June 2 (Bloomberg) -- BurnLounge Inc., a digital music seller shut down by the Federal Trade Commission over its multilevel marketing, was found by a federal appeals court to be an illegal pyramid scheme in a case closely followed by Herbalife Ltd. watchers.
The U.S. Court of Appeals in San Francisco ruled today that the company’s marketing methods violated the Federal Trade Commission Act because its distributors paid for the right to sell products and were motivated primarily by payments from the company for recruiting new members.
Herbalife said the ruling, which holds that the practice of recruits buying merchandise for their own use doesn’t constitute a pyramid scheme, “validates” its business methods, which have been criticized by New York hedge fund manager Bill Ackman and are being investigated by the FTC.
Product consumption by participants is “a legitimate measure of demand for multilevel marketing companies,” the company said in an e-mail. The ruling “is consistent with Herbalife’s position that the widespread demand Herbalife has demonstrated for its products, by members and non-members alike, confirms that it is a multilevel marketing company with proper business practices.”
The merchandise sold by some BurnLounge distributors was “simply incidental” and the chance to earn cash rewards, rather than music, was the “major draw” of the sales program, the court said, upholding a lower-court ruling.
The case was being closely watched in connection with an FTC investigation of Herbalife, said Kevin Thompson, an attorney for multilevel marketing companies. He said the court stopped short of ruling that commissions generated from goods sold to the sales force, rather than customers outside the company’s network of distributors, are illegal.
“This decision is good for Herbalife and good for the network-marketing industry because it clarifies the issue of paying commissions” to distributors buying products, he said by phone. “As long as the products have legitimate value, the company will be in a good position to thwart off pyramid arguments.”
Lawrence Steinberg, an attorney for BurnLounge, said the appeals court failed to understand that the company’s business model didn’t compensate for recruiting and only paid commissions on sales of products.
“We do take some solace in that this new decision clarifies the law and, for the first time, recognizes the legitimacy of sales made to the many distributors who join a multilevel marketing company so that they can buy products at a discounted price for their own personal use,” Steinberg said in an e-mail.
The company is considering whether to seek further review by the appeals or U.S. Supreme Court.
A district court in 2012 ordered BurnLounge to pay $17 million in refunds to customers who were burned by the scam, the FTC said at the time. The appeals court sent the case back to the lower court to revise part of the award against the company.
The FTC is investigating claims Herbalife is a pyramid scheme after Ackman publicly accused the seller of vitamins and weight-loss shakes of misleading distributors, misrepresenting sales and inflating the prices of its products.
Herbalife, which has denied Ackman’s claims, disclosed in March that the FTC had started a civil probe into its practices following months of lobbying by Ackman, who had bet $1 billion against the company’s stock, and his New York-based Pershing Square Capital Management LP.
The company, which is based in the Cayman Islands and run from Los Angeles, has said it’s cooperating with the FTC probe and welcomes the opportunity to clear up “misinformation in the market.
Today’s ruling ‘‘supports the view that BurnLounge vs. Herbalife is like rotten apples to sweet oranges,’’ said Robert Chapman, an Herbalife investor at Chapman Capital LLC in Manhattan Beach, California, who has been an outspoken critic of Ackman’s position. ‘‘Internal consumption is not all bad.’’
BurnLounge, which operated from 2005 to 2007, sold music and music-related merchandise, according to the appeals court ruling. Customers could buy the music or purchase a retailer package enabling them to sell music and earn rewards to buy more music. Retailers could pay an extra fee that would allow them to redeem the awards for cash rather than music. It was that aspect of the business that a district court found to be a pyramid scheme.
Herbalife distributors sell directly to family, friends, neighbors and strangers. They buy products at a discount and sell them at a markup. They earn even more by recruiting, training and coaching a sales team, and then generating royalties and production bonuses based on the total sales by their network.
To qualify for commissions and royalties, distributors must make at least one sale to each of 10 retail customers each month. In addition, at least 70 percent of the retail value of the products a distributor orders must be consumed or sold.
The goal is to prevent inventory loading, which can constitute a hidden recruiting fee within an illegal pyramid scheme. Herbalife’s 10-customer and 70 percent rules stem from a 1979 FTC ruling in a pyramid-scheme claim against Amway, one of the most well-known multilevel marketers in the world. The FTC used similar benchmarks to determine that the company wasn’t a pyramid scheme. Herbalife and other direct sellers have since adopted the benchmarks to avoid trouble.
The case is FTC v. BurnLounge Inc., 12-55926, U.S. Circuit Court of Appeals for the Ninth Circuit (San Francisco).
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