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Ninth Circuit Rejects FTC Ban On Internal Consumption Commissions

The appellate court has rejected the FTC’s argument that internal sales cannot be considered sales to ultimate users for purposes of a pyramid scheme analysis.

In FTC v. BurnLounge, the U.S. Court of Appeals for the Ninth Circuit upheld the lower court’s findings that BurnLounge operated an illegal pyramid scheme. While that aspect of the decision is a victory for the Federal Trade Commission, the appellate court rejected the agency’s argument that internal sales cannot be considered sales to ultimate users for purposes of a pyramid scheme analysis.

As background, in 2007, the FTC alleged that BurnLounge and its principals sold opportunities to operate on-line digital music stores, but that the scheme was really an illegal pyramid scheme. One defendant settled, and the remainder litigated the matter. In 2012, the district court ruled in favor of the FTC and found that aspects of the Burn Lounge MLM program constituted an illegal pyramid scheme. The district court ordered non-settling defendants to pay $16.2 million in redress, and prohibited them from engaging in pyramid, Ponzi, or chain letter schemes or any schemes in which compensation for recruitment is unrelated to the sale of product to customers who are not participants. Included in the order, was a ban on “Prohibited Marketing Schemes” which included paying commissions on the “sale of products or services…to or other recruits or the participants’ own accounts.” Defendants appealed.

On appeal, the Ninth Circuit affirmed the district court ruling that the challenged aspect of the BurnLounge MLM program was an illegal pyramid scheme. A key issue that many were watching was whether the district court’s entry on an order finding the payment of compensation on internal sales was unlawful. As written, the ban could be read to prohibit compensation based on purchases by participants or on sales by one participant to another. Indeed, on appeal, the FTC argued that “internal sales…cannot be sales to ultimate users.”

In its decision, the appellate court rejected the FTC’s argument that internal sales cannot be considered sales to ultimate users as being supported by case law. Instead, the appellate court found that there was nothing inherently wrong with paying compensation on internal sales. The court relied on a prior FTC advisory letter to the Direct Sales Association which stated:  “The 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.” The court found, nevertheless, that the challenged program was a pyramid scheme because the primary compensation to participants was for the recruitment of members – and not the sale of products (“the merchandise in the packages was simply incidental”).

Take-away:  The BurnLounge decision helps clarify that determining bona fides of an MLM program is whether the primary compensation is sales of products to third parties, rather than recruitment of persons or internal purchases of the product for the ability to earn money. However, the decision seems to stand for the proposition that there is nothing inherently unlawful about paying commissions on internal consumption sales.

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