Introduction
BurnLounge was a purported network marketing company. They positioned themselves as a blend between iTunes, MySpace and Amway. The FTC filed its initial complaint against Burnlounge in June of 2007. After a bench trial (and a two year wait), the judge held Burnlounge to be an illegal pyramid scheme.
Facts
Business model
It’s important to understand the Burnlounge model for purposes of understanding the pyramid scheme analysis. Also, it’s beneficial to understand the Burnlounge model because their failure is very informative for other companies in the network marketing space. At its core, Burnlounge created a network of replicated websites, referred to as “BurnPages.” These BurnPages allowed the independent “retailers” (a/k/a distributors) to sell music and other items. There were multiple entry points into the Burnlounge program:
1) Retailer: Paid a $30 fee for the right to operate their own BurnPage. Retailers were not eligible to receive income from music sales. Instead, they received “Burn-Rewards,” which they could redeem for music.
2) Mogul: If they wanted to earn cash rewards, they had to pay $7 per month and purchase one of the below product packages. Upon this occurrence, they were dubbed “Moguls.”
Product Packages
1) Basic: Basic members pay a $7 monthly fee in addition to paying $30 for the Basic package. The package included:
a. BurnPage
b. Editing software for the BurnPage
c. Back-office support
d. Sample copy of BurnLounge Magazine
e. Annual subscription to “FrontBurner Magazine, which was an online website.
2) Exclusive: Exclusive members pay a $7 monthly fee in addition to paying $130 for the Exclusive package. The package included:
a. All of the items in the Basic package
b. Annual subscription to “BurnLounge Presents,” which was a monthly bundle of 10 songs selected by the company and available for download
c. Monthly DVD subscription featuring independent artists chosen by the company
d. Annual subscription to “BurnLounge Magazine”
3) VIP: VIP members pay a $7 monthly fee in addition to paying $430 for the VIP package. The package included:
a. All of the items in the Basic and Exclusive packages
b. The “Event Pass,” which provided for better seating and early access admissions at certain concert events
c. “BurnLounge University,” which consisted of six DVDs documenting the history of the music industry.
NOTE: Retailers always maintain the option of converting to “Moguls” at any time. The vast majority of Retailers chose to become Moguls (97%).Compensation Plan
The BurnLounge compensation plan is confusing. When referencing it, the judge wrote, “Indeed, it would appear that BurnLounge was attempting to create a labyrinth of obfuscation rather than a readily understood compensation system.” Essentially, there were multiple income opportunities in the BurnLounge plan. There was a unilevel component where the participants earned a percentage of the volume generated by their personally enrolled representatives. In addition to this program, Moguls earned the “real money” in the binary plan. In order to qualify for the binary compensation, Moguls had to “sell” two VIP packages to members in their downline (the VIP package was the most expensive offering) and hit monthly performance standards. In the binary plan, Moguls earned a percentage of the total volume from their business by optimizing their two legs.
Income Claims
BurnLounge had policies in place that prohibited the field from making income claims. Despite this policy, aggressive income claims were still made by top leaders. Claims were made where people said they were earning in excess of $200,000 in income. BurnLounge officers testified that they made efforts to police the income claims. BL’s head of Customer Service testified that he dealt with income claim issues a few times a week. Furthermore, BL’s Executive Vice President made a strong statement from a company event about the importance of ending the use of income claims. According to BL, nobody was ever terminated for making income claims. While it was discouraged, apparently nobody was penalized.When income claims were made, income disclosures were not provided to the prospective participants. The FTC argued that the income claims made by field leaders was pervasive throughout the BurnLounge organization.
Issues
Was BurnLounge operating as an illegal pyramid scheme? Were the income claims made by BurnLounge leaders “misleading?”
Law
Pyramid Scheme
Operating a pyramid scheme is an unfair and deceptive act affecting commerce, which triggers the FTC Act. Pyramid schemes are inherently fraudulent because they’re destined to collapse.As determined by the Koscot case, pyramid schemes are:
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 which are unrelated to the sale of the product to ultimate users.”
The judge referenced Omnitrition, which is an unpopular case in the MLM industry. Referencing Omnitrition, the judge wrote, “The satisfaction of the second element of the Koscot test is the sine qua non of a pyramid scheme.
Income Claims
“A statement is misleading if the representation is likely to deceive reasonable consumers to their detriment.” Southwest Sunsites, Inc. v. FTC.
Application of the Law to the Facts
Pyramid Scheme? BL consisted of two components: 1) the sale of music and music-related products through the BL software; and 2) the BL Mogul program, which was the income opportunity. It was only through the latter that anyone could possibly achieve any “significant financial return.”
MLM Attorney Commentary: Given the minuscule amount of revenue accrued from external sales (3%), it was apparent to the court that the only real way to earn income via the BL opportunity was by focusing almost exclusively on recruiting new participants who purchased the product for themselves. After a detailed breakdown of the BL offering and prices, the court concluded the BL prices were gratuitously inflated to support the pay plan.
“[B]ecause participation in the program required the purchase of a product package, and Moguls earned cash for selling these product packages to those they sponsored, they by default received compensation for recruiting others into the program.” The Basic package was the only required package, technically. The court wrote,
BurnLounge argues that the sale of the Basic Package is the sale of a product to an ultimate user. While it is true that the BurnPage could be considered a “product” and a Retailer to be the “user” of that product, this argument ignores the nature of the use itself. That it is a tool for sales and (more importantly) for recruitment, as demonstrated by a review of the BurnLounge promotional material, the presentations of its spokespersons, and the statistics as to the participants who bought into the enterprise. While it is true that Retailers could merely sell music downloads through their BurnPages, Retailers/Moguls generated many times more revenue from the sale of the business opportunity to new participants than the meager rewards of vending the music downloads available on the BurnLounge system.
MLM Attorney Commentary: In order for a transaction to be commissionable, the item sold needs to have some kind of relevance for people outside of the program, lest it be labeled a recruitment scheme. With the Basic package, the court concluded the BurnPages to essentially be “non commissionable” because they were primarily used as tools by distributors to sell music and recruit more distributors, not as actual products.
Unlike the Basic package, the premium packages, the Exclusive and VIP packages, were optional. BL argued that the sale of these packages were truly sales to end users. The court acknowledged that the items bundled in the Exclusive and the VIP packages had SOME value (“extremely limited”). However, regardless of this limited value, the court concluded that it was the financial incentives that ultimately led the BL distributors to purchase those items. Because of this fact, the court concluded that the sale of the Exclusive and VIP packages were pyramidal in nature. Specifically, the court held, “Inventory loading pyramids are not illegal simply because there are wholesale purchasing requirements. They are illegal because the purchases are incentivized by commissions that result from recruiting others to join the scheme through similar purchases.” (emphasis mine)
MLM Attorney Commentary: “MOTIVE” is the key word here. Because of the limited value of the items coupled with the small external sales (3%), the judge concluded that the primary driver that led distributors to buy the premium packages was the compensation plan. In my opinion, it’s ill-advised to make certain rewards in the pay plan contingent on a distributor purchasing a certain item. Distributors should never be required to purchase a higher ticket item in exchange for an ability to earn more compensation. It can always be argued that the true motivation behind those purchases is for the money, not for the value. It makes no sense for a company to expose itself to the additional risk.
Misleading Income Claims? The defendants (BurnLounge and the individual leaders) argued that the misleading statements about income were mere “puffery” i.e. not material. “Generalized or exaggerated statements upon which reasonable consumers would not rely are considered ‘puffery’ and are non-actionable.” With BurnLounge, the judge found that the statements were not vague. On the contrary, the statements were very specific. The judge further noted, “In addition, where a person markets [a pyramid scheme], he/she must at a minimum advise potential investors of the unlikelihood of any substantial returns. The court concluded that the defendants did not provide the material information
MLM Attorney Commentary: Whenever an income claim is made, whether it is express or implied, it’s imperative that adequate income disclosures be provided. Since the company is usually not involved in making income claims, it’s important to (a) provide good income disclosures to the field; and (b) implement AND ENFORCE policies designed to get the leaders to share those disclosures with prospects when income claims are made. With BurnLounge, it appears that they actually had policies in place against sharing income claims; however, those policies seem to have been ignored. If those policies were actually enforced and their was a history of enforcement i.e. suspensions and terminations, this particular issue might have been mitigated.
Conclusion
After waiting for two years after the trial, the judge finally concluded that BurnLounge was, in fact, a pyramid scheme. It’s important for serious students of the network marketing industry should take a hard look at this case. There’s a lot to be learned. In my opinion, if I were to point out one toxic element in their business model that ultimately led to the regulatory action, it would be the extra incentives in the compensation plan that led the majority of BL participants to buy the premium packages. The compensation plan drives behavior. When the barrier to the “real money” was the purchase of a premium package, the vast majority of participants will do it regardless if they really want the products. This appears to be the case with BurnLounge. While BurnLounge tried hard to argue that its products were valuable, the extra incentives in the pay plan provided an easy opportunity for the FTC to argue that the participants bought the bundles to crack into bigger commissions. Simple mistakes, big consequences.
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