Can Internet-Based Membership Programs Be Illegal Pyramid Schemes?

by Orrick, Herrington & Sutcliffe LLP

[authors: Metanat, Morvarid; Reznick, Robert P.]

In a decision that could have substantial implications for many Internet-based businesses, on March 14, 2012, a federal court in California enjoined the operation of a web-based promoter of websites and provider of digital content on grounds that the operation was an illegal pyramid scheme — or multi-level marketing program (MMP) — that violated the Federal Trade Commission Act.  The court also ordered that the promoters pay a total of $17 million in restitution to defrauded consumers.  MMPs have been the subject of legal scrutiny for some time, and case law has laid out standards for determining which are lawful and which are not.  This decision, involving a company called BurnLounge, is significant in applying these standards to a business model based upon contemporary messaging and social media resources.  The opportunities to exploit MMPs in the contemporary environment, and the need to understand the legal limits on what may be attempted, are as different as chain letters sent through U.S. Mail versus those sent through Facebook. 

I.  The BurnLounge Program

The BurnLounge business model was both complicated and confusing, even to the court.  In a somewhat simplified form, the court in its July 1, 2011, Statement of Decision described what BurnLounge did and how it (and its members) sought to make money:

BurnLounge had agreements to license a wide range of digital songs, and purportedly had agreements in place to add movies, advertising and other digital content.  In exchange for upfront and annual fees, it offered turnkey websites to its members, who could then customize the websites to sell BurnLounge content to visitors.  In turn, members could purchase "product packages" from BurnLounge that allowed their customers themselves to become members and operate a BurnLounge website. 

Members earned noncash points in respect of sales they made to customers.  These points could be applied to BurnLounge fees, music fees and other merchandise.  Members who paid an additional fee could earn cash, and some 97% of members elected to do so. 

Members were compensated in a number of ways.  In addition to retaining a portion of the proceeds of their sales to customers, they earned a portion of the downstream fees and sales of members that they recruited.  A complicated system also served to require the growth of such networks in order for members at each level to profit.  This was the defining element of the MMP, which caused the court to view the program as a form of "pyramid" — with later-joining members earning a percentage of monies in relation to a smaller and smaller share of BurnLounge members.

Over the course of its two-year life, BurnLounge signed up more than 60,000 members and took in revenues of more than $28 million. Music sales accounted for only about $500,000; almost $20 million came from the sale of packages, and about $6 million came from monthly fees.  More than 90% of members never recouped their investments, and the FTC's expert testified that, under the best of circumstances, 87.5% of members would not be expected to do so.  The principal reason offered by the expert for this conclusion was that, as is generally true with respect to pyramid schemes, the financial model requires an open-ended ability to recruit new members.

II.  Legal Analysis

The FTC's suit was based on an alleged violation of Section 5 of the Federal Trade Commission Act, a general consumer protection statute that prohibits unfair or deceptive acts or practices.  Prior cases have identified the characteristics of business opportunities and have distinguished between lawful MMPs (e.g., Amway) and illegal pyramid schemes.  As a technical matter, all MMPs are businesses in which participants pay a company in order to receive (i) the right to sell a product and (ii) the right to receive compensation for recruiting additional members (such compensation being unrelated to the sale of the product to the ultimate users).  The district court in the BurnLounge case explained that the principal factor distinguishing a lawful MMP from an illegal pyramid scheme is whether the "primary purpose" of the enterprise and its members is to sell the product to end users or if it is simply to recruit new members.  If recruiting new members is the "primary purpose" of the enterprise, and if it is the case that success as a practical matter will not be achievable for all but the earliest joiners, the court concluded that the business model would be considered illegal. 

The court's finding was also based on its conclusion that the promoters of BurnLounge had made material misstatements and omissions in recruiting members: in essence, claiming that the membership was a money-making proposition when the economics were otherwise.

III.  Implications for Internet-Based Businesses

The proliferation and acceptance of both Internet-based commerce and social media provide an easy vehicle to access a vast audience for financial gain.  Many Internet-based businesses take advantage of the relative ease of mass marketing through these media.  Such businesses should be especially cognizant of conduct that may expose them to potential liability under the recent BurnLounge decision and the principles on which it was based.  While most Internet-based businesses may think their business models are far removed from being considered a "pyramid scheme," their sense of security may be based on outdated assumptions that such illegal conduct must look like a chain letter or Bernie Madoff-like operation.

Social media outlets that do not require that a "member" pay into their business model probably run a lower overall risk of being deemed an illegal MMP.  However, social media outlets such as Facebook are riddled with advertisers that provide incentives to users for recruiting their friends to also take advantage of the advertisement — incentives ranging from cash to discounts or to coupons for consumer goods.  Under the BurnLounge decision, these businesses are at risk of being viewed as pyramid schemes themselves, or for providing an environment in which such schemes may operate.  The line between lawful operations and those that might be characterized as illegal pyramid schemes can be a fine one, and all businesses that embrace an MMP business model should understand the rules of the road.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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