burnlounge-logoShut down in 2007, BurnLounge was just before my time covering the MLM industry.

For those unfamiliar with the company, launched in 2004, BurnLounge consisted of affiliates (Moguls) purchasing ‘music-related merchandise, and packages of music-related
merchandise‘, primarily to qualify for commissions.

BurnLounge affiliates recruited new affiliates who did the same, and long story short in 2007 the FTC shut them down for being a pyramid scheme.

Mogul package sales drove 92.6% of BurnLounge’s revenue in 2006, its one full year of operation, while music sales during the same year only amounted to 4.9% of revenue.

BurnLounge lost the case against them in court,

The defendants were also ordered to pay in aggregate about $17 million towards consumer redress – of this BurnLounge and Juan Alexander Arnold are to pay $16,245,799, John Taylor $620,138 and Rob DeBoer $150,000.

On February 29, 2012 an order was issued barring the defendants from operating a pyramid scheme and ordering them to pay some $17 million in damages. (Wikipedia)

The district court described BurnLounge’s bonus system as “a labyrinth of obfuscation.” It found there was a 93.84% failure rate for all Moguls, meaning 93.84% of Moguls never recouped their investment.

The district court also found that BurnLounge’s marketing focus was on recruiting new participants through the sale of packages.

BurnLounge appealed and yesterday saw the United States Court of Appeals for the Ninth Circuit hand down their decision.

The panel held that BurnLounge’s scheme satisfied both prongs of the Webster v. Omnitrition International, Inc., 79 F.3d 776 (9th Cir. 1996), pyramid scheme test because Moguls paid for the right to sell products, the rewards BurnLounge paid were primarily for recruitment, and Moguls were clearly motivated by the opportunity to earn cash.

Remembering that “Moguls” are what BurnLounge referred to as their affiliates, the appeal rejection should come as no surprise. Affiliates by definition are “motivated by the opportunity to earn cash”, otherwise they’d be retail customers.

Combine that with commissionable affiliate package deals, and regardless of what products and services are attached to the packages, what you have is still an opportunity primarily paying out on the recruitment of new affiliates (92.6% as was the case here).

This was spelled out in the District Court decision against the company:

The district court found that because purchasing a package was required for participation as a Retailer or Mogul, and because Moguls earned cash for selling packages, “[Moguls] by default received compensation for recruiting others into the program.”

In BehindMLM’s MLM reviews I tend to use the “defacto recruitment commissions” when I see a product or service is attached to recruitment, but recruitment commissions “by default”essentially means the same thing.

In upholding the District Court’s decision, the Court of Appeals agreed that the FTC’s two-prong test (established in Webster vs. Omnitron International Inc.) was sufficient for ‘determining whether a multi-level marketing (MLM) business is a pyramid scheme.

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 sale of the product to ultimate users.

On the first prong, the appeals court upheld that

(Moguls) were required to purchase a package (Basic, Exclusive, or VIP) in order to access a BurnPage. BurnPages provided Moguls with the ability to sell music, merchandise, and packages.

The sale of packages thus conveyed “the right to sell a product.

And on the second,

The FTC has explained that in a pyramid, “participants purchase the right to earn profits by recruiting other participants, who themselves are interested in recruitment fees rather than the sale of products.

Here, the FTC presented ample evidence to support the district court’s finding that BurnLounge was an illegal pyramid scheme. It did so by showing that:

(1) Moguls were required to recruit new members in order to become eligible for all three types of cash bonuses and

(2) Moguls were motivated by the opportunity to earn cash rewards, as shown by data illustrating the sharp difference in package purchasing patterns of Moguls and non-Moguls, and by the fact that BurnLounge’s sales plummeted after the Mogul program was enjoined.

After the parties entered into a stipulated preliminary injunction in July 2007 that stopped BurnLounge from offering the ability to earn cash rewards, BurnLounge’s revenues plummeted.

BurnLounge still offered packages, but its revenues decreased from $476,516 in June 2007 to $10,880 in August 2007.

Basically once the recruitment party was over, the sale of products and services within BurnLounge “plummeted”, revealing a complete lack of sales activity outside of the business opportunity.

Had BurnLounge affiliates of been selling products and services to a significant number of retail customers, they’d have been able to make the argument that retail activity was alive and well within the company.

On the topic of motivation, while BurnLounge’s music packages were available to non-participants (retail), it should be noted that

96.8% of the participants who bought packages became Moguls, which is strong evidence that package purchases were motivated by the opportunity to earn cash.

In the age of digital products and services, one of the recurring arguments I see raised against claims of recruitment-driven commissions being paid out, is that “we only pay commissions on the sale of products and services”.

Here, we can clearly see that that is not enough. Why people are buying these products and services matters.

There’s no clear-cut benchmark for this, but I like to use a 50% ratio. If  around 50% of your product and/or service revenue is not coming from non-participants (retail), then you’re likely operating an effective pyramid scheme.

Here I’ll also emphasize the point that there’s nothing inherently wrong with affiliates purchasing products (which is one of the common misconceptions that take root when one raises objections to the “we only pay commissions on the sale of products” argument). The problem arises, as was the case in BurnLounge, when this makes up the majority of your sales revenue.

96% of the product and service packages BurnLounge sold was to affiliates, and this in turn made up 92.6% of the company’s total revenue. That is primarily what they were busted on and it should not be confused with questions of whether or not affiliates can purchase products and/or services (internal consumption).

Again, internal consumption is fine, but the majority of revenue coming from internal consumption by newly recruited affiliates is likely evidence of pyramid scheme.

Recurring internal consumption, based around the purchase of products and/or services for example, would be fine (provided of course an affiliate was not simply purchasing product each month to qualify for commissions).

You can’t make the argument that an ongoing purchase of product by affiliates has anything to do with recruitment commissions if they’re not recruiting. And of course the “value of the product” is also then a much easier reason to swallow as opposed to income motivation.

BurnLounge themselves tried to use the “but we have products!” argument, asserting that the FTC

to show that the scheme provides “the right to receive in return for recruiting other participants into the program rewards which are unrelated to sale of the product to ultimate users.”

That argument (which is still commonly deployed today by MLM affiliates), got shot down.

Reading “completely” into the test would be inconsistent with the outcome in Omnitrition. See id. at 782 (holding Omnitrition was likely a pyramid scheme because of its recruitment focus, notwithstanding the fact that Omnitrition made some retail sales).

Courts applying the Koscot/Omnitrition test have consistently found MLM 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.

BurnLounge participants joined the scheme by buying packages, which included a BurnPage and merchandise. Participants earned rewards by recruiting others to join the scheme, i.e., by recruiting new participants to buy packages.

In each of these scenarios, the participants sold something (inventory or packages), but the rewards the participants received in return were largely for recruitment, not for product sales.

That products were purchased as a side-effect of the running of the BurnLounge pyramid scheme was ultimately neither here nor there.

The rewards BurnLounge paid to Moguls were primarily in return for selling the right to participate in the money-making venture—the Mogul program. The
merchandise in the packages was simply incidental.

Drawing a conclusion from the above points, the appeals court wrote:

The second prong of the Omnitrition test does not require that rewards for recruiting be “completely” unrelated to the sale of products.

If it did, any illegal MLM business could save itself from liability by engaging in some retail sales.

Such an outcome would be clearly contrary to our case law: a pyramid scheme “cannot save itself simply by pointing to the fact that it makes some retail sales.” Omnitrition, 79 F.3d at 782.

Basically the “but we have products!” argument is bust. And rightfully so.

How an MLM company sets up it’s compensation plan a role in things too. Time and time again I see MLM compensation plans that contain a paragraph detailing tiny percentages paid out on retail sales, and then encyclopedic volumes on the commissions tied into building an affiliate downline via recruitment.

Here’s what the appeals court had to say about BurnLounge and this practice:

Moguls received more lucrative bonuses if they sold premium packages. Moguls were also eligible to receive Mogul Team Points, with the goal of receiving Mogul Team Bonuses, by selling packages to new participants.

The district court found that Mogul Team Bonuses were “[t]he most lucrative.” This finding is supported by the record: in 2006, BurnLounge paid
a total of $2,726,965.50 in Concentric Retail Bonuses and four times that amount, nearly $8,480,975.00, in Mogul Team Bonuses.

The fact that BurnLounge paid approximately four times more in Mogul Team Bonuses than Concentric Retail Bonuses supports the district court’s finding that Moguls had a strong incentive to recruit new participants.

This incentive was the danger our court warned of in Omnitrition, where we stated, “The 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.”

Too many times I get into discussions with affiliates who are quick to correct my analysis of a company they’re in, because of what can and can’t be done.

The fact of the matter is though, that if your MLM company uses a compensation plan that is heavily skewered towards affiliate recruitment, what can be done on the retail side of things becomes irrelevant.

If a compensation plan rewards affiliates to recruit and pays them peanuts to make retail sales, then it should come as no surprise that is what is going to be focused on by the affiliate-base. The mere fact that retail sales can be made in no way negates that.

All in all, while it’s certainly useful to have a recent court decision to cite for analysis of other companies going forward, ultimately the BurnLoung appeal rejection doesn’t really introduce any information we didn’t already know.

They key-points I took away from the 9th Circuit BurnLounge decision are as follows:

  • the existence of internal consumption is not a sole factor in determining whether or not an MLM company is a pyramid scheme
  • that products and/or services are bundled with affiliate recruitment does not negate a recruitment-driven business model
  • how a compensation plan is set up and what it pays affiliates to do is a likely indicator of how an MLM company is effectively operating
  • end-users and retail customers are not one and the same, a company can have plenty of end-users and still be a pyramid scheme due to a lack of retail customers purchasing whatever is being marketed

We affirm the district court’s holding that BurnLounge was an illegal pyramid scheme, in violation of § 5(a) of the FTCA.

BurnLounge’s scheme satisfied both prongs of the Omnitrition test because Moguls paid for the right to sell products, the rewards BurnLounge paid were primarily for recruitment, and Moguls were clearly motivated by the opportunity to earn cash rewards from recruitment.

Perhaps not as definitive as some would have liked, but there it is.

 

Footnote: You can read the entire BurnLounge appeal decision over at the 9th Circuit Appeals Court website.