(ARTICLE FEATURED IN SEEKING ALPHA) Battle Over BurnLounge: Both sides claim victory

Below is an excerpt from my article about the Ninth Circuit opinion on BurnLounge.  The article can be read in full over at Seeking Alpha.  It’s an important subject.  Click here to read it.

Summary

  • The Court successfully threaded the needle on the issue of “ultimate users,” essentially creating two classes of participants.
  • The Court provided several factors throughout the opinion to help outsiders deduce the motivation driving consumption. This is especially helpful in assessing $HLF.
  • The Opinion will require the FTC’s pyramid scheme expert to create another analytical framework to distinguish pyramid schemes from legitimate direct selling companies (assuming they need one).
  • The Court adopted the logic provided by the FTC in its 2004 Staff Advisory Opinion.
  • The Court eliminated all confusion regarding Omnitrition as it completely ignored the widely referenced dicta that consumption from participants cannot count as sales to “ultimate users.”

On June 2nd, 2014, the Ninth Circuit published its long awaited BurnLounge Opinion. Within hours, both sides of the Herbalife battlefield issued statements claiming victory about the decision. I’ve taken the week to process the opinion. During this time, I’ve tried to keep up to speed with the online chatter regarding various interpretations. One thing is clear: the gray space in MLM law separating legitimate direct selling companies from pyramid schemes has been minimized considerably.

On the one side, Bill Ackman’s Pershing Square spun it as validation of its argument that commissions in the Herbalife plan were derived primarily by opportunity driven demand (recruitment rewards) instead of legitimate product consumption. On the other side, the MLM industry (myself included), breathed a sigh of relief, submitting that the decision validates a lot of our main points in responding to common criticisms of the model. This article is intended to cull out the key nuggets in the BurnLounge decision and interpret what it means going forward.

End of Excerpt

Click here to read the rest of the article on Seeking Alpha.  Seeking Alpha is a news site dedicated to publishing content about publicly traded companies.  The article took me quite a bit of time to prepare.  I hope you find it informative.

Update on the Fortune Hi Tech Case – FTC Passes on Scalpel, Goes for Sledgehammer

As a refresher, in early February of 2013, the FTC got an injunction issued against Fortune Hi Tech Marketing. The summary of the lawsuit can be found here: FTC vs. Fortune Hi Tech.

FTC’s Strategy

FTC passes on the scalpel and picks up the sledgehammer.

FTC passes on the scalpel and picks up the sledgehammer.

Since the lawsuit was filed, I’ve had a lot of time to study the FTC’s arguments against FHTM. In particular, I closely studied the FTC’s expert report prepared by Dr. Peter Vander Nat. The FTC’s entire case hinges on the validity of Peter Vander Nat’s report.

In the lawsuit, the FTC passed for the scalpel and picked up the sledgehammer. In summary, they’re no longer relying on Vander Nat’s convoluted math formula, which I discussed in my last article regarding the FTC’s economist. If you’re following the news with Herbalife, I think you’ll find this next point interesting. Currently, there’s a lot of bickering back and forth between MLM proponents and critics alike over the interpretation of Vander Nat’s formula. People are discussing how Herbalife stacks up to the standard. With one word, I can put the entire debate to rest for both sides.

Are you ready for it?

The word is:

IRRELEVANT

The formula is irrelevant. In Vander Nat’s lengthy declaration used against Fortune Hi Tech, the formula is never mentioned. Not once. Why? The answer is obvious. The FTC is distancing itself from it because the formula is too broad and too confusing. The FTC’s case against BurnLounge (sued in 2006) is jeopardized due to the ambiguity of this standard. The case is currently under appeal. The main source of contention: Vander Nat’s qualification as an expert. Vander Nat had never studied an MLM that he concluded was legal. Where’s the fairness in using an objective standard to measure right from wrong when you never find anything right? There’s no wisdom in designing a water-filter if there’s no opportunity for water to pass through.

Sledgehammer

In his declaration, Vander Nat opines and argues that FHTM was operating as an illegal pyramid scheme. Instead of relying on his formula, he bases his finding on a few assumptions. Those assumptions are all addressed in Charles King’s declaration (available below). Dr. King was retained by FHTM as its expert in their effort to dissolve the injunction. Out of Vander Nat’s assumptions, there’s one that should be concerning for all people in the network marketing industry: commissions triggered via internal consumption are “recruitment bonuses.” In other words, rewards triggered via distributor consumption are illegal. This argument represents a dangerous and irresponsible strategy employed by the FTC. In one of the footnotes in his declaration, Vander Nat writes, “…I also understand that the ultimate users of the products – for purposes of the Koscot test – are people who are not participants in the business venture.” With this framework, he pulls out all revenue garnered from distributor consumption. He then compares the money left over (not much) with the money paid out in bonuses. He then concludes that the pay plan is underfunded and relies on “recruitment bonuses” to survive. Charles King sums it nicely when he writes:

Since Vander Nat is not counting commissions generated via internal consumption, it creates the impression that the plan lacks sufficient revenue from product sales to support the commissions. He treats the difference between revenue available for commissions and the amounts paid as recruitment bonuses. Using his own definition of “end user,” he’s able to dramatically shrink the commission pot; thus, creating the false impression that the Commission Plan is insufficient and underfunded.

Optimal Scenario

Vander Nat also relies on an economic theory known as “Optimal Scenario.” Using the Optimal Scenario framework, Vander Nat assumes that if EVERYONE were to hit the high levels in the FHTM business, the plan would be underfunded. The reality: not everyone hits the levels nor does everyone try. While Vander Nat acknowledges that breakage exists (money in the plan from un-earned commissions), he ignores it completely. In network marketing, the participants operate with various goals. There are some that want to earn a few hundred dollars a month, some do it for social reasons, some want to save money on product, some are supporting a friend or relative, etc. They’re not all trying to “max out” the pay plan. This assumption was faulty and led to a faulty conclusion.

What does all of this mean?

Change is coming. Stay tuned. In 2004, the FTC said that the amount of internal consumption is inconsequential for pyramid scheme analysis. Based on their recent case against FHTM and various posts on their website, the FTC appears to be back-tracking. It’s going to take strong leadership to steer this conversation in a favorable direction for the industry. And strong leadership requires that we at least acknowledge the areas where we’re weak. Cultures of hype need to stop. Product value matters. Without question, the industry is going to look different within 18 months. How different? We’ll see.

If you’re reading this via email, click this link to review the declaration prepared by Charles King.

MLM Detractor Blatantly Mischaracterizes the Law: Ignores Facts and Precedence

Bruce CraigRetired Wisconsin litigator, Bruce Craig, wrote an article featured on Seeking Alpha titled, “An Investor’s Guide to Identifying Pyramid Schemes.” While the title certainly implies a hint of objectivity, it’s simply false advertising . In a nutshell, the author holds on to his long-standing, 30+ year view that all MLMs are pyramids. Unfortunately, Craig willfully omits several well-known facts that obliterate his entire argument. It’s this kind of willful omission that makes him guilty of the very behavior he claims to be against.

Bruce’s thesis is simple: When analyzing a MLM for legality, retail sales do not matter…at all. In fact, he essentially concludes that all MLMs are illegal. If there’s any sort of recruitment element to a program, it’s “inherently deceptive” due to their “exponential characteristics.” In other words, with no limits on recruitment, epic doom is inevitable. This “all MLMs are pyramids” rationale is made crystal clear in Bruce Craig’s 2009 letter to the FTC when he says, “[The Amway case] has effectively legitimized pyramids, now called MLM’s.”

True North

I always respect people’s right to voice their opinions. While I might disagree with the points, I think good, open dialogue is the only path to progress. But…in the Seeking Alpha article, Bruce crosses a line. He is not providing objective, well-researched information to investors, as implied in the title. He’s making a carefully crafted argument. The article is “Outcome Determinative,” meaning he begins with the end in mind (all MLMs are pyramids) and stitches quotes together in support his argument. While making his argument, he leaves out several material bits of information.

Bruce Craig’s “True North” is ultimately protection of consumers. When he says he cares about consumers, I believe him. But as Abe Lincoln said in the recent movie (“Lincoln”), “What good is True North if you end up stuck in a swamp?” At some point, critics like Bruce need to be practical. Taking the position that all MLMs are illegal immediately removes you from the conversation. Completely. And without influence, there’s no change. The industry is not going away. Instead of drawing hard lines and praying for a nuclear bomb to decimate the entire industry, wiping out even the cleanest of companies, he and critics like him should try to offer suggestions to make the industry better. I have a personal experience of being hammered with the political process. I tried to pass an anti-pyramid bill in Tennessee in 2010. The bill was killed by the DSA. Instead of whining about the political process (as done in nearly every article posted by critics), I joined the DSA. I’m a firm believer that the right ideas win over time. Bruce’s article lacks objectivity, which is why it will only serve to excite the critics and be largely ignored by everyone else, including regulators.

I’m going to address Bruce’s points in no particular order.

Market Uncertainty With Respect to MLMs

When writing about his motivation for the article, Bruce writes, “The recent incident involving David Einhorn and Herbalife (HLF) drew my attention to the stock market and the subject of pyramid schemes. It seemed that the significant drop in Herbalife’s stock price reflected a market uncertainty about the inherent stability and legality of this company.”

This is false. As a quick recap, Einhorn asked a few questions during an earnings call with Herbalife. During the call with Einhorn and shortly thereafter, Herbalife’s stock dropped 20% ($1.7 Billion loss in value). The market was not reacting to uncertainties about Herbalife’s model, the market was reacting to Einhorn. Einhorn is a legend on Wall Street, having successfully shorted multiple companies, including Lehman Brothers and Green Mountain Coffee. The market perceived that Einhorn smelled blood with Herbalife. Herbalife’s stock dropped 10% during Einhorn’s 5 minute conversation on the earnings call. 5 minutes is hardly enough time for analysts to research MLM law and thoughtfully conclude that the Herbalife stock was junk. They were reacting to Einhorn. Despite this “market uncertainty,” the other publicly traded companies in the MLM industry are doing just fine. The average rate of return on the publicly traded MLMs is well over 30%, soundly beating the DOW, NASDAQ and the S&P 500. It’s not even close.

Misleading Analysis on BurnLounge

In his article, Craig referenced a definition in the judge’s final order against BurnLounge. This case represents the most recent case against a pyramid scheme. In the final order, the court defined “Prohibited Marketing Scheme” as:

An illegal pyramid sales scheme . . . in which participants pay money or valuable consideration in return for which they obtain the right to receive rewards for recruiting other participants into the program, and those rewards are unrelated to the sale of products or services to ultimate users. For purposes of this definition, ‘sale of products or services to ultimate users does not include sales to other participants or recruits or to the participants’ own accounts.

If you were to read this definition out of context, it would certainly seem that it’s illegal to pay commissions on product consumption generated by distributors (known as internal consumption). In fact, if interpreted literally, this sort of definition would spell the end of the network marketing industry, period. Bruce takes advantage of this quote and contrasts it with a seemingly contradictory statement the FTC made in 2004. In the FTC’s Advisory Memo to the DSA, it said, “In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme.

There are 3 key facts that Bruce fails to mention:

1) The definition in the BurnLounge order is IDENTICAL to the definition found in another case against a pyramid scheme twelve years ago (FTC vs. Equinox). The FTC’s advisory memo quoted by Bruce came well after the Equinox case. The FTC made its position clear: Paying commissions on internal consumption is fine.

2) The definition that Bruce quoted was specifically limited to the BurnLounge case. First, it’s clear when it reads, “For purposes of this Final Judgment….the following definitions shall apply.” Second, Bruce failed to reference the other part of the FTC’s memo…the one that clearly says that the definitions found in the Orders do not represent the “general state of the law.” It’s pretty important…and he left it out. The memo says,

[T]he FTC often enters into consent orders with individuals and companies that the Commission has determined have violated the FTC act. To protect the public from those who demonstrated unwillingness follow the law, these orders often contain provisions that place extra constraints upon a wrongdoer that do not apply to the general public. These ‘fencing-in’ provisions only apply to the defendant signing the order. . .”.

It’s crystal clear. Despite what Bruce was suggesting in his article, the FTC was not contradicting itself in the BurnLounge order. It’s doing exactly what it’s been doing over the past twenty years. Bruce Craig is not a disinterested reporter looking to provide help for investors. He’s an opportunist taking advantage of media generated by David Einhorn to lob a grenade at an industry he clearly hates.

3) Bruce fails to reference the BurnLounge Statement of Decision. Prior to the Final Order, the judge wrote a 31 page opinion where he stated his conclusion about BurnLounge. I summarized this BurnLounge Statement of Decision on my site. While Bruce argues that retail sales have no place in pyramid scheme analysis, the judge in BurnLounge dedicated almost 10 pages to the value of the BurnLounge product (or lack thereof). He ultimately concluded that the products had SOME marginal value; thus, he discounted the amount of consumer harm. If everything hinged on the “exponential characteristics” of the marketing plan, as submitted by Bruce, there would be zero need to discuss the product. Bottom line: retail sales DO matter. If the products have legitimate value as demonstrated by retail sales, it’s indicative of a legitimate program. Speaking of retail sales, even the FTC’s own economist, Peter VanderNat, wrote about the importance of retail sales when distinguishing legitimate MLMs from pyramids. There’s just no way around it: retail sales matter.

The rationale that led Bruce Craig to reference a single sentence out of context while ignoring the 31 page Statement of Decision is beyond me.

Tolman Case

While Bruce was eager to reference two pyramid cases from over 35 years ago, he ignores a case that was published in 2004. In Tolman, the court held that paying commissions on downline purchases “does not, by itself, render a multi-level marketing scheme an illegal pyramid.” Paying commissions on internal consumption is perfectly legal.

Bottom Line

Critics are desperate. It’s not just Bruce Craig. There have been a number of negative reports lately, all having commonality on a certain line of thought: “MLMs say that everyone can win….and since people fail, it’s fraud.” They’ll use words like “destined to collapse” without referencing a single case of market saturation. And they’ll never reference the technology tools available today that eliminate all geographic barriers for distributors; thus, negating their saturation arguments. They simply hate the space and they want it gone. And now they’re growing angry because they’ve been largely ignored by the FTC over the past several years. It’s not a surprise: their position is logically, politically and economically untenable.

The space needs to improve. I agree on that point. I’ve written exhaustively about my ideas to improve the MLM space. The industry is not perfect, but it’s still a great space. And whether the critics like it or not, the business model is accelerating. Peer to peer advertising is a much more cost effective and efficient means of distributing unique products and services. While I agree that the space needs to improve, I take exception when another lawyer makes an argument while leaving out material information. It’s just poor form.

If you found this post informative, please hit the +1 button above. And to continue following me, check out my Google Plus page. Also, feel free to subscribe via email.


ACES Radio Live With Troy Dooly and Jim Gillhouse

When both Troy Dooly and Jim Gillhouse call me to be a guest on their program, I jump every single time. They ask great questions and lead fantastic conversations on their program.

During this episode, we talk about the troubling language in the final BurnLounge order. Feel free to listen and share your thoughts below.  Already after this interview, I’ve been a part of some great conversations about the future of the space.  It’s a very healthy discussion.  

Listen to internet radio with ACES Radio Live on Blog Talk Radio

Self Deception: a cancer holding the MLM industry back

It’s a strong title, I know.  But it’s true.  We all suffer from “self deception” to a certain extent.  It’s a trick we play on ourselves to shift accountability. We tell ourselves that we’ll start that diet….next week.  We tell ourselves that we lack the time to read and learn new skills.  We tell ourselves that exceptional people are just born exceptional.  We tell ourselves that we need just a little more education and work experience before we start our own businesses.  We give ourselves every possible excuse to maintain our view of the world.  Change is scary.  It hurts; hence the saying “no pain, no gain.”  Yet, there’s no way around it.  Change is a prerequisite for progress.  Strong leadership is required to ensure that the RIGHT kind of change is being pursued.  Right now in the MLM industry, we’re heading in the wrong direction, in my opinion.  I’m just calling it like I see it.  I’ll admit, I’m part of the problem.  I’ve got leadership positions and I’ve done a poor job at communicating the scope of the problem.

So what’s the problem?

We need clearer standards.  The MLM industry is cloaked in a veil of ambiguous law where there’s an ocean of gray separating legitimate companies from pyramid schemes.  I was prompted to write this article based on the industry’s response to the BurnLounge Final Order (click here for a summary of the BurnLounge decision).  Since BurnLounge’s fate was officially sealed when the final order hit last month (pending an appeal), people are now figuratively saying “yeah, I always knew those guys were really stupid.  After all, their product could not really stand on its own in the marketplace.”  (See comment above about self deception).  And now, people are rightfully unnerved by some verbiage in the BurnLounge order.  In particular, the Order defines a “Prohibited Marketing Scheme” as:

[A]n illegal pyramid sales scheme . . . in which participants pay money or valuable consideration in return for which they obtain the right to receive rewards for recruiting other participants into the program, and those rewards are unrelated to the sale of products or services to ultimate users.  For purposes of this definition, a sale of products or services to ultimate users€ DOES NOT include sales to other participants or recruits or to the participants own accounts. (emphasis mine).

In other words, according to this Order, it’s illegal to pay commissions on volume consumed by other participants in the downline. This is a practice EVERYONE does, across the board. In fact, in it’s advisory letter to the DSA, the FTC has stated this is fine.

Consequence of the BurnLounge Order?

Before you lose sleep over the BurnLounge Order, keep in mind this definition is not automatically binding for future decisions.  It has no authoritative value beyond this Order.  But what if a judge with an axe to grind against the industry wants to adopt a similar interpretation of “Illegal Pyramid Scheme?”  And what about your future customers?  What if they come across this definition?  It could easily be interpreted as the law of the land, causing more confusion and disharmony in the industry.  Someone could very easily read it and falsely think, “Huh, that makes sense.” Whether it carries authoritative value or not, I’m not comfortable with this definition inked on an Order.

But here’s the kicker.  Given the ambiguity in the law, what do we expect?  What IS the definition of a pyramid scheme? It’s basically been boiled down to a “you know it when you see it” test.  Universally, we all agree that products in the industry need to have the ability to stand on their own in the marketplace irrespective of the compensation plan.  So we all admit that there’s needs to be SOME revenue attributable to outside customers i.e. people unaffiliated with the program.  In the BurnLounge case, only 3% of its revenue came from customers.  How much is enough?  There’s no firm answer.

Was BurnLounge really that different?

While we’re coming up with reasons to distinguish BurnLounge from the rest of the companies in the MLM industry, I see more similarities than differences.  While they made some very stupid mistakes, whether it be by bad counsel or corporate hubris, at the end of the day, they were buried by their paltry customer numbers.

So how do we respond?  How do we improve?

One option is to seek peace. To try to convince ourselves that the owners were simply reckless. The better option would be to seek improvement by having an honest conversation about the problem.  While we easily roll BurnLounge under the bus and reference their junk products as the main reason for their demise, we should at least acknowledge, industry-wide, the major importance of accruing revenue from external customers.  When proving the marketability of a product, the only metric that really matters is revenue from customers.  More is better.  While we all agree that BurnLounge was a bad business, we need to have an honest discussion about WHY it was a bad business.  And all roads leads to the offering of a legitimate product with true value.

Instead…

We’re trying to “get tough on crime” by passing legislation that would effectively legitimize a model very much like BurnLounge.  Instead of shrinking the gray and increasing the standards in the industry, we’re falling back to old tricks, talking about resurrecting old bills to “clarify” the ambiguity in the industry.  We all know the FTC and regulators want to see external sales.  So why are we even discussing old bills that obliterate all external sales obligations? The DSA model legislation, in my opinion, does not go far enough.  In the bill, it carves out an exception for an illegal pyramid scheme as:

(A) Nothing in this Act may be construed to prohibit a plan or operation, or to define a plan or operation as a pyramid promotional scheme, based on the fact that participants in the plan or operation give consideration in return for the right to receive compensation based upon purchases of goods, services, or intangible property by participants for personal use, consumption, or resale so long as the plan or operation does not promote or induce inventory loading and the plan or operation implements an appropriate inventory repurchase program.”  (emphasis mine).

Inventory loading is defined as:

The plan or operation requires or encourages its independent salespeople to purchase inventory in an amount, which exceeds that which the salesperson can expect to resell for ultimate consumption or to consume in a reasonable time period, or both.

It might take you a few times to read it to understand the gray area.  But basically, if the product gets consumed in reasonable quantities each month, the company is not a pyramid (in most cases).  Suppose we sell a membership to a Facebook-wannabe website.  In this business, we charge $10,000 per month to access a clunky social network, one that offers half of the features found on a free alternatives.  Is it “inventory loading?”  The site, after all, is being used.  What if we sold $10,000 shots of lemonade?  If people drink the lemonade, is it “inventory loading?”  Clearly, it’s a case of opportunity driven demand.  Clearly, it would be a BurnLounge-esque program where the lemonade is a token product concealing a money transfer scheme. I want to engage in a conversation with the DSA to simplify and tighten the current bill. One thing is for sure: nothing is going to get done on a legislative level without the DSA’s support.

HR 1220

And what about the congressional bill that was proposed in 2003, titled HR 1220 Anti-Pyramid Promotional Scheme Act?  In that bill, a similar definition of “Pyramid Scheme” is illustrated:

The term `pyramid promotional scheme’ means any plan or operation in which a participant gives consideration for the right to receive compensation that is derived primarily from the recruitment of other persons as participants in the plan or operation, rather than from the sales of goods, services, or intangible property to participants or by participants to others.

Again, the bill creates a carve-out that would allow a company like BurnLounge to skate by with NO retail sales to customers.

Before we complain about a judge’s dangerous definition of a “pyramid scheme,” we need to acknowledge that we’re not exactly helping ourselves by fighting for fewer safeguards.  If we’re not able to get on the same page regarding sensible standards, a judge will do it for us at the stroke of a pen.  Somewhere along the way, we’ve been convinced that it’s in our best interest to push for these sorts of solutions.  I’m telling you, we NEED to do better.

Saving the industry by defining the gray

When I first started my practice, I wrote an ebook titled “Saving the network marketing industry by defining the gray.”  The thesis is right there in the title.  The industry needs saving.  And it can only be saved by creating clear standards to distinguish good companies from the bad ones. And it’s going to take courage and a little bit of sacrifice.

Conclusion

There’s a lot of people upset at the verbiage in the BurnLounge order. The outrage makes sense. But…I think this Order is just the tip of the iceberg if we’re not able to improve the standards. And in order to improve the standards, we need to stop with the self-deception, pull ourselves out of the box and acknowledge the problem. If we do not find a viable solution to the problem, a judicial body will!

Proposed Solution

The sponsor relationship between a distributor and a new participant is the foundational element in the industry. How a participant is recruited generally dictates how they build the business in the future. The idea of recruiting someone and training them to only get on autoship and recruit more people is broken. In theory, when someone sponsors someone else, they’re committing themselves to teaching that new person how to move product and build an organization. Before they’re allowed to build an organization, it makes sense that they demonstrate SOME proficiency in selling product. Before I teach you how to sell soap, I should at least have some demonstrable results doing the same, right?

Until someone provides a better idea, I’m a believer in a required retail sales rule. Before someone can earn a bonus on downline volume, they must make a single sale each month to a nonparticipant customer. Keep in mind, this is only an idea. It’s not currently the law, so it’s perfectly fine for companies to operate without a retail sales rule. If each distributor were required to sell something, they’d think long and hard before joining a company with gratuitously inflated prices on the products. When Amway got in trouble in the UK, they were saved by their decision to require $200 in retail sales before someone can sponsor other participants. This incredibly high standard is not necessary here, but we can learn from it. In the 70s when Amway got into some heat with the FTC, they were saved largely by their retail sales rule. I drafted a proposed bill for Tennessee lawmakers a couple of years ago. I still think it advances the industry in the right direction.

The alternative: nothing gets done. If you’re not supportive of higher standards in the industry, at least stop complaining when judges create their own definitions.

What do you think?

Does the BurnLounge order concern you? What can we do to improve? If you learned something in this article, please hit the +1 button or “Like” it.

FTC vs. BurnLounge – Case Summary

A few months ago, I published a concise ebook that summarized the FTC / BurnLounge decision.  This ebook was pre-released only for my MLM newsletter subscribers.  Now, it’s available for you.  The article is below. There’s a lot to be learned from this decision. If you prefer a PDF copy, click here.  It’s a concise summary of exactly what went wrong with the BurnLounge business model. And I apologize if the formatting is a little janky in spots. I had a hard time converting the Word file to work with this page

Introduction

BurnLounge was a purported network marketing company. They positioned themselves as a blend between iTunes, MySpace and Amway. The FTC filed its initial complaint against Burnlounge in June of 2007. After a bench trial (and a two year wait), the judge held Burnlounge to be an illegal pyramid scheme.

Facts

Business model

It’s important to understand the Burnlounge model for purposes of understanding the pyramid scheme analysis. Also, it’s beneficial to understand the Burnlounge model because their failure is very informative for other companies in the network marketing space. At its core, Burnlounge created a network of replicated websites, referred to as “BurnPages.” These BurnPages allowed the independent “retailers” (a/k/a distributors) to sell music and other items. There were multiple entry points into the Burnlounge program:

1) Retailer: Paid a $30 fee for the right to operate their own BurnPage. Retailers were not eligible to receive income from music sales. Instead, they received “Burn-Rewards,” which they could redeem for music.

2) Mogul: If they wanted to earn cash rewards, they had to pay $7 per month and purchase one of the below product packages. Upon this occurrence, they were dubbed “Moguls.”

Product Packages

1) Basic: Basic members pay a $7 monthly fee in addition to paying $30 for the Basic package. The package included:

a. BurnPage

b. Editing software for the BurnPage

c. Back-office support

d. Sample copy of BurnLounge Magazine

e. Annual subscription to “FrontBurner Magazine, which was an online website.

2) Exclusive: Exclusive members pay a $7 monthly fee in addition to paying $130 for the Exclusive package. The package included:

a. All of the items in the Basic package

b. Annual subscription to “BurnLounge Presents,” which was a monthly bundle of 10 songs selected by the company and available for download

c. Monthly DVD subscription featuring independent artists chosen by the company

d. Annual subscription to “BurnLounge Magazine”

3) VIP: VIP members pay a $7 monthly fee in addition to paying $430 for the VIP package. The package included:

a. All of the items in the Basic and Exclusive packages

b. The “Event Pass,” which provided for better seating and early access admissions at certain concert events

c. “BurnLounge University,” which consisted of six DVDs documenting the history of the music industry.

NOTE: Retailers always maintain the option of converting to “Moguls” at any time. The vast majority of Retailers chose to become Moguls (97%).
 

Compensation Plan

The BurnLounge compensation plan is confusing. When referencing it, the judge wrote, “Indeed, it would appear that BurnLounge was attempting to create a labyrinth of obfuscation rather than a readily understood compensation system.” Essentially, there were multiple income opportunities in the BurnLounge plan. There was a unilevel component where the participants earned a percentage of the volume generated by their personally enrolled representatives. In addition to this program, Moguls earned the “real money” in the binary plan. In order to qualify for the binary compensation, Moguls had to “sell” two VIP packages to members in their downline (the VIP package was the most expensive offering) and hit monthly performance standards. In the binary plan, Moguls earned a percentage of the total volume from their business by optimizing their two legs.

Income Claims

 


BurnLounge had policies in place that prohibited the field from making income claims. Despite this policy, aggressive income claims were still made by top leaders. Claims were made where people said they were earning in excess of $200,000 in income. BurnLounge officers testified that they made efforts to police the income claims. BL’s head of Customer Service testified that he dealt with income claim issues a few times a week. Furthermore, BL’s Executive Vice President made a strong statement from a company event about the importance of ending the use of income claims. According to BL, nobody was ever terminated for making income claims. While it was discouraged, apparently nobody was penalized.When income claims were made, income disclosures were not provided to the prospective participants. The FTC argued that the income claims made by field leaders was pervasive throughout the BurnLounge organization.

Issues

Was BurnLounge operating as an illegal pyramid scheme? Were the income claims made by BurnLounge leaders “misleading?”

Law

Pyramid Scheme

Operating a pyramid scheme is an unfair and deceptive act affecting commerce, which triggers the FTC Act. Pyramid schemes are inherently fraudulent because they’re destined to collapse.As determined by the Koscot case, pyramid schemes are:

Characterized by the payment by participants of money to the company in return for which they 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 product to ultimate users.”

The judge referenced Omnitrition, which is an unpopular case in the MLM industry. Referencing Omnitrition, the judge wrote, “The satisfaction of the second element of the Koscot test is the sine qua non of a pyramid scheme.

Income Claims

“A statement is misleading if the representation is likely to deceive reasonable consumers to their detriment.” Southwest Sunsites, Inc. v. FTC.

Application of the Law to the Facts

Pyramid Scheme? BL consisted of two components: 1) the sale of music and music-related products through the BL software; and 2) the BL Mogul program, which was the income opportunity. It was only through the latter that anyone could possibly achieve any “significant financial return.”

MLM Attorney Commentary: Given the minuscule amount of revenue accrued from external sales (3%), it was apparent to the court that the only real way to earn income via the BL opportunity was by focusing almost exclusively on recruiting new participants who purchased the product for themselves. After a detailed breakdown of the BL offering and prices, the court concluded the BL prices were gratuitously inflated to support the pay plan.

“[B]ecause participation in the program required the purchase of a product package, and Moguls earned cash for selling these product packages to those they sponsored, they by default received compensation for recruiting others into the program.” The Basic package was the only required package, technically. The court wrote,

BurnLounge argues that the sale of the Basic Package is the sale of a product to an ultimate user. While it is true that the BurnPage could be considered a “product” and a Retailer to be the “user” of that product, this argument ignores the nature of the use itself. That it is a tool for sales and (more importantly) for recruitment, as demonstrated by a review of the BurnLounge promotional material, the presentations of its spokespersons, and the statistics as to the participants who bought into the enterprise. While it is true that Retailers could merely sell music downloads through their BurnPages, Retailers/Moguls generated many times more revenue from the sale of the business opportunity to new participants than the meager rewards of vending the music downloads available on the BurnLounge system.

MLM Attorney Commentary: In order for a transaction to be commissionable, the item sold needs to have some kind of relevance for people outside of the program, lest it be labeled a recruitment scheme. With the Basic package, the court concluded the BurnPages to essentially be “non commissionable” because they were primarily used as tools by distributors to sell music and recruit more distributors, not as actual products.

Unlike the Basic package, the premium packages, the Exclusive and VIP packages, were optional. BL argued that the sale of these packages were truly sales to end users. The court acknowledged that the items bundled in the Exclusive and the VIP packages had SOME value (“extremely limited”). However, regardless of this limited value, the court concluded that it was the financial incentives that ultimately led the BL distributors to purchase those items. Because of this fact, the court concluded that the sale of the Exclusive and VIP packages were pyramidal in nature. Specifically, the court held, “Inventory loading pyramids are not illegal simply because there are wholesale purchasing requirements. They are illegal because the purchases are incentivized by commissions that result from recruiting others to join the scheme through similar purchases.” (emphasis mine)

MLM Attorney Commentary: “MOTIVE” is the key word here. Because of the limited value of the items coupled with the small external sales (3%), the judge concluded that the primary driver that led distributors to buy the premium packages was the compensation plan. In my opinion, it’s ill-advised to make certain rewards in the pay plan contingent on a distributor purchasing a certain item. Distributors should never be required to purchase a higher ticket item in exchange for an ability to earn more compensation. It can always be argued that the true motivation behind those purchases is for the money, not for the value. It makes no sense for a company to expose itself to the additional risk.

Misleading Income Claims? The defendants (BurnLounge and the individual leaders) argued that the misleading statements about income were mere “puffery” i.e. not material. “Generalized or exaggerated statements upon which reasonable consumers would not rely are considered ‘puffery’ and are non-actionable.” With BurnLounge, the judge found that the statements were not vague. On the contrary, the statements were very specific. The judge further noted, “In addition, where a person markets [a pyramid scheme], he/she must at a minimum advise potential investors of the unlikelihood of any substantial returns. The court concluded that the defendants did not provide the material information

MLM Attorney Commentary: Whenever an income claim is made, whether it is express or implied, it’s imperative that adequate income disclosures be provided. Since the company is usually not involved in making income claims, it’s important to (a) provide good income disclosures to the field; and (b) implement AND ENFORCE policies designed to get the leaders to share those disclosures with prospects when income claims are made. With BurnLounge, it appears that they actually had policies in place against sharing income claims; however, those policies seem to have been ignored. If those policies were actually enforced and their was a history of enforcement i.e. suspensions and terminations, this particular issue might have been mitigated.


Conclusion

 


After waiting for two years after the trial, the judge finally concluded that BurnLounge was, in fact, a pyramid scheme. It’s important for serious students of the network marketing industry should take a hard look at this case. There’s a lot to be learned. In my opinion, if I were to point out one toxic element in their business model that ultimately led to the regulatory action, it would be the extra incentives in the compensation plan that led the majority of BL participants to buy the premium packages. The compensation plan drives behavior. When the barrier to the “real money” was the purchase of a premium package, the vast majority of participants will do it regardless if they really want the products. This appears to be the case with BurnLounge. While BurnLounge tried hard to argue that its products were valuable, the extra incentives in the pay plan provided an easy opportunity for the FTC to argue that the participants bought the bundles to crack into bigger commissions. Simple mistakes, big consequences.

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The full statement of decision is included below.