|June 16, 2014|
Previously published on June 10, 2014
In FTC v. BurnLounge—after providing a crash course on pyramid schemes and how to properly distinguish a pyramid from a legit multi-level marketing (MLM) operation—the Ninth Circuit upheld the district court’s finding that BurnLounge’s business constituted an illegal pyramid scheme in violation of Section 5(a) of the Federal Trade Commission Act. In doing so, however, the court was careful to make clear that internal sales (i.e. sales of products to recruits) are properly classified as sales to “ultimate users” and, thus, do not by themselves constitute a pyramid scheme. This aspect of the court’s decision is a big victory for direct sellers, who rely on and are motivated by sales to downstream recruits but whose primary motivation is for the sales of products versus merely signing up new recruits.
BurnLounge operated a multi-level marketing business that offered participants the ability to become retailers of music and other merchandise ("Merchandise") by purchasing a package. Packages provided participants with a webpage and the right to sell Merchandise through the webpage. Participants were compensated for selling Merchandise and also for selling packages to new participants. By default, payment was in the form of points redeemable for more Merchandise, but for an additional monthly fee, participants could convert their points to cash, which was the preferred choice for the vast majority of participants. Specifically, participants could be paid in three ways:
- Concentric Retail Bonuses. These bonuses were based on Merchandise sales made on the participant’s webpage and on the webpage of downstream recruits up to six degrees away. The latter was only available if the participant sold the same number of packages as the number of degrees away the recruit was. In other words, for a participant to be paid for sales made by a direct recruit’s recruit (two degrees), the participant must have also previously sold at least two packages.
- Product Package Bonuses. These were paid for selling packages to new recruits with some incidental requirements that Merchandise also be sold.
- Mogul Team Bonuses. These were paid solely for selling premium packages to new recruits regardless of whether Merchandise was ever sold.
To determine whether BurnLounge was an illegal pyramid scheme, the court applied a two-prong test developed by the FTC and adopted by the Ninth Circuit in Webster v. Omnitrition, 79 F.3d 776 (9th Cir. 1996). The test asks whether participants pay money to receive “(1) the right to sell a product and (2) the right to receive in return for recruiting other participants into the program rewards which are unrelated to the sale of the products to the ‘ultimate users.’” Id. at 781 (quoting In re Koscot Interplanetary, Inc., 86 F.T.C. 1180 (1975). The second prong of the test is satisfied where “[t]he mere structure of the scheme suggests that [the defendant’s] focus was in promoting the program rather than selling the products.” Id. at 782 (emphasis in original). See also In re Amway Corp., 93 F.T.C. 618, 716-717 (1979) (In a pyramid, “participants purchase the right to earn profits by recruiting other participants, who themselves are interested in recruitment fees rather than the sale of products.”).
The court found the straightforward first prong of the test easily satisfied. As to the second prong, BurnLounge argued that the test was not met because, inter alia, sales by participants to new recruits constituted sales to “ultimate users,” and any rewards paid on these sales were related to the sales of products to “ultimate users.” The FTC argued that internal sales cannot constitute sales to “ultimate users.” The court accepted the foundation of BurnLounge’s argument by ruling that “when participants bought packages in part for internal consumption (to obtain the ability to sell music through [webpages] and to use the package merchandise), the participants were the ‘ultimate users’ of the merchandise and that this internal sale alone does not make BurnLounge a pyramid scheme.” As a result, the court rejected the FTC’s argument that internal sales cannot constitute sales to “ultimate users.” BurnLounge’s argument still failed, though, because even though there were sales to “ultimate users,” the rewards were for recruiting, not for sales, rendering the rewards unrelated to sales to “ultimate users.” Accordingly, with both prongs of the test being satisfied, the district court’s finding that BurnLounge was an illegal pyramid scheme was upheld.
Finally, although this case was a victory for the FTC and a loss for the marketer, the decision still represents a big win for marketers. The court’s rejection of the FTC’s argument that internal sales cannot constitute sales to ultimate users provides additional protection to direct sellers who rely on internal sales. Legitimate direct sellers and other MLM companies may now be less likely to be targeted by regulators simply because they rely on internal sales. Indeed, even if the seller relies primarily on internal sales, so long as the bonus structure makes clear that the focus is on sales of products to ultimate users versus recruitment, illegal pyramid scheme concerns will likely be averted.