United States: Ninth Circuit Agrees With FTC That Online Marketing Program Was An Unlawful "Pyramid Scheme"

The legal status of many membership programs promoted via social media and spam has been called into question by a recent decision of the U.S. Court of Appeals for the Ninth Circuit, which affirmed a judgment that one such program was an illegal pyramid scheme.  The Ninth Circuit's statement of the law provides useful guidelines but few bright-line tests, and promoters of business models that rely upon the recruitment of new members by current members would be well advised to evaluate their programs in light of the new guidance.

In 2012, we wrote about a district court decision in a case brought by the Federal Trade Commission finding that a membership-based online music marketing program was an illegal "pyramid scheme."  With the affirmance of that decision, we return to the case to review the Court of Appeals' restatement of the characteristics of an illegal pyramid scheme in the online context, and to underscore that the very characteristics of online marketing programs that make them attractive (and sometimes lucrative) to promoters also create unique legal risks.

I. BACKGROUND

From 2005 to 2007, a company called BurnLounge sold music and music-related merchandise through its website.  In addition, it promoted a business opportunity in which customers could themselves become resellers of the same music and music-related merchandise, and participate financially in the recruiting of new members.  Customers could do business with BurnLounge in three ways:

  1. They could simply buy music and merchandise.
  2. They could buy a membership package to become an "Independent Retailer," in connection with which they would be supplied with a template to set up their own retail web pages to sell music and merchandise.  Independent retailers earned money from their direct sales and also earned credits, redeemable only for music and merchandise, for selling membership packages to new customers.
  3. They could buy a membership package and pay more money to become a "Mogul." Moguls earned money from their direct sales and, unlike Independent Retailers, could obtain cash for selling membership programs to new customers.

BurnLounge thus operated as a "multi-level marketing" ("MLM") scheme: its business model involved a parent organization and the recruitment of distributors who in turn earned compensation by recruiting additional distributors.  Over the course of its two-year life, BurnLounge signed up more than 60,000 members and took in revenues of more than $28 million, almost $26 million of which was attributable to membership package sales and membership fees.  More than 90% of members never recouped their investments, and the FTC's expert testified that, under the best of circumstances, 87.5% of members would not be expected to do so.  The expert reasoned that, as is generally true with pyramid schemes, the BurnLounge financial model required an open-ended ability to recruit new members to remain profitable beyond the first few levels of participation.

In 2007, the Federal Trade Commission filed suit against BurnLounge to enjoin its operations as illegal under Section 5 of the Federal Trade Commission Act, 15 U.S.C. § 45(a)(1), and to seek disgorgement from the company and various insiders to fund consumer redress.  By stipulated preliminary injunction the Mogul program was suspended and the assets of the individual defendants were frozen. 

In 2012, following a bench trial, the U.S. District Court for the Central District of California declared the entire BurnLounge operation to be an illegal pyramid scheme, based upon the finding that a "majority" of BurnLounge's business was derived from Moguls, and the Mogul program was itself an illegal pyramid scheme.  The district court also found the individual defendants jointly and severally liable for more than $16 million in disgorgement for consumer redress.

II. THE NINTH CIRCUIT'S DECISION

The U.S. Court of Appeals for the Ninth Circuit affirmed the district court's finding of a violation of the FTC Act and generally upheld the district court's imposition of a remedy.1 The appeals court applied the analysis it developed in Webster v. Omnitrition Int'l, Inc., 79 F.3d 776 (9th Cir. 1996), in which it found an MML program is an illegal pyramid scheme where participants pay the company for (1) the right to sell a product and (2) the right to receive compensation for recruiting other participants into the program, where such rewards are unrelated to sale of the product to ultimate users.

The first prong of the Omnitrition test was easily satisfied by the requirement that Moguls purchase a membership package to host webpages that would resell BurnLounge music, merchandise, and memberships. 

The appellate court also confirmed, after a much lengthier analysis, that the Mogul Program satisfied the second prong of the Omnitrition test, which the court construed as requiring that the "focus" of the program be the recruitment of new members, rather than to deliver profit from the sale of products or services to consumers.2  Thus, Moguls were required to recruit new members in order to obtain eligibility for several types of cash bonuses and were motivated to do so "primarily" by the opportunity to earn cash rewards.3  The court found evidence of this motivation in two facts:  dramatic differences in the package-purchasing patterns of Moguls and Independent retailers (who could not earn cash from recruiting), and the steep drop in BurnLounge's sales after the district court initially enjoined the Mogul program. 

The court of appeals also addressed the question of how to treat Moguls' purchases for their own use that were required before the Moguls could receive cash rewards.  To the extent such purchases were deemed sales to ultimate users, per Omnitrition's second prong, they would support the lawfulness of the program.  Rejecting the positions that both BurnLounge and the FTC advanced, the court acknowledged these purchases should be treated as having been made to "ultimate users," but ignored them under the Omnitrition analysis nevertheless because the purchases did not reflect "consumer demand for the merchandise."4

The Ninth Circuit's opinion hardly reflects an exercise in the drawing of bright lines, relying as it does on a standard that looks to the "focus" of the BurnLounge program and the "primary" reason why Moguls sought to recruit new members.  Indeed, the court expressly declined to provide further guidance, noting that because the program at issue "clearly" failed the Omnitrition test "we do not need to decide the degree to which rewards would need to be unrelated to product sales in a case presenting a closer question."5

Notably, the court of appeals did not base its liability finding on the district court's determination that the BurnLounge scheme was a financial success only for those at the top of the pyramid (the district court had found 93.84% of Moguls never recouped their investment). This may be viewed as suggesting that proof of the near-inevitability that a substantial number of participants in a scheme will not make money is not essential to a prima facie showing that a scheme is an illegal pyramid.  And at some level, this conclusion would be consistent with the mathematical fact that pyramid schemes can be profitable for all only on the assumption of a limitless supply of new members.  But with so much in the court's opinion left to judgment calls as to motivation and intent, it is fair to say that the facts of financial performance have not yet been rendered conclusively irrelevant.

III. THE IMPORTANCE OF BURNLOUNGE TO ONLINE MARKETING PROGRAMS

While enforcement actions against pyramid schemes have been undertaken for decades, the application of that law to the online environment is still in its early days.  And there is reason to believe that more cases will follow, as social media and the availability of bulk spam emails offer two conditions that are essential to the creation and growth of pyramid schemes:  the ability of a promoter to reach many potential pyramid scheme participants at low cost, and the participants' timeless belief that they can do the same, and make a fortune in the process.  The potential significance of the BurnLounge opinion is underscored by the participation of the Direct Selling Association as amicus curiae.  Among other things, the association argued that the test ultimately embraced by the court of appeals was too broad, sweeping "many legitimate MLMs" into the category of illegal pyramids.6

Many business models prevalent on social media are MLMs.  Indeed, entire websites address the promotion of MLMs via social media.  See, e.g., http://www.mlmsocial.com/home.php (MLM Social:  The Social Network for Network Marketers).   For these entities, the BurnLounge decision will provide guidance but not complete peace of mind.  Also worth noting is the ease with which MLMs and pyramid schemes reaching U.S. consumers may be operated substantially or entirely offshore, complicating enforcement efforts.  Such complications can be significant, although as seen in certain cases of offshore gambling operations, the U.S. Government is willing to press difficult cases if sufficiently motivated.

Regardless, businesses concerned about enforcement efforts would be well advised to assess whether regulators might see their financial motivations as related primarily to the recruitment of more members, and the extent to which the model can be predicted to impose overwhelming odds of losses on a foreseeably significant number of participants. 

A copy of the published decision of the court of appeals on liability appears here, and its unpublished decision on remedies appears here.

Footnotes

1 The Court of Appeals remanded certain calculations to the district court for adjustment and/or clarification.

2 Slip Op. at 12-13, 15, 18.

3 The court of appeals' analysis also disposed of BurnLounge's argument that, taking the language of the second prong of the Omnitrition test literally, liability could only attach where members earned fees exclusively for recruiting new members.

4 Id. at 19.

5 Slip Op. at 18.

6 Id. at 18.

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