On June 2, 2014, the United States Court of Appeals for the Ninth Circuit upheld a permanent injunction awarded to the Federal Trade Commission (“FTC”) against multi-level marketer BurnLounge, Inc.  The injunction, issued by the district court in 2012, barred BournLounge from continuing its business operations.  The Court upheld the district court’s ruling that BurnLounge was, in fact, an illegal pyramid scheme because it offered rewards that were primarily paid for recruitment of individuals into the business rather than for the sale of goods.  In its decision, the Court expounded on factors to be considered when deciding whether a multi-level marketing business is lawful or nothing more than a pyramid scheme.

Two-Prong Test to Determine Pyramid Scheme

In upholding the injunction against BurnLounge, the Court reiterated its two-prong test used to determine the lawfulness of a multi-level marketing business.  “A pyramid scheme is ‘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 Court held that not only was recruiting built into the compensation structure for members to be eligible for cash rewards, but selling packages was “the only form of recruitment” offered by BurnLounge.  Quoting a previous decision, the Court held that “‘[t]he promise of lucrative rewards for recruiting others tends to induce participants to focus on the recruitment side of the business at the expense of their retail marketing efforts, making it unlikely that meaningful opportunities for retail sales will occur.’”  To support its holding, the Court pointed to the fact that after BurnLounge entered into a voluntary preliminary injunction at the start of the case, stopping BurnLounge from offering the ability to earn cash rewards for recruitment, its revenues plummeted.  The Court stated “[t]he dramatic decline in revenue after the ability to earn cash rewards was eliminated provides further evidence that the sale of BurnLounge packages was primarily directed at participants who were interested in the [recruitment] program, where it was possible to earn cash rewards.”

Rewards Do Not Have to Be “Completely” Unrelated to Find Pyramid Scheme

In prosecuting its appeal, BurnLounge argued that because its rewards program had some tangential relationship to the sale of products, its platform should not have been held to be a pyramid scheme.  The Court rejected this argument.  The Court ruled that the actual practices of the business must be considered.  In plain terms, the decision noted that “courts . . . have consistently found [multi-level marketing] businesses to be illegal pyramids where their focus was on recruitment and where rewards were paid in exchange for recruiting others, rather than simply selling products.”  In this case, the Court found that rewards were primarily paid for recruitment and not for the sale of products.  The Court quoted from an FTC letter which stated, in part, that “[t]he critical question for the FTC is whether the revenues that primarily support the commissions paid to all participants are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in a money-making venture.”    Because the rewards BurnLounge paid to its members were primarily in return for selling the right to participate in the money-making venture, the merchandise in the packages was simply incidental.

Protect Yourself

We have previously delineated key differences between multi-level marketing businesses and pyramid schemes.  (Multi-Level Marketing Programs vs. Pyramid Schemes).  Additionally, in January of this year, we wrote about the FTC’s investigation of multi-level marketer Herbalife.  (United States Senator Seeks Investigation into Alleged Pyramid Scheme).  In this regulatory climate, it is critical that multi-level marketing ventures seek competent counsel to advise them on their business practices in order to avoid being deemed illegal pyramid schemes.