Thank You, 9th Circuit Court Of Appeals

Includes: HLF
by: William Keep


9th Circuit Court of Appeals emphasizes rewards based primarily from recruitment in finding BurnLounge, an MLM, to be a pyramid scheme.

Court decision affirms the importance of the compensation structure in practice, the Koscot/Omnitrition decisions, and the need for effective, enforced rules.

The decision has implications for Herbalife and other MLMs regarding their reliance on recruitment and the effectiveness of anti-pyramid scheme policies.

I read here that one should accept a compliment with a simple "thank you." So I would like to say "thank you" to the Ninth Circuit Court of Appeals regarding their recent decision (here) on BurnLounge. The compliment was their recognition of the "expert [i.e., my] testimony regarding a MLM business's "marketing materials, organizational structure, and recruiting policies" (page 23) in Gold Unlimited (case and description of expert testimony here). But much more importantly regarding expert testimony, the Court spent considerable space recognizing the work of Peter Vander Nat of the FTC, thereby complimenting the consistency with which the FTC has applied the Omnitrition decision (here) and quite literally marrying Omnitrition to the Koscot decision (here), more than a nod to Douglas Brooks.

Recap: BurnLounge operated as a multilevel marketing company selling music, merchandise, and packages of music-related merchandise. In 2007 the FTC filed a complaint (here) against the company, accusing it of operating a pyramid scheme. In 2012 the US District Court Central District of California Western Division found against the company, awarding $16,245,799.70 to reimburse consumers harmed by "the BurnLounge pyramid scheme" (here) - not sure who gets the 70 cents. To avoid embarrassing yourself with an uninformed comment, find all case filings here.

Soon after the decision Herbalife (NYSE:HLF) assured us (here) that "This ruling...confirms that it [Herbalife] is a multilevel marketing company with proper business practices." Paraphrasing, in Obi-Wan Kenobi style (here), the company said: "These aren't the droids [MLMs] you're looking for…Move along." Self-interest can make companies say funny things. Other than yet another win based on a proven legal argument and analytical approach, let's see what gifts the Court gave the FTC so they too can move along in a meaningful way.

AFFIRMED: MLM structures that in practice lead to a primary reliance on recruitment risk being found to be pyramid schemes. Full stop. The Court's overall decision links: Structure - Practice - Performance. By repeatedly pointing to the: "structure of the scheme," "compensation structure," "business structure," "bonus structure," and "organizational structure," the Court sets the foundation for understanding the impact of incentives (pages 12, 13, 15, 19, and 23). Putting brick-upon-brick, the Court logically says: "To determine whether a MLM business is a pyramid, a court must look at how the MLM business operates in practice" (page 11) Finally, referencing Peterson v. Sunrider Corp (here), the Court notes: "Even where a marketing plan formally bases commissions on sales, the plan may still be found illegal if, in practice, profits come primarily from recruitment" (page 16). Structure-Practice-Performance matters, not the firm's public statements, its efforts to reign in distributors after the media expose deceptive practices, its occasional "surveys," or its longevity.

Leaving no doubt in how to view an MLM's performance regarding a reliance on recruitment the Court uses the word "primarily" eight times, in six instances adding "primarily" to "for," "from," or "through" recruitment and "enrolling new people" (pages 3, 13, 15, 16, 18, 20, 23, 24). It is hard to image anyone missing that message. By affirmatively referencing Gold Unlimited a number of times, the Court also reinforces that once the sufficiency of retail sales is raised in the context of proposed "Amway defenses," the burden of proof for these defenses rests with the MLM.

AFFIRMED: Koscot and Omnitrition together represent the law of the land in the 9th Circuit. The significance of the Court's reliance on "Koscot/Omnitrition" is hard to overstate. For years the industry has claimed that the Omnitrition decision was not "well settled law" (here), and led to legal "confusion" with language that was mere "dicta" (here). The industry liked this argument so much it was featured it the Direct Selling News (here).

As part of their civic duty, courts like to help out confused lawyers and this Court was certainly up to the task. Getting into the legal nitty gritty of Koscot/Omnitrition, the Court reaffirms the 2-prong test, using the word "prong" at least a dozen times, ultimately concluding "BurnLounge's scheme satisfied both prongs of the Omnitrition test" (page 24). As noted above, the Court provides additional clarification by frequently adding the word "primarily" to its pyramid scheme test, as in "profits come primarily from recruitment" (page 16).

But what about "internal consumption," an area of much hand-wringing? [As an aside, let me first apologize for not using larger font in the sentence in the 2002 Vander Nat/Keep paper (here) where we specifically exclude consideration of a "buyers' club" (footnote #8). Imagine how much digital ink could have been spared had that message been more clearly understood.] Some might be confused by the Court's strong affirmation of Omnitrition and simultaneous recognition of participant purchases for internal consumption as purchases by the "ultimate user." Here too, however, the Court provides guidance. By referencing two sentences from the FTC's 2004 Staff Advisory (here), rather than just the first, the Court provides context for understanding the role of "internal consumption." In doing so the Court differentiates between the inevitable internal consumption that occurs as MLM distributors use some of their own products and "recruitment with rewards unrelated to product sales" per the Omnitrition test. The Court did not let the existence of "internal consumption" cloud the more important issue, concluding: "The rewards BurnLounge paid were primarily for recruitment, not for the sale of products" (page 18)

AFFIRMED: MLM policies and practices matter. The Court's go-to case here is, as would be expected, the 1979 Amway decision (here): "Though Amway created incentives for recruitment by requiring participants to purchase inventory from their recruiters, it had rules it effectively enforced that discouraged recruiters from "pushing unrealistically large amounts of inventory onto" recruits." One more time for the slow reader " (page 17)…"IT HAD RULES IT EFFECTIVELY ENFORCED" - get it? Rules that get enforced.

Many MLMs may want to pay particular attention to the Court's message that words matter. Here, I raised questions about Herbalife's 70% rule; here, we noted how Amway has walked away from its earlier 70% rule, now providing less protection; and the statement that appears in every Herbalife annual report since 2004 makes one wonder about enforcement: "As a result, there can be no assurance that our Members will participate in our marketing strategies or plans, accept our introduction of new products, or comply with our Members policies and procedures." (here page 26). How important are enforced rules? The Court noted that BurnLounge "had no rules promoting retail sales over recruitment" (page 17 - the Court emphasized "no" with italics).

What else did the Court accomplish in 24 pages? Upholding the lower court while repeatedly referencing Koscot, Omnitrition, and Gold Unlimited, means bringing all of this case law into the legal vocabulary of the 9th Circuit and reinforces the importance of sales that extend beyond recruitment. When it comes to finding an MLM to be a pyramid scheme, inventory loading turns out to be a bit of a boogeyman (the lower court found none in BurnLounge). The Court's nuanced approach can be seen throughout, from its take on "internal consumption" (page 20), to noting "This test does not require that rewards be completely unrelated to product sales" (page 15), to recognizing that a pyramid scheme can operate within a larger framework: "The Mogul program was the only aspect of BurnLounge that the district court found to be a pyramid" (page 7). All and all, a damn fine decision.

What's next? Here is my wish list, you may want to make your own:

  1. BurnLounge coughs up millions of dollars
  2. The FTC and SEC proceed with their investigation of Herbalife in full light of the BurnLounge decision.
  3. The FTC promulgates a process whereby every five years every MLM operating in the United States submits for review its anti-pyramid scheme rules and methods of enforcement. Any changes between the five years would need to be submitted when in enacted.
  4. The FTC, SEC, and state AGs establish an annual conference on pyramid schemes, sharing information and ensuring the states are current on federal court decisions and MLM practices
  5. The establishment of an international conference concerning MLMs and pyramid schemes, inviting academics, regulators, enforcement, and industry representatives.

Have a nice day!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have received no compensation from any parties associated with the Herbalife controversy.

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