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Editor’s Note: On the publication of the Ninth Circuit Court of Appeals’ opinion on the BurnLounge case, attorney Kevin Thompson published an article on Seeking Alpha detailing the decision and what each aspect of the Court’s opinion meant for the direct selling industry as a whole, and Herbalife in particular. This article contains excerpts of Thompson’s longer article, which you can access on SeekingAlpha.com or Thompson’s website.
On June 2, 2014, the Ninth Circuit published its long awaited BurnLounge Opinion. Within hours, both sides of the Herbalife (HLF—NYSE) battlefield issued statements claiming victory about the decision. One thing is clear: The gray space in MLM law separating legitimate direct selling companies from pyramid schemes has been minimized considerably.
BurnLounge was held by the court to be a pyramid scheme. In its opinion, the Ninth Circuit clarified a lot of contentious issues surrounding the industry. The factors assessed in reaching that determination are informative for long and short investors going forward. And of course, the factors are informative for the industry as a whole. While the people betting against Herbalife have argued that the entire industry has been propped up with bubble gum and duct tape over the years with clever interpretations of case law, this opinion clears the air considerably.
Thoughtful Analysis Regarding the Definition of “Ultimate User”
The Court dedicated an entire section to the definition of “ultimate user.” Before diving into the law, it’s important to understand the basics: The practice of paying commissions on purchases made by distributors for self-consumption and/or resale is known as “internal consumption.” The opposite is when distributors buy primarily to qualify for bonuses, i.e. buy things they would never buy at prices they would never pay without the financial opportunity. In BurnLounge, the Court held that participants in the plan can be counted as “ultimate users” provided that the participants bought the products for legitimate “internal consumption,” i.e. personal use.
The Court held, “BurnLounge is correct 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 does not make BurnLounge a pyramid scheme.” (BurnLounge Decision, p. 19). The Court went on to say, “Whether the rewards are related to the sale of products depends on how BurnLounge’s bonus structure operated in practice.” Bottom line: Factors need to be weighed when assessing whether commissions are driven by “ultimate users.”
What Is an “Ultimate User”?
In this regard, the Court looked to the FTC’s 2004 Staff Advisory Opinion for guidance. The section quoted by the court reads, “In fact, the amount of internal consumption in any multi-level compensation business does not determine whether or not the FTC will consider the plan a pyramid scheme. The critical question for the FTC is whether the revenues (that support the commissions) are generated from purchases of goods and services that are not simply incidental to the purchase of the right to participate in the money-making venture,” (emphasis mine).
BurnLounge was held to be a pyramid scheme because “the rewards BurnLounge paid were primarily for recruitment, and (distributors) were clearly motivated by the opportunity to earn cash rewards from recruitment.” (BurnLounge Decision, p. 3-4). The Court weighed several factors in reaching its conclusion that the majority of the rewards were tied to recruitment, not legitimate product sales to “ultimate users.”
Retail vs. Non-Retail
It’s now a moot point. Up until this case, critics argued that the majority of a company’s revenue must come from retail sales, i.e. sales to customers outside of the network. Their rationale: Rewards via internal consumption were “recruitment rewards,” thus, the majority of revenue must come from customers instead of participants. While external sales remain a strong indicator of product value, it’s not a bright-line, determining factor. More importantly, it’s not a requirement.
In its opinion, the Court made itself clear that purchases made by the participants can be counted as legitimate sales PROVIDED… and this is key… there’s legitimate consumer demand for the products. In other words, the Ninth Circuit affirms the idea that there are essentially two categories of purchases: (1) those by ultimate users inside or outside the network, and (2) those derived via opportunity driven demand, i.e. people inside the network buying to qualify for commissions, otherwise known as “channel stuffing,” “garage qualifying,” “inventory loading,” etc.
Factors the Court Used in Finding that BurnLounge Lacked Sufficient “Ultimate Users”
It’s now reality beyond debate: Revenue from participants inside the network must be carefully considered when assessing a company’s legitimacy. The resulting commissions from internal consumption cannot be blindly treated as “recruitment rewards” as critics would prefer.
What are the factors that the Ninth Circuit used?
- Purchasing patterns
- Lack of value
- Requirements to buy to qualify
- Lack of consumer safeguards
- Emphasis of the marketing
While these factors were not centrally located, they were referenced in various locations throughout the opinion. They’re discussed more fully below.
Purchasing patterns: The Court was disturbed by the fact that 95 percent of distributors bought the premium products while only 35 percent of non-distributors (customers) bought the same. (BL Decision, p. 14). The Court said, “If package purchases were driven by the value of the merchandise included in the packages rather than by the opportunity to earn cash rewards, one would expect to see comparable numbers of (distributors) and (non-distributors) buying the same packages.”
Lack of value: The Court held that the BurnLounge products had limited value, thus, the primary motivation leading to the purchases was NOT for legitimate product consumption. (BL Decision, pages 10, 19). Instead, the BurnLounge distributor was motivated to enhance earning potential. The Court held, “In practice, the rewards BurnLounge paid for package sales were not tied to consumer demand for the merchandise in the packages; they were paid to (distributors) for recruiting new participants. BurnLounge, through its recruitment efforts, created its own synthetic market.”
Requirements to buy to qualify: In BurnLounge, participants were REQUIRED to buy the premium packages to qualify for deeper commissions. Since the motivation driving distributor consumption is crucial in pyramid scheme analysis, BurnLounge was immediately dead in the water when it required distributors to buy. The Court held, “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, (distributors) by default received compensation for recruiting others into the program.” (BurnLounge Decision, p. 10). Plus, distributors had to recruit several additional participants to qualify for the basic bonuses (“concentric retail bonuses”). Without question, the plan forced people to focus on recruitment and buy items they never would have bought at prices they never would have paid but for the income opportunity.
Lack of consumer safeguards: This is a point that’s more nuanced. While the Court did not reference the “Amway Safeguards” specifically, they did note that Amway was found to be legitimate due to its policies. As a recap, the FTC held Amway to be a legitimate enterprise largely because of its consumer safeguards. Specifically, Amway had a 70 percent rule (where 70 percent of all purchases needed to move to other people), the 10 customer rule (where distributors had to certify that products went to at least 10 customers each month) and the buyback rule (where distributors had 12 months to return sellable inventory). These safeguards were not specifically referenced in the opinion. However, in response to BurnLounge’s argument that it was just like Amway, the Court said, “Though Amway created incentives for recruitment by requiring participants to purchase inventory… it had rules it effectively enforced that discouraged recruiters from ‘pushing unrealistically large amounts of inventory onto’ recruits.”
In my opinion, the 70 percent rule and the 10 customer rule are no longer relevant. Those rules are vestiges from an era that pre-dates direct fulfillment. In those days, the “directs” had to purchase inventory on behalf of their entire organizations and fulfill the orders; thus, warranting rules that ensured the inventory was moving to “ultimate users.” Today, unique orders can be shipped to individual homes. The risk of inventory loading is greatly reduced provided that there’s a robust, easy-to-understand and clearly communicated buyback policy.
The Court held that BurnLounge had zero policies to prevent bonus buying. Once bought, the products were non-refundable.
Emphasis of the marketing: The Court held that BurnLounge participants focused primarily on recruitment over product value. The Court wrote, “The district court also found that BurnLounge’s marketing focus was on recruiting new participants through the sale of packages.” (BurnLounge Decision, p. 10). In BurnLounge, the pay plan literally required participants to recruit several people to achieve the basic levels in the plan. Plus, the products had minimal value, leaving distributors with little choice but to focus on the financial opportunity.
What Does This Mean Going Forward?
Network marketing companies will get more intelligent in delineating between “ultimate users” and everyone else. The market is already moving toward preferred customer programs where people can receive product discounts as preferred customers WITHOUT joining the business. Since we know these are metrics the courts want, it’s important to show clean data. Absent clear delineation, we have the factors provided in the BurnLounge case to help. Currently, when people join to save money on product (as my friend recently did with an essential oils company), short sellers treat them as “victims” or “failures” for purposes of beefing up the failure rate and finding a pyramid scheme. As the BurnLounge opinion makes clear, it’s not proper to make such distinctions without carefully considering the motivation driving the sales.
Kevin Thompson is an MLM attorney specializing in working with direct selling companies, large and small. He is a founding member of Thompson Burton PLLC and a Supplier Member of the Direct Selling Association.