In a short time, China has moved from being the world’s workshop to its most lucrative consumer market. China is a market with 1.4 billion consumers and in 2013, Chinese consumers spent nearly half of their annual salary on consumer products. These consumers are increasingly spending big on health supplements, cosmetics, weight loss products, vitamins and other recurring, affordable luxury type products for better quality of life.
China does not only have the world’s biggest consumer market but this market is expected grow by USD 2.3 trillion from 2015 to 2020 – Over the course of five years this growth will roughly equal a market 1.3 times the size of Germany or the UK.
Even better news for MLM companies is that retail growth rates for their types of product are exploding – health supplements have grown by 25.2% in the years up to 2014, and cosmetics currently have a compound annual growth rate of 12%, weight loss products 5%, and vitamins 9.7%.
However, China is not just a massive market for MLM. In many ways, Chinese society makes for fertile ground for MLM with its close-knit communities of friends and family that dominate social interactions and life. As such, traditional advertising is much less effective in China than in the West as word of mouth and similar advertising through channels such as “friends’ circles” and popular social networking applications like Wechat are far more effective. This culture creates the perfect environment for MLM and network marketing which is primarily based on affiliates having a close network of friends and family.
Direct-selling in China is BIG and is continuing to grow at a rate 3 times the level of growth in the US, not accounting for the recent liberalization of direct-selling for international companies which will lead to even more accelerated growth. Hu Yuanjiang, secretary-general of the Direct Selling Expert Committee of the China Marketing Association has indicated that growth in the industry is predicted to keep increasing to hit RMB 1 trillion (USD165 billion) in less than 10 years.
International companies have a great opportunity to take a major slice of this market due to their cutting edge products, management experience, established brands and the trust that Chinese consumers have in direct sales products such as cosmetics, nutritional and supplement goods.
The question is how to take advantage of this opportunity.
Direct Sales in China – From Being Banned to Liberalization
Although in many ways China seems an ideal environment for MLM, it has had a difficult road to travel.
The hardline restrictions can be traced back to 1997 pyramid schemes in Albania that resulted in civil disorder and violence that threatened the stability of the Albanian government. Albania’s susceptibility was due to unfamiliarity with financial markets, a difficult transition from central planning to a market economy and limited financial sector reform – the PRC government saw the instability and immediately clamped down on direct selling companies in May 1998.
Over time this ban has been relaxed and China now allows direct selling operations but restrictions continue to apply to multi-level marketing (MLM) i.e. direct selling whereby distribution of products or services distributors to earn income from their own retail sales and the sales made by their directly/indirectly recruited salespeople.
Chinese Legal Restrictions
According to “Regulation of Direct Sales and Regulation on Prohibition of Chuanxiao” (2005) MLM in China is illegal.
Article 7 of the law uses terms such as ‘multi-level cheating’ and ‘illegal pyramid schemes’ interchangeably for any sales structure whereby payments are made on a multi-level basis. Accordingly in China multi-level payments structures are treated as if they are an illegal pyramid scheme. The law does not allow for any loopholes. Rather, the law simply states that any commission payouts beyond one level may result in serious legal consequences including criminal liability.
Accordingly China views multi-level payouts very differently from the rest of the world which draws a distinction between legitimate MLMs and pyramid schemes as outlined in the landmark Amway Corp 1979 ruling. The Amway ruling stressed the main difference between a legitimate MLM business model and a pyramid scheme is that whereas a legitimate MLM makes money primarily from the sale of products to end users with a focus on selling products rather than recruiting ever more salespeople. On the other hand a pyramid scheme charges steep startup costs for joining, including such items as mandatory training, starter kits and non-refundable membership fees and offers payment simply for recruiting other distributors. Essentially, it compensates those at the top of the pyramid with participation fees paid by those recruited from the bottom.
MLM with Chinese Characteristics
The restrictions China places on MLM structures does not mean that MLM companies are not able to operate in China – they just need to change the way they operate.
Direct sales are legal in China. Indeed a distinctly liberalizing trend can be discerned. The 2015 Foreign Investment Catalogue explicitly allows for foreign investment in direct sales companies and there has been a steady increase in the number of direct selling licenses being issued by the PRC Ministry of Commerce (MOFCOM). In 2015, approximately 20 companies obtained direct selling licenses for China. In the year to date 73 companies (both domestic and international companies) have been issued with direct selling licenses.
PRC law clearly allows companies to do direct sales provided 1) company only pays out one level of commission; 2) individual direct sellers undergo extensive training; and 3) company obtains a direct selling license.
In addition direct sales companies must also comply with a host of operational requirements.
Restrictions as to Product Types – Not all products can be sold via a direct sales business model in China. PRC law limits direct sales to products such as cosmetics (including personal care, beauty and hair products), health food and nutritionals, sanitation articles, healthcare appliances and small kitchen appliances.
Sales People – direct selling sales people must wear badges at all times when sales are being conducted. In addition the law caps commissions to individual direct sellers at 30% of his/her sales, which includes bonuses, commissions, and any other economic benefit received.
Capital Requirements & Security Deposit – direct selling companies are subject to minimum capital requirements of RMB 80 million and placing an initial security deposit of RMB 20 million. These requirements are meant as safeguards for consumers and sales affiliates against unscrupulous business practices and are not fees paid to the PRC government. The companies do not actually lose this money as registered capital can be used for operational costs and the security deposit is in fact a deposit.
Building a China Compliant Structure – In our experience many direct sales and network marketing companies encounter difficulty in restructuring their business model from an MLM model in which affiliates are compensated for their entire downline and organization size to a structure which only allows for one level of commission being paid.
Indeed, many network marketing companies starting up in China find it very difficult to root out MLM remuneration structures and standard MLM-speak. International network companies must always bear in mind that such MLM elements can lead to compliance issues and confusion as to the overall business model.
International MLM companies need to restructure their entire compensation scheme to operate compliantly in China. There are a number of structures which allows this to be achieved. Some companies use distribution models whereby higher commission percentages are paid based on sales volume and this enables top level distributors to on-sell products to lower level distributors and earn the difference between such wholesale price and price to lower level distributors. This model effectively allows top level affiliates to be compensated by their entire organization without having several layers of commission which would be illegal in China.
Conclusion
China is a massive opportunity for international network marketing companies. The market is already huge and has the potential to quadruple by 2020, effectively creating a consumer market worth USD 5 to 7 trillion.
However, network marketing companies need to ensure that their China operations are not confused with “Chuanxiao” the Chinese term for pyramid schemes. The mere mention of Chuanxiao strikes fear into the hearts of many Chinese. Due to Chinese sensitivities and laws international network marketing companies need to be careful to ensure full compliance. A failure to do so will not only result in operational problems or civil claims but also potentially criminal liability.
MARK SCHAUB
International Partner
Shanghai
T +86 21 2412 6003
schaub@cn.kwm.com
