindhearted exchange”, was established by Tianming Zhang in 2013 in Shenzhen and had been promoting itself as a “patriotic charity” organization that strives to “help the poor and achieve common wealth”. Shan Xin Hui, through its online investment platform, offers investment returns (said to be 10% – 30%) to individuals who “make donations” to the organization.
The organization upholds its charitable (albeit unlikely) slogan of “lower returns for the rich, higher returns for the poor” by offering lower investment returns on larger donations and higher investment returns on smaller donations made by individual investors. None of Shan Xin Hui’s business makes much sense or is true.

Unlike legitimate direct sales companies, where bona-fide goods or services are sold, Shan Xin Hui seems to be a Ponzi scheme which marketed “investments” with unsustainable returns.

What is the Campaign Targeting?

In the past, most crackdowns against pyramid schemes were normally triggered by pensioners protesting. This Campaign is somewhat different in that a main aim is to deal with organizations that prey upon potential job seekers.

This is a change of focus on the part of the Chinese authorities and is no doubt due to both the increasing numbers of students being defrauded and in some cases even dying due to the activities carried out by such organizations.

The Campaign specifies that priorities include a thorough investigation of suspect marketing activities relating to recruitment; eradicating organizations and networks that fraudulently lure students into such organizations; or illegally detain students under the guise of starting a business or obtaining employment.

The Campaign seeks to mete out serious punishment upon founders and leaders of such organizations – in many cases these organizations are structured in a cult-like manner. These organizations are markedly different from legitimate direct selling companies as they use force to keep members hostage to promote the illegal pyramid schemes.

It is also interesting to note that the authorities clearly recognize the importance of social media in MLM and direct selling structures operating in China. The authorities have taken steps to strictly regulate both online and offline postings of job hunting information (it is almost surprising that offline postings are still a thing in China), as well as rental properties that are used for criminal activities. Two men were recently detained for knowingly leasing properties for use in a criminal activity.

Impact on International MLM Companies

As outlined above the Chinese crackdown does not focus on international MLM companies in China that generally operate legal direct selling businesses or operate via cross-border e-commerce. However, this has not stopped these international MLM companies being impacted by the crackdown. There have been sharp falls in share prices and also potential downgrading of credit ratings.
The Campaign is clearly focusing on illegal activities by Chinese criminal gangs engaging in violence, kidnapping and other activities that even the most vociferous US network marketing critic would not suggest are common practices.

Accordingly, at present it seems that the international MLM companies will be more affected by overseas media than by the authorities within China. However, crackdowns in China can expand in scope or take different paths so vigilance and caution is still recommended. The actions currently undertaken by the Chinese authorities may put international network marketing companies on notice as to the types of actions they may face if they attract unwarranted attention.

One possible action they may need to contend with include the arrest of founders and top management – however, it should be stressed that to date this has been very much directed at fraudulent or cult-like pyramid schemes. Another notable feature has been the targeting of online media as the authorities are able to shut down websites and social media channels – which can severely impact day to day operations.

What’s Next?

At present most international MLM companies operating in China would be best advised to maintain a low profile at present. This means no press releases, no public statements but rather be calm and just sit out the storm. Communications to affiliates or the market may be misinterpreted and may not calm but rather attract attention. In these uncertain times international MLM companies should ensure that their business model is compliant and ensure a robust compliance model is in place in order to deal with any non-compliant practices or affiliate actions that may attract the attention of the authorities.

If possible, direct selling companies with entities in China should also consider obtaining a legal direct selling license. Up until 2016, the PRC government issued limited direct selling licenses but in the last year there has been a significant increase in the issuance of such licenses. Such licenses are expensive (requiring a large registered capital as well as providing for a consumer protection fund) and are limited to certain categories of products but on the positive side they provide a layer of legitimacy and protection.

The greatest risk for most direct selling companies operating in China is of rogue affiliates falsely promoting the business or engaging in illegal activities. As such, ensuring compliance of affiliates as well as being able to distance the company from rogue organizations is key to long-term and sustainable success in China.

With tighter regulations in relation to cross-border e-commerce and tightening scrutiny over customs, many international MLM companies operating via the cross-border e-commerce model may also face additional issues, including products being stopped at customs and fulfillment issues in respect of customers.