Hat tip to Don Ryan over at ASD Updates for breaking the story on the lawsuit.
Hat tip to Don Ryan over at ASD Updates for breaking the story on the lawsuit.
With the recent buzz of Federal Trade Commission v. Fortune Hi-Tech Marketing, Inc. slowly coming to a close, I wanted to write an article to reiterate the importance of proper income claims. Statements regarding a network marketing company’s income opportunity go to the heart of the Federal Trade Commission’s (“FTC”) mission to extinguish deceptive, unfair, or unsubstantiated claims made by a company and its distributors. And let’s be honest here, it’s not the distributors’ fault. The majority of income claims made by a distributor are more likely than not truthful statements, but the FTC is not JUST concerned with the truth. Promises of riches and an opportunity to live the American Dream can cloud even the most reasonable person’s judgment. With this in mind, the FTC wants to ensure that all potential distributors make a fully informed decision before choosing to join an MLM program.
In this article, we discuss the legality of income claims made by MLMs and their distributors while using the recent Fortune Hi-Tech (“FHTM”) case as a framework. In Part 2 of this series, we’ll use what we learn in this article to help develop solutions that meet the FTC’s requirements.
What Was All the Fuss About?
Among other reasons in its case against FHTM, the FTC alleged that FHTM’s distributors misrepresented the income opportunity. Specifically, the FTC argued that FHTM violated Section 5(a) of the FTC Act which prohibits “unfair or deceptive acts or practices in or affecting commerce” by misrepresenting or omitting material facts in its income claims. In my opinion, the FTC’s argument about FHTM operating as a pyramid was weak. There’s not much to be learned there. But there’s a lot that can be learned by analyzing its argument regarding improper income claims. The FTC based its allegations off of recorded video and audio presentations, pictures on social media networks, and Twitter posts uploaded by various distributors. These facts underscore the importance of properly educating distributors on how to make clean product and MLM income claims online.
Examples cited by the FTC include the following:
Recorded Video Presentations
Recorded Audio Presentations
Sound familiar? No matter how long you have been involved in the network marketing industry, chances are you’ve heard claims similar to the examples above on a regular basis. I’m not trying to point any fingers at distributors. The statements referenced above could potentially all be true. The key is whether those distributors shared legally sufficient income disclosures to the prospects immediately after making the claims. When it comes to these income disclosures, the FTC preferences are confusing and they require a lot from all marketers. In most cases, distributors are simply unaware of how to promote their opportunities appropriately. That’s just the nature of the beast, and it all ties back to compliance training. It’s important to understand the FTC’s top priority is ensuring income claims are adequate. With that being said, the best place to start when learning how to play a game is studying the rules.
The Rules of the Game
The FTC used the following legal argument to make its case against FHTM:
Any income claim that is considered to be deceptive needs a disclosure. The FTC considers an income claim deceptive where information that would affect a reasonable consumer’s judgment is misrepresented or omitted. There is a presumption that all information regarding earning potentials affect consumer’s judgment, even when you do not guarantee they will make any money. Out of those claims, it is also presumed to be reasonable for consumers to rely on statements you expressly make, regardless of whether you tell them making “big money” is a sure thing or not. In other words, all income claims that are atypical need adequate disclosures.
The FTC says that any income claim made is regarded as what consumers will “general[ly achieve . . . .” In other words, what you represent as potential money to a prospect is what a reasonable prospect will expect to earn. IF YOU LACK SUBSTANTIATION (aka, you have no proof) that the majority of your distributors earn the amount represented by a few high earners, you must give a clear and conspicuous disclosure indicating exactly the percentage of distributors who earn at least the amount you represented. And you must also disclose the average earnings. If you’re a distributor that’s working with a particular company, if they do not provide adequate income disclosures, DO NOT MAKE INCOME CLAIMS. The pressure is on them to provide the data.
If you are the motivated (or self-burdening) type, I’d like to challenge you with a little homework project. Look at the examples cited by the FTC against FHTM above and determine what type of disclosure is necessary using the rules we discussed in this article. In our next installment, we’ll discuss our own solutions and ideas for the proper ways to make income claims.
 See FTC v. Bay Area Bus Council, Inc., 423 F.3d 627, 635 (7th Cir. 2005); FTC v. World Media Brokers, 415 F.3d 758, 763 (7th Cir. 2005); Kraft, Inc. v. FTC, 970 F.2d 311, 322 (7th Cir. 1992), cert. denied, 507 U.S. 909 (1993); FTC v. QT, Inc., 448 F. Supp. 2d 908, 957 (N.D. Ill. 2006).
 FTC v. Febre, No. 94 C 3625, 1996 WL 396117, at *2 (N.D. Ill. July 3, 1996) (conditional earnings claims would be understood to represent typical or average earnings and are therefore deceptive).
 See World Travel Vacation Brokers, 861 F.2d 1020, 1029 (7th Cir. 1988).
 FTC v. Five Star Auto Club, Inc., 97 F. Supp. 2d 502, 528 (S.D.N.Y. 2000).
 16 C.F.R. § 255.2(b) (Guides Concerning the Use of Endorsements and Testimonials in Advertising); see also In re Cliffdale Assoc., Inc., 103 F.T.C 110, 173 (1984), 1984 WL 565319 (F.T.C.), at *16 (testimonials presumed to represent typical experiences).
 In re Nat’l Dynamics, 85 F.T.C. 1052 (1975).
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.
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:
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.
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.
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.
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.
The FTC has sued Fortune Hi Tech marketing, alleging them to be a pyramid scheme. As of today, an injunction has been issued. Read below for the FTC’s press release. Also, a copy of the complaint is provided below.
At the request of the Federal Trade Commission and the states of Illinois, Kentucky, and North Carolina, a federal court has halted an allegedly illegal pyramid scheme pending trial. The FTC and the state attorneys general seek to stop the allegedly illegal practices of the Fortune Hi-Tech Marketing (FHTM) operation, which claimed consumers would make substantial income by joining the scheme. The operation affected more than 100,000 consumers throughout the United States, including Puerto Rico, and Canada. In some areas, including Chicago, the scheme targeted Spanish-speaking consumers.
“Pyramid schemes are more like icebergs,” said C. Steven Baker, Director of the FTC’s Midwest Region. “At any point most people must and will be underwater financially. These defendants were promising people that if they worked hard they could make lots of money. But it was a rigged game, and the vast majority of people lost money.”
According to the complaint filed by the FTC and the state attorneys general, the defendants falsely claimed consumers would earn significant income for selling the products and services of companies such as Dish Network, Frontpoint Home Security, and various cell phone providers, and for selling FHTM’s line of health and beauty products. Despite FHTM’s claims, nearly all consumers who signed up with the scheme lost more money than they ever made. To the extent that consumers could make any income, however, it was mainly for recruiting other consumers, and FHTM’s compensation plan ensured that most consumers made little or no money, the complaint alleged.
“This is the beginning of the end for one of the most prolific pyramid schemes operating in North America,” Kentucky Attorney General Jack Conway said. “This is a classic pyramid scheme in every sense of the word. The vast majority of people, more than 90 percent, who bought in to FHTM lost their money.”
As alleged in the complaint, FHTM promoted itself as a way for average people to achieve financial independence. Some FHTM representatives claimed they earned more than 10 times as much as their previous earnings in their second and subsequent years with FHTM. One person claimed that another representative earned more than $50,000 in his sixth month and millions of dollars in subsequent years. Another person promoted a recruitment meeting on her Twitter account, stating, “Bring ur friends & learn how 2 make $120K aYR.” At its 2012 national convention in Dallas, FHTM called its top 30 earners to the stage to present them with a mock-up of a $64 million check, which several of them shared as a photo on social networking websites.
To participate in the scheme, consumers paid annual fees ranging from $100 to $300. To qualify for sales commissions and recruiting bonuses, they had to pay an extra $130 to $400 per month and agree to a continuity plan that billed them monthly for products unless they canceled the plan. Those who signed up more consumers and maintained certain sales levels could earn promotions and greater compensation, but contrary to FHTM’s claims, the complaint alleged, its compensation plan ensured that, at any given time, most participants would spend more money than they would earn.
According to the complaint, recruits were told they could earn high commissions by selling products to people outside the operation, but instead only minimal compensation was paid for sales to non-participants, and few products were ever sold to anyone other than participants. The scheme provided much larger rewards for recruiting people than for selling products, and more than 85 percent of the money consumers made was for recruitment.
In addition to charging the defendants with operating an illegal pyramid scheme and making false earnings claims, the FTC charged them with furnishing consumers with false and misleading materials for recruiting more participants. The attorneys general offices of Illinois, Kentucky and North Carolina joined the FTC complaint, as well as alleging violations of their respective state laws.
The defendants are Paul C. Orberson, Thomas A. Mills, Fortune Hi-Tech Marketing Inc., FHTM Inc., Alan Clark Holdings LLC, FHTM Canada Inc., and Fortune Network Marketing (UK) Limited. On January 24, 2013, the court halted the deceptive practices, froze the defendants’ assets, and appointed a temporary receiver over the corporations pending a trial.
The Commission vote, including Commissioner J. Thomas Rosch, authorizing the staff to file the complaint was 5-0. The complaint was filed in the U.S. District Court for the Northern District of Illinois, Eastern Division.
If you’re reading this via email, please click this review the FTC vs. Fortune Hi Tech lawsuit.
Disclaimer: This article contains my opinions. I’m not stating with certainty that Zeek is fraudulent; however, in my opinion, I believe that to be the case. I think the investigation is timely and will serve a valuable function.
It’s official. Zeek Rewards has recently closed its doors. Literally. In fact, the SEC and U.S. Secret Service are now involved. This is what we know: the doors are locked and the website is down. It’s not looking good. Was this done voluntarily? Were they required to do this by the SEC? This all has occurred recently after the North Carolina AG’s office expressed “concern” over the Zeek model.
I’ve got mixed emotions.
I’m both angry and relieved.
I really think we lost our minds with this model. The MLM community took the bait and walked off a cliff like a herd of lemmings. Do you want to know what happened? I’m going to be candid:
Zeek exploited the gray. They took a bath in it. They skinned it and made a coat out of it. They hired the right people and adopted the right lexicon. And who is going to pay the price? The entire industry. This is bigger than just the participants. There’s an ocean of gray separating legitimate network marketing companies from pyramid schemes. Instead of shrinking the gray, we fight like hell to obfuscate. As an industry, we’re self-delusional. It’s true. We think it’s better to have vague standards. But now we’re seeing first hand what happens when the inmates take over the asylum.
“Those are not investments, those are ‘samples’ given to ‘customers’ in an effort to entice them into buying more….it’s like Amway distributors giving samples of soap to customers.”
It’s not the same thing! Amway distributors are not spending $50,000 on soap, giving it all away to strangers while dramatically increasing their earning potential. Amway distributors have a direct, real connection with customers. With Zeek, it’s just a combination of 1s and 0s on a computer screen. Who in the hell were these customers? Where were they coming from? Were they real? Were they ever asked to verify their accounts? Nobody knew and nobody seemed to care. People knew the angle. They read from the script, mastered the narrative and explained with eloquence why Zeek was “just like Amway, but with penny auctions.” Zeek affiliates were essentially rewarded IMMEDIATELY after they bought the bids, regardless if they were ever used. This is not consistent with traditional MLMs.
I’m angry because they leveraged your credibility. They leveraged the credibility of my colleagues and competitors. They leveraged mine. And we all look like idiots.
I’m angry because this recent news is going to be devastating for tens of thousands of people. People that will likely associate this horrible experience with “network marketing.” These were the people that cashed in on their 401(k)s because they were promised tremendous gains in a short amount of time. These were the people that “invested” more money than they could afford to lose, hoping that maybe, for once in their life, they could get a decent ROI. If the money ends up being locked away in receivership, which is a possibility, it’s not coming out without a court order. Will everyone get their money out? I’m not sure.
I’m angry because this actually impacted my relationships with clients, current and former. When I gave my candid advice, I was sometimes met with hostility. I was considered “out of touch.” I was told that Zeek was “spending countless dollars to be compliant” and I was just envious to be on the outside.
I’m angry because we allowed the cancer to infiltrate the host and spread. We opened the door and welcomed it with open arms. Zeek leadership took on top positions with trade associations, recruited top distributors from reputable companies and networked intelligently with industry influencers. Have cash? We’ll dance. We provided them with the semblance of legitimacy, and they ran with it. We empowered them.
I’m relieved because the conversation is finally over. I’ve been fielding calls at least twice a week with somebody else looking to launch their version of Zeek. It’s hard to tell someone “no” when there’s someone across the street making a fortune with the exact same model. Finally, it’s over. We can resume normal business.
I’m relieved because this should mark the end for companies having to defend themselves from Zeek. Zeek was soaking up a lot of leaders from a lot of different companies, causing a considerable disruption in the space. Companies, trying to hold onto their people, found themselves in the cross hairs between zealous distributors looking for a quick buck and industry pundits, all defending the Zeek model. It put company executives in an awkward spot.
When people have a serious economic position with something, they’ll fight hard to protect it. They’ll go to great lengths to find a mental justification, even if it defies all logic and intuition. There were a lot of distributors in Zeek that really should have known better. They were around for the FutureNet, SkyBiz and Equinox cases. They knew better. And despite that experience, they really believed they were in the clear on this one. I think their belief was genuine. They were just under a spell. Once they got a taste of the enormous commissions, they were hooked and went to great lengths to defend the business. Adults under the influence of serious cash are like teenage boys with girls…all logic goes out the door.
People relied heavily on the credibility of Zeek’s lawyers: Gerald Nehra and Kevin Grimes. They said “These guys are good; therefore, we’re good.” I can speak on this first hand: hiring an attorney by itself does not legitimize a program. At the end of the day, we MLM attorneys explain the boundaries for our clients and provide advice. It’s on them to follow the advice and stay within the lines. I can guarantee you of one thing with 110% certainty, Zeek is not surprised by recent events. Grimes and Nehra are both good attorneys and good competitors. I’m confident Zeek was fully informed of these potential issues. MLM attorneys can lead horses to water…we can never make them drink.
If someone promises you easy, run fast!. We can do better. Any measure of success in life requires hard work. Really, really hard work. In the network marketing industry, we need to stand for meritocracy: as you perform, so shall you bonus. We work hard to ensure the pay plans are fair and that reps are rewarded commensurate with the work they do. With Zeek, the general tone was that people could make money with minimal effort. There was very little effort involved in reaping the rewards from the penny auction platform (with the exception of buying some customers and placing ads online). I understand that measures were taken to strengthen the program i.e. the compliance course, eliminating the customer co-op, etc; however, rewards were still allocated immediately upon purchases, regardless if the bids were ever used. This was a problem. There must always be a direct connection between the rewards received and work performed.
With modern technology, there seems to be more “make money while sitting on your rear-end.” And as typical Americans, we’re drawn to it! As network marketers, we need to promise VALUE instead of promising EASE.
Richard Brooke recently said, “If it quacks like a duck, it may not be technically a duck but duck hunters WILL KILL IT!” Zeek just looked too much like a security. I understand that there are countervailing arguments, but the bottom line is simple: Zeek fought hard to train people to NOT call it an investment opportunity because that’s exactly what it looked like. People, when they were pitching the program as an investment opportunity, were just following their instincts. Why? Because it looked like a duck….
There are a number of issues that will likely come to light during this investigation. Is it a Ponzi scheme? Is it a pyramid? Is it an unregistered security? Is it all of the above? Will criminal charges follow? Who knows…
As an industry, I think it’s time to tighten up the skates. This should serve as a wake up call. This is embarrassing. Absolutely embarrassing. Zeek flew under the banner of protection provided by US, the network marketing community. They danced in the gray and profited. We need to stop drinking our own kool-aide and shrink the gray. When I first started practicing, I wrote an ebook that has been read over 12,000 times. It’s titled, Pyramid Schemes: Saving the network marketing industry by defining the gray. I propose some ideas on ways to make the space better. I think it’s time. Otherwise, this WILL happen again. And at the pace of technology, it will happen soon.
As for my representation of Bidify, which I’m sure will be an issue, they’re paying attention to this situation. Since retaining me, they’ve made a number of difficult decisions. I’m not going to comment further on their business other than to say they’re working hard to get their model in order. Their recent decision to reduce the max cost to 5,000 euros forever is proof of it. If you want to park a lot of cash, Bidify is not the spot for you.
If you learned something, please hit the +1 or “Like” button above and get it out there. Thanks.
The SEC filed suit against Zeek Rewards. See below for a copy of the complaint. The most shocking sections are paragraphs 44, 45 and 46.
44. Defendants represent that daily awards are calculated by dividing “up to 50%” of daily net profits by the number of Profit Points outstanding among all Qualified Affiliates. This calculation results in a daily dividend paid to each Qualified Affiliate that consistently has averaged approximately 1.5% per day.
45. In fact, the dividend bears no relation to the company’s net profits. Instead, Burks unilaterally and arbitrarily determines the daily dividend rate so that it averages approximately 1.5% per day, giving investors the false impression that the business is profitable.
46. Despite encouraging affiliates to purchase and give away VIP Bids to promote and drive traffic to the Zeekler penny auction website, Defendants fail to disclose that almost none of the VIP Bids given away by Qualified investors are actually used on the Zeekler penny auction website. Of approximately 10 billion VIP Bids purchased by or awarded to investors, less than one-quarter of one percent have been actually used in auctions on the Zeekler penny auction website. Thus, the VIP Bids do little or nothing to actually promote the retail business.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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!
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.
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.
SMH. It’s a new acronym I’ve recently learned. It means “Shaking My Head.” And that’s what I immediately did when I read about Melaleuca’s CEO, Frank VanderSloot, denying all ties to the MLM industry.
While it certainly seems like a ridiculous exercise, I list a few obvious reasons in the video why VanderSloot is wrong to make such a distinction.
In the video, I reference his statement to the press (included below). I also reference the FTC’s definition of a “Multilevel marketing program” as per the FTC vs. FUTURENET case.
Note, this is not a controlling definition given the circumstances of the case; however, it gives us a good idea of how the FTC defines a MLM.
“Multi-level marketing program” means any marketing program in which participants pay money to the program promoter in return for which the participants obtain the right to (1) recruit additional participants, or to have additional participants placed by the promoter or any other person into the program participant’s downline, tree, cooperative, income center, or other similar program grouping; (2) sell goods or services; and (3) receive payment or other compensation; provided that: (a) the payments received by each program participant are derived primarily from retail sales of goods or services, and not from recruiting additional participants nor having additional participants placed into the program participant’s downline, tree, cooperative, income center, or other similar program grouping; and (b) the marketing program has instituted and enforces rules to ensure that it is not a plan in which participants earn profits primarily by the recruiting of additional participants rather than retail sales.”
Essentially, it boils down to whether there’s a recruitment component to a pay plan. If there’s an an opportunity for an override commission from downline productivity, where participants can sponsor other participants and earn income from their sales, it’s a MLM. Using the factors above, and some of the obvious factors referenced in the video, Melaleuca would clearly qualify as a MLM. There’s an enrollment fee that gives people the right to sponsor other participants (element #1) and the right to sell products (element #2), which gives people the ability to receive payment for product volume (element #3) assuming the commissions are not driven by enrollment fees.
“It’s unfortunate that someone would suggest that Melaleuca is something like Amway. It’s not. We started Melaleuca 26 years ago to market environmentally responsible products and to provide a business opportunity for folks who weren’t successful in climbing the corporate ladder and didn’t inherit wealth from their parents. We try to be champions of the little guy. My father was a little guy. And I still see myself as a little guy.
Contrary to those who do not know us, our business model is nothing like Amway or Herbalife. I challenge anyone to find any similarity whatsoever. There is no investment of any kind unless you want to call a $29 membership fee an “investment.” And anyone can get a refund on that by just asking.
We do offer a home-based business opportunity. But it is no “pyramid scheme.” We have long been critical of the many MLM/pyramid schemes operating in this country. I agree with those who say that typical MLM companies destroy people’s finances. Most are designed to attract people to “invest” in large purchases with the promise of “getting rich” quickly by getting others to invest. The guy at the top always wins and the guy on the bottom always loses.
In Melaleuca’s case there is no investment and no getting others to invest. We do pay commissions to those who have referred customers based on what those customers purchase. There is really no way to lose money on referring customers. And there’s no way for customers to lose either when they’re buying high-quality products at grocery store prices. Customers just order the products they use every month directly from the factory. We have hundreds of thousands of customers who buy from us each month. They don’t ever resell anything. They don’t invest in any inventory. There can be no pyramiding without some kind of investment. In 26 years, no one has ever complained that they lost money. It’s simply not possible.
Our business model works pretty well for most folks. We have already paid over $2.9 billion in commissions to households across the country. Our mission is to enhance lives by helping people reach their goals regardless of their beliefs, backgrounds, or affiliations. Last month we sent out almost 200,000 checks to American households alone. Members of those households tell us we are doing a pretty good job achieving that mission.”
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.
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.”
1) Basic: Basic members pay a $7 monthly fee in addition to paying $30 for the Basic package. The package included:
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%).
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.
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.
Was BurnLounge operating as an illegal pyramid scheme? Were the income claims made by BurnLounge leaders “misleading?”
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.
“A statement is misleading if the representation is likely to deceive reasonable consumers to their detriment.” Southwest Sunsites, Inc. v. FTC.
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.
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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Do you think this was a fair decision?
The full statement of decision is included below.
Debra Valentine, General Counsel for the FTC, provided the following tips for consumers when discerning good companies from bad ones. She gave the speech in 1998, which makes it a little dated. BUT, I was doing some research and found this article interesting and thought you might find it informative. To read the complete article, go here.
Here are some tips that consumers and business might find helpful.
1. Beware of any plan that makes exaggerated earnings claims, especially when there seems to be no real underlying product sales or investment profits. The plan could be a Ponzi scheme where money from later recruits pays off earlier ones. Eventually this program will collapse, causing substantial injury to most participants.
2. Beware of any plan that offers commissions for recruiting new distributors, particularly when there is no product involved or when there is a separate, up-front membership fee. At the same time, do not assume that the presence of a purported product or service removes all danger. The Commission has seen pyramids operating behind the apparent offer of investment opportunities, charity benefits, off-shore credit cards, jewelry, women’s underwear, cosmetics, cleaning supplies, and even electricity.
3. If a plan purports to sell a product or service, check to see whether its price is inflated, whether new members must buy costly inventory, or whether members make most “sales” to other members rather than the general public. If any of these conditions exist, the purported “sale” of the product or service may just mask a pyramid scheme that promotes an endless chain of recruiting and inventory loading.
4. Beware of any program that claims to have a secret plan, overseas connection or special relationship that is difficult to verify. Charles Ponzi claimed that he had a secret method of trading and redeeming millions of postal reply coupons. The real secret was that he stopped redeeming them. Likewise, CDI allegedly represented that it had the backing of a special overseas bank when no such relationship existed.
5. Beware of any plan that delays meeting its commitments while asking members to “keep the faith.” Many pyramid schemes advertise that they are in the “pre-launch” stage, yet they never can and never do launch. By definition pyramid schemes can never fulfill their obligations to a majority of their participants. To survive, pyramids need to keep and attract as many members as possible. Thus, promoters try to appeal to a sense of community or solidarity, while chastising outsiders or skeptics. Often the government is the target of the pyramid’s collective wrath, particularly when the scheme is about to be dismantled. Commission attorneys now know to expect picketers and a packed courtroom when they file suit to halt a pyramid scheme. Half of the pyramid’s recruits may see themselves as victims of a scam that we took too long to stop; the other half may view themselves as victims of government meddling that ruined their chance to make millions. Government officials in Albania have also experienced this reaction in the recent past.
6. Finally, beware of programs that attempt to capitalize on the public’s interest in hi-tech or newly deregulated markets. Every investor fantasizes about becoming wealthy overnight, but in fact, most hi-tech ventures are risky and yield substantial profits only after years of hard work. Similarly, deregulated markets can offer substantial benefits to investors and consumers, but deregulation seldom means that “everything goes,” that no rules apply, and that pyramid or Ponzi schemes are suddenly legitimate.