China's Milestone Direct Selling Regulations: A Victory for Single-level Selling over Multi-level Selling

Multi-level direct selling has a positive side in that it provides incentives for sales representatives to disseminate the core selling ideas of the firm as well as grow and build a cooperative relationship within their team. On the other hand, multi-level direct selling can also be problematic in that, if obtaining commissions from lower-level sellers is over-emphasized, direct selling can lead to pyramid schemes, which are widely viewed as encouraging deceptive selling methods rather than focusing on selling legitimate goods. Some typical types of pyramid schemes may include any or a combination of the following characteristics:

i. Participants need to pay high entry fees or unreasonable prices for certain goods in order to be able to introduce new participants (or to be qualified for being promoted to a higher level);

ii. Participants can obtain compensation from the fees paid by the participants they have introduced and even from the fees paid by lower-level participants who were introduced by participants they have introduced;

iii. There is a clear upper and lower-level structure like a pyramid; and

iv. The income of participants depends on the number of participants they have developed and their lower-level referrals.

The essence of pyramid schemes is that the focus is on developing lower-level participants rather than selling products or services to end users, thus making them unsustainable as long-term business models.

There is an added level of complexity to this problem in China due to the words in Chinese for "direct selling" and "pyramid schemes". Two Chinese words have been used carelessly to describe both concepts, namely: chuanxiao (??) and zhixiao (??). Prior to the issuance of the new Direct Selling Regulations and Anti-pyramid Regulations, both terms were not clearly defined in PRC legislation. Chuanxiao was often used in regulations issued prior to the 1998 ban to refer to direct selling, while zhixiao was less common but also referred to direct selling. Pyramid schemes were usually referred to as illegal activities in the form of chuanxiao.

China's issue of the Circular on the Prohibition of Direct Selling in 1998 used chuanxiao to describe either direct selling or pyramid schemes. After this, however, the term chuanxiao became more and more associated with pyramid schemes in various regulations issued thereafter. Since then, Chinese officials and the Chinese press have tended to use zhixiao to refer to direct selling. With the promulgation of the new Direct Selling Regulations and Anti-pyramid Regulations by the State Council, zhixiao is now officially used to refer to legitimate direct selling and chuanxiao is used to refer to illegal pyramid schemes. However, since the Direct Selling Regulations only allow the single-level mode and the Anti-pyramid Regulations refer to the multi-level mode as a type of prohibited pyramid scheme (as discussed below in more detail), zhixiao now means the permitted single-level direct selling approach and chuanxiao means illegal pyramid schemes, including multi-level direct selling.

HISTORICAL DEVELOPMENT

Direct selling has undergone two significant stages in China: the period prior to 1998 when it was permitted and the period following 1998 when it was generally banned. Several foreign investors were able to continue direct selling activities after 1998 but only by agreeing to certain conditions. The promulgation of the new regulations re-opens the direct selling market in China, in line with the country's WTO commitment, and signifies the beginning of a third stage in the evolution of direct selling in China.

Prior to 1998

Avon's joint venture in Guangzhou established in 1990 is regarded as the first ever officially approved direct selling enterprise in China. Up to 1998, Avon was followed by other major international players such as Amway and Mary Kay, while domestic direct selling businesses and various pyramid schemes were also burgeoning. Both single-level and multi-level sales were allowed during this period.

After noticing several problems in multi-level direct selling and becoming concerned about the use of pyramid schemes, the Chinese government started to restrict multi-level direct selling and launched crackdowns on pyramid schemes in 1994.¹ In 1995, the State Council ordered a halt to the approval of new multi-level direct selling enterprises and started investigations of existing direct selling enterprises on the suspicion of increasing fraud in direct selling.² Following the State Council's order, the State Administration for Industry & Commerce (SAIC) initiated various investigations of existing direct selling enterprises, and by October 1996 eventually approved 57 enterprises and their branches to engage in multi-level direct selling (including Amway) and five enterprises to engage in single-level direct selling (including Avon).³

The SAIC also promulgated Procedures for the Administration of Direct Selling (chuanxiao) on January 10, 1997, which provided detailed rules on the establishment, operation and compensation to sales representatives of direct selling enterprises, including both multi-level and single-level arrangements. However, the above-mentioned restrictions remain unchanged,⁴ and the 1998 ban was launched only one year later.

The 1998 Ban

On April 18, 1998, the State Council issued a Circular on the Prohibition of Direct Selling Activities (chuanxiao, the '1998 Ban Notice') immediately banning all types of direct selling.

The 1998 Ban Notice and subsequent supplemental rules⁵ indicated that direct selling tends to involve closed and tightly knit organizations promoting cult practices and superstitious beliefs, as well as gangster and hooligan activities, and is often used to sell fake, smuggled or low quality products at exorbitant prices. The authorities concluded it was too difficult to inspect and administer direct selling and accordingly banned.

The Post-1998 Direct Selling Mode

Shortly after the promulgation of the 1998 Ban Notice, the Ministry of Foreign Trade and Economic Cooperation (MOFTEC, now called the Ministry of Commerce (MOFCOM)), SAIC and the State Domestic Trade Bureau issued the Circular on Questions Concerning the Change of Sales Method by Foreign-funded Direct Selling Enterprises on June 18, 1998 (Document No. 455), which ordered foreign-invested direct selling enterprises to operate through fixed stores (by erecting specialized counters in department stores, selling products to domestic wholesalers or retailers, or establishing their own retail stores).

Based on Document No. 455, some enterprises have continued direct selling through sales representatives in addition to fixed stores. Although the post-1998 legislation avoided calling the selling mode of these stores direct selling (chuanxiao or zhixiao), it has been the only legitimate way to engage in direct selling in China since 1998 (the 'post-1998 direct selling mode'). So far, only 10 foreign-invested enterprises (FIEs) have been approved to engage in the post-1998 direct selling mode, including Amway and Avon.⁶

According to Document No. 455 and its Implementing Rules⁷, the post-1998 direct selling mode was very restrictive in terms of financial thresholds and operational requirements. Application was only open to established foreign-invested direct selling enterprises in 1998 that had made a minimum of US$10 million total investment in China. No sales representative could be engaged in a particular city unless a store was established in the same city and each sales representative had to be based in a specific store and could only sell in the city where the store was located. All products had to be available in the stores to all walk-in customers, and selling products made by other parties was prohibited. If a sales representative was not a formal employee of the enterprise, a service contract was supposed to be signed with such a representative. Compensation for each sales representative was based on the sales revenue achieved by himself/herself, and no compensation could be provided for referrals (however, this requirement appears to have not been strictly observed since there have been reports that several post-1998 enterprises are still using multi-level compensation methods).

Amway and Avon both transformed themselves into the post-1998 direct selling mode in 1998 but with different strategies. While not totally abandoning its sales representatives, Avon established more than 6,000 retail stores (with several hundred directly invested in by Avon) and set up operations at about 2,000 department store counters throughout China. Avon's sales representatives' mode remained single-level. Amway has opened fewer than 200 stores since 1998 while relying on its sales representatives for most of its sales revenue (which has reached about Rmb17 billion and is the highest in the industry).

The Legislation Period

China promised in its WTO Accession Protocol to remove the restrictions on conducting wholesale or retail services away from a fixed location within three years of its WTO accession (i.e., by December 11, 2004), by issuing legislation on direct selling.

With the deadline of December 11, 2004 approaching, SAIC and MOFCOM became active in preparing the new legislation on direct selling in early 2004. Although it was initially intended to issue the new legislation by this deadline, it finally took about one and a half years for the initial drafts proposed by SAIC and MOFCOM to be passed as the new Direct Selling Regulations and Anti-pyramid Regulations in August 2005. During this period, the drafts were revised several times as summarized below.

The drafts of the new regulations were reported to have been prepared by SAIC and MOFCOM as early as February 2004, which included a draft of Provisional Rules on Foreign Invested Direct Selling (zhixiao) Companies. In a closed-door seminar held by MOFCOM and SAIC in Xiamen on September 10, 2004, 22 enterprises (16 foreign-invested and six domestic, including Amway and Avon) were invited to attend, and three drafts were presented for discussion. These included the Administrative Measures for Direct Selling (zhixiao) (issued by MOFCOM), the Administrative Measures for Training of Sales Representatives (also issued by MOFCOM) and the Anti Pyramid Scheme Fraud Regulations (issued by SAIC). The drafts were then submitted to the State Council for review and approval. It appears, however, that the State Council was not satisfied with the drafts and there have been news reports that the drafts were returned by the State Council to MOFCOM and SAIC for revisions in December 2004. No regulations were issued by the expected deadline of December 11, 2004, and it took another eight months before the new Direct Selling Regulations and Anti-pyramid Regulations were formally promulgated.

None of the drafts have been made public, but based on various leaks and news reports written by some journalists who were given a chance to see the confidential drafts, it appears that most of the key provisions of the new Direct Selling Regulations and Anti-pyramid Regulations are based on the drafts as amended from time to time during the legislation period.

One notable incident during the legislation period was Avon's obtaining of the first direct selling trial licence from MOFCOM and SAIC on April 8, 2005. According to the disclosed trial operation plan, Avon will recruit no more than 3,000 sales representatives in the Beijing, Tianjin and Guangdong provinces. Compensation to sales representatives will be single-level and limited to not more than 25% of their sales revenues. Avon will also pay Rmb20 million to a government-designated account as a security deposit to cover any future disputes and complaints. Some observers have commented that this has demonstrated the government's preference for single-level selling and may have contributed to the adoption of only a single-level mode in the new Direct Selling and Anti-pyramid Regulations.

THE NEW REGULATIONS

Triumph of Single-level Selling

A distinctive characteristic of the new Direct Selling and Anti-pyramid Regulations is that single-level direct selling has become the only legitimate way of direct selling and multi-level selling has been categorized as an illegal pyramid scheme.

The Direct Selling Regulations provide that compensation to a sales representative must be based on his or her sales revenue achieved by selling products to end-users only and must not exceed 30% of such sales revenue. In addition, the definition for an illegal pyramid scheme as provided in the Anti-pyramid Regulations includes situations where the participant's compensation is calculated and paid based on the sales revenues achieved by other participants developed by himself or herself or below him or her, which is the typical multi-level direct selling compensation mode. This multi-level mode is expressly listed in the Anti-Pyramid Regulations as one of the three typical activities that are considered to be an illegal pyramid scheme. The single-level model has been declared to be the only legitimate direct selling mode.

In the Direct Selling Regulations, "compensation" is defined to include any commission, bonus and various rewards and economic gains the sales representative may receive from the direct selling enterprise. This is to prevent an enterprise from making disguised payments or providing other sorts of benefits (such as free air tickets or free travel opportunities) to sales representatives in order to circumvent compensation thresholds under the new legislation. In short, if such payments or benefits are provided as a kind of incentive for referrals, they may constitute a form of multi-level compensation.

Also, while requiring all direct selling enterprises to sign a sales service contract with each sales representative, the Direct Selling Regulations prohibit employees of a direct selling enterprise to be employed as direct sellers. This closes the door on another way of avoiding compensation limits in employing sales representatives, or those that meet equivalent standards (such as revenues achieved), as formal employees of a direct selling enterprise. Compensation paid to formal employees is defined as salary and is not subject to direct selling compensation limits.

This has caused concern for multi-level direct selling operators who constitute a majority of the direct selling business in China. They worry that moving from multi-level to single-level sales will slow the growth of sales teams and that the existing sales representatives will be less cooperative with each other and become competitors.

While multi-level players are facing a big challenge, single-level practitioners are not without problems. On April 11, 2005, only three days after Avon was awarded a trial licence, dozens of Avon's store owners protested to the company that they should be allowed to return their inventory back to Avon. Apparently, the store owners were worried about erosion to their business by the sales representatives recruited under the trial programme, since these sales representatives could purchase goods from Avon directly rather than from the retail stores and thus were exempt from the burden of erecting and maintaining a store, thereby minimizing costs.

From the government's perspective, single-level direct selling is far easier to control than multi-level direct selling and provides a higher degree of information transparency to protect consumers' rights. Although it was reported that in previous drafts of the regulations both single-level and multi-level selling were allowed but with a 25% or 30% compensation limit (compensation under typical multi-level direct selling can often rise to 40-60%), the government finally took the more cautious step of not allowing multi-level direct selling at all. Amway announced that it would restructure its compensation framework to comply with the new Direct Selling and Anti-pyramid Regulations.

High Entry Threshold

Only PRC-registered enterprises are allowed to engage in direct selling and foreigners are required to set up FIEs in order to conduct direct selling in China. Most threshold and operational requirements apply equally to both domestically funded enterprises and FIEs. MOFCOM and SAIC are the approval authorities for the establishment of direct selling enterprises. Applications must be submitted to a provincial branch of MOFCOM, which then submits the application to MOFCOM and SAIC for a decision on approval within 90 days.

As was expected, the threshold requirements are high. The minimum required registered capital is Rmb80 million (nearly US$10 million), the same as the requirement in the drafts and an increase from the requirement of the post-1998 rules of a minimum US$10 million total investment⁸ (i.e., in which case the minimum registered capital would be US$5 million based on China's mandatory requirements on the ratio between total investment and registered capital of an FIE). Also, a security deposit of Rmb20 million (around US$2.5 million) must be paid into a government-designated account at the time of establishment and the amount will thereafter be adjusted monthly to consist of 15% of the company's sales income in the previous month, between a range of no more than Rmb100 million but no less than Rmb20 million. These add up to a minimum cash commitment of Rmb100 million (around US$12.5 million) in order to set up direct selling operations in China and will surely deter most small and middle-sized players.

Investors in any direct selling enterprise must have good commercial reputations and have no record of serious transgressions during the past five years. This again indicates the cautious attitude of the government, since previously the clean-record period in the drafts was two years. One special qualification requirement for foreign investors is that they must have at least three years of overseas direct selling experience. The previous requirements for foreign investors to be a member of the WFDSA (World Federation of Direct Selling Associations) and for domestic enterprises to have at least an average Rmb500 million annual turnover for the past three years (which would permit only one domestic company to be qualified) have been removed from the new Direct Selling and Anti-pyramid Regulations.

Restricted Operations

In addition to the steep financial threshold, the Direct Selling Regulations have also imposed a number of restrictions on the operations of direct selling enterprises.

In recruiting sales representatives, a direct selling enterprise must:

i. Not advertise regarding compensation for sales representatives;

ii. Not require payment of certain fees or purchase of certain goods as a condition of engagement;

iii. Not recruit people under the age of 18, or people who are incapacitated or partially incapacitated from legally binding themselves, or students, teachers, medical professionals, civil servants, soldiers, military officers, its current employees and foreigners; and

iv. Sign a sales service contract with each sales representative, a sample of which should be submitted in the application for establishment. Sales representatives may terminate the service contract with the direct selling enterprise at any time during the first 60 days after signing and by giving 15 days' notice anytime thereafter.

Any sales representative must not engage in direct selling until he or she has obtained a sales representative certificate from the direct selling enterprise after receiving certain training and passing relevant exams. The training and exams must be provided free of charge. Teachers for the training sessions must be formal employees of the direct selling enterprise with at least one year of employment with the enterprise, a bachelor's degree and no criminal record. A list of the training teachers of each direct selling enterprise must be reported to MOFCOM to be published on MOFCOM's website, so people can easily determine whether a training session is permitted by searching for the teacher's name on MOFCOM's website. Foreigners are prohibited from acting as direct selling training teachers. The fact that training sessions involve people meeting together has been one of the reasons the Chinese government has attacked pyramid schemes. The Direct Selling Regulations require MOFCOM and SAIC to formulate separate rules on direct selling training.

In order to operate direct selling in a certain city or area, the direct selling enterprise must establish a branch in the applicable province (if the enterprise is not registered in that province) and certain service outlets (for the purpose of providing information regarding pricing and return policies and post-sales services) which must meet the requirements of the local county/district government or relevant higher level authority. Any sales representative may only conduct direct selling in that city or area. A list of direct selling enterprises and their branches will also be published on MOFCOM's website so people can check as to whether a direct selling enterprise is permitted to conduct direct selling in a certain area.

The restrictions on selling activities are intended to protect consumers and also, to some extent, sales representatives. Each sales representative must present to potential consumers his or her sales representative certificate and the sales service contract they signed with the direct selling enterprise. Sales representatives cannot enter a consumer's residence without permission, must immediately stop any selling activity and leave the consumer's residence if so requested, must disclose to the consumers the product return policies in detail, provide sales invoices and receipts, and provide the contact information of the service outlets of the direct selling enterprise.

Products must be labelled with prices which should be the same as the price displayed in the service outlets of the direct selling enterprise and the offered price. The Direct Selling Regulations require a 30-day cooling off period, during which time the consumer may demand product replacement or return as long as the products have not been unpacked. Sales representatives will have the same rights against direct selling enterprises. This mandatory no-reason cooling off period is a rare national rule. Most other consumer-related rules in China require a seller to accept return requests by consumers only with a reason, such as defects in the sold product not caused by the consumer themselves. Where there is any dispute regarding product replacement or return between the direct selling enterprise and the sales representatives, or between the former two parties and the consumers, the burden of proof is on the selling party in each situation. The direct selling enterprise is jointly liable for the selling activities of its sales representatives and must pay compensation to its sales representatives at least monthly.

In addition to the amount of the security deposit required to be retained at a government-designated account, the Direct Selling Regulations also provide that MOFCOM and SAIC may jointly decide to use the deposit if a direct selling enterprise unjustifiably refuses or is unable to: (i) pay compensation to its sales representatives; (ii) return the purchase price to consumers who request return of the products; or (iii) pay any indemnity to consumers due to product liability reasons. A direct selling enterprise is required to replenish the deposit within one month, furthermore, if the deposit is expended or is below the required amount. The deposit may not be used by the direct selling enterprise or otherwise encumbered in any way. Any interest that accrues on the deposit belongs to the direct selling enterprise and the deposit will be returned if the enterprise ceases to engage in direct selling as approved by MOFCOM and SAIC.

Favourable Developments

There are also some positive aspects to the new Direct Selling and Anti-pyramid Regulations. Direct selling enterprises are no longer restricted to selling self-produced products only. They can sell products manufactured by their parent companies and subsidiaries under their control. Direct selling enterprises may also obtain trading rights and distribution rights if relevant PRC requirements are met. Therefore, direct selling can be combined with other distribution channels to promote the sales of the products of a whole group.

The drafts of the new legislation had provided a list of products allowed for direct selling, including cleaning products, cosmetics, health food and small kitchenware. However, the new regulations do not contain such a list but authorize MOFCOM and SAIC to issue a list separately. Therefore, more flexibility has been allowed, since a MOFCOM and SAIC rule will be easier to amend than State Council regulations.

Further, using the general term 'service outlets' (not stores) without setting the minimum number required for each city or province frees each direct selling enterprise from the burden and obligation of establishing and running stores as was required during the post-1998 period.

Pyramid Schemes and SAIC's Right to Inspect

The issuance of the separate Anti-pyramid Regulations demonstrates the government's concern over pyramid schemes. Pyramid schemes are defined in the Anti-pyramid Regulations as containing any one of the following characteristics: (i) the compensation to a participant depends on the number of participants developed by him or her, directly or indirectly; (ii) the compensation to a participant depends on the sales revenue achieved by participants developed by him or her, directly or indirectly (such as in multi-level direct selling); and (iii) participants are required to pay certain fees or to purchase certain products in order to participate or to be able to refer others.

SAIC and its local branches are granted certain rights to investigate direct selling enterprises and unlicensed enterprises suspected of engaging in direct selling. They are authorized to impose penalties detailed in the Direct Selling Regulations. The Anti-pyramid Regulations authorize SAIC and the Ministry of Public Security (the police) to investigate enterprises suspected of engaging in pyramid schemes and to penalize parties for any violations. Anyone who organizes pyramid schemes, introduces, entices or forces others to participate in pyramid schemes, or who participates in pyramid schemes personally, or provides space, supplies, warehousing or internet information services to pyramid schemes, may be penalized.

MORE ACTION TO COME

The Anti-pyramid Regulations will become effective on November 1, 2005, one month earlier than the Direct Selling Regulations. It is generally believed that the timing of the implementation of these regulations has been staggered to emphasize the government's determination to attack pyramid schemes and build a better market environment for direct selling. To realize this goal, it has been reported that SAIC may launch a series of raids against illegal pyramid schemes. Similar views have been expressed by officials from the Legislative Office of the State Council and SAIC in an exclusive interview with the Xinhua News Agency. It has also been reported that SAIC may upgrade its anti-pyramid scheme office to a higher level and give it additional powers, including the ability to research and investigate the market and provide more leadership for the development of direct selling.

In addition, as indicated in the new regulations, MOFCOM and SAIC are required to prepare detailed rules regarding the scope of direct selling products, training of direct sellers, reporting and disclosure requirements for direct selling enterprises, the payment and use of the security deposit, etc. Since the product list and training requirements have been covered in previous drafts, there is reason to believe that certain implementing rules covering at least some of the above issues will be made and issued in the near future.

Endnotes

1 Announcement on Stopping Transgressions in Multi-level Direct Selling, issued by the State Administration of Industry and Commerce (SAIC) on August 10, 1994; Circular on Cracking Transgressions in Multi-level Direct Selling, issued by SAIC on September 2, 1994.

2 Notice on Stopping the Establishment of New Multi-level Direct Selling Enterprises, issued by the General Office of the State Council on September 22, 1995.

3 Implementing Measures on Investigating and Sorting Multi-level Direct Selling Enterprises, issued by SAIC on October 17, 1995; Notice on Further Strengthening the Inspection and Administration of Multi-level Direct Selling, issued by SAIC on October 10, 1996.

4 Circular on Several Issues Regarding the Approval and Inspection Administration of Direct Selling Enterprises, issued by SAIC on January 22, 1997; Circular on Several Issues Relating to the Approval of Direct Selling Enterprises, issued by SAIC on March 7, 1997.

5 Circular on the Prohibition of Direct Selling Activities, issued by SAIC on April 28, 1998; A Promotional Outline of Attacking Direct Selling (chuanxiao) and Disguised Direct Selling (chuanxiao) (the SAIC Promotional Outline), issued by SAIC on August 5, 2004.

6 The SAIC Promotional Outline.

7 Issued by SAIC, MOFTEC and the State Economic and Trade Commission on February 4, 2002.

8 Article 4, Document No. 455.