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From Antitrust Law Daily, June 3, 2014

Injunction against illegal pyramid scheme upheld in FTC suit

By Jeffrey May, J.D.

An operation that had been touted as a cutting-edge way to sell digital music through multi-level marketing was an illegal pyramid scheme, the U.S. Court of Appeals in San Francisco has decided. A district court’s order granting the FTC's request for a permanent injunction against BurnLounge, Inc. was affirmed (FTC v. BurnLounge, Inc., June 2, 2014, Christen, M.).

BurnLounge operated a multi-level marketing business between 2005 and 2007 that offered participants the ability to become “Independent Retailers” of music and other merchandise. These retailers purchased packages, providing access to a ready-made and customizable web page, called a “BurnPage.” A BurnPage was the vehicle through which the retailers sold music, music-related merchandise, or packages of music-related merchandise to customers in return for “BurnRewards.” Retailers could redeem BurnRewards for music or merchandise. These retailers could redeem BurnRewards for cash, rather than music or merchandise, if they become “Moguls” by paying an additional fee and meeting other requirements of the Mogul program.

The FTC brought an action in 2007 against BurnLounge, as well as its CEO/creator and another participant in the BurnLounge scheme. After a bench trial, the federal district court in Los Angeles—finding BurnLounge’s bonus system to be “a labyrinth of obfuscation”—issued a permanent injunction against BurnLounge’s continued operation and imposed monetary awards against the defendants.

The appellate court ruled that the Mogul program was an illegal pyramid scheme in violation of the FTC Act. The court applied the FTC’s test for determining whether a multilevel marketing business is a pyramid scheme. Under the test, previously approved by the Ninth Circuit, 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 that are unrelated to sale of the product to ultimate users.”

The Moguls' purchase of a package in order to access a BurnPage satisfied the first prong. The court explained that the test's second prong was “the sine qua non of a pyramid scheme” and was characterized by “recruitment with rewards unrelated to product sales.”

The finding of a pyramid scheme was supported by BurnLounge’s focus on recruitment of new participants. BurnLounge offered Moguls rewards, in the form of cash bonuses, primarily for recruitment rather than for sales of merchandise. The Moguls were motivated by the opportunity to earn cash rewards from recruitment.

The court rejected BurnLounge's argument that the second prong of the test required that rewards be completely unrelated to product sales. Because the outcome in the case was clear, the court did not decide the degree to which rewards needed to be unrelated to product sales, as might be required in a case presenting a closer question.

Internal consumption. BurnLounge could not convince the court that its sales of packages to Moguls as ultimate users precluded a finding that the Mogul program was a pyramid scheme. BurnLounge correctly argued that, when participants bought packages in part for internal consumption, the participants were the “ultimate users” of the merchandise, and that this internal sale alone did not make BurnLounge a pyramid scheme, the court explained. However, it was incorrect to conclude that all rewards paid on these sales were related to the sale of products to ultimate users.

FTC expert testimony. The district court did not abuse its discretion by admitting the testimony of FTC expert Dr. Peter Vander Nat. Vander Nat was qualified to testify, and his testimony about whether BurnLounge was a pyramid and about the amount of consumer harm was relevant and reliable, the appellate court ruled. It was noted that BurnLounge had sufficient opportunity to cast doubt on the expert's testimony at trial in light of two days of cross-examination.

This is Case No. 12-55926.

Attorneys: Lawrence B. Steinberg (Buchalter Nemer, P.C.) for BurnLounge, Inc. Burke W. Kappler for FTC.

Companies: BurnLounge, Inc.

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