Federal Trade Commission v. BurnLounge, Inc. , 753 F.3d 878 ( 2014 )

FOR PUBLICATION
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
FEDERAL TRADE COMMISSION, No. 12-55926
Plaintiff-Appellee,
D.C. No.
v. 2:07-cv-03654-
GW-FMO
BURNLOUNGE, INC., a Corporation;
JUAN ALEXANDER ARNOLD, an
individual,
Defendants-Appellants,
and
JOHN TAYLOR, an individual; ROB
DEBOER, an individual,
Defendants.
FEDERAL TRADE COMMISSION, No. 12-56197
Plaintiff-Appellee,
D.C. No.
v. 2:07-cv-03654-
GW-FMO
BURNLOUNGE, INC., a Corporation;
JUAN ALEXANDER ARNOLD, an
individual, ROB DEBOER, an
individual,
Defendants,
2 FTC V. BURNLOUNGE, INC.
and
JOHN TAYLOR, an individual,
Defendant-Appellant.
FEDERAL TRADE COMMISSION, No. 12-56228
Plaintiff-Appellant,
D.C. No.
v. 2:07-cv-03654-
GW-FMO
ROB DEBOER, an individual,
Defendant-Appellee,
OPINION
and
JOHN TAYLOR, an individual,
Defendant,
BURNLOUNGE, INC., a Corporation;
JUAN ALEXANDER ARNOLD, an
individual,
Defendants.
Appeal from the United States District Court
for the Central District of California
George H. Wu, District Judge, Presiding
Argued and Submitted
December 6, 2013—Pasadena, California
Filed June 2, 2014
FTC V. BURNLOUNGE, INC. 3
Before: Harry Pregerson, Marsha S. Berzon,
and Morgan Christen, Circuit Judges.
Opinion by Judge Christen
SUMMARY*
Federal Trade Commission
The panel affirmed the district court’s order granting a
permanent injunction against BurnLounge, Inc.’s continued
operation based on the court’s holding that BurnLounge’s
multi-level marketing business was an illegal pyramid
scheme in violation of § 5(a) of the Federal Trade
Commission Act.
BurnLounge operated a multi-level marketing business
that offered participants the ability to become “Independent
Retailers” of music and other merchandise. Independent
Retailers could earn points redeemable for music or
merchandise, or they could pay an additional fee to become
“Moguls” and earn cash rewards.
The panel held that BurnLounge’s scheme satisfied both
prongs of the Webster v. Omnitron International, Inc., 79
F.3d 776 (9th Cir. 1996), pyramid scheme test because
Moguls paid for the right to sell products, the rewards
BurnLounge paid were primarily for recruitment, and Moguls
were clearly motivated by the opportunity to earn cash
*
This summary constitutes no part of the opinion of the court. It has
been prepared by court staff for the convenience of the reader.
4 FTC V. BURNLOUNGE, INC.
rewards from recruitment. The panel also held that the
district court did not abuse its discretion in admitting the
Federal Trade Commission’s expert testimony because the
testimony was relevant and reliable.
COUNSEL
Lawrence B. Steinberg (argued) and Efrat M. Cogan,
Buchalter Nemer, P.C., Los Angeles, California, for
Defendants-Appellants BurnLounge, Inc. and Juan Alexander
Arnold.
W. James Jonas III, W. James Jonas III, P.C., San Antonio,
Texas, for Defendant-Appellant John Taylor.
No appearance for Defendant/Cross-Appellee Rob DeBoer.
Burke W. Kappler (argued), Attorney; John F. Daly, Deputy
General Counsel for Litigation; and David C. Shonka, Acting
General Counsel, Federal Trade Commission, Washington,
D.C.; Chris M. Couillou and Dama J. Brown, Federal Trade
Commission, Atlanta, Georgia, for Plaintiff-Appellee/Cross-
Appellant Federal Trade Commission.
M. Jeffrey Hanscom and Joseph Mariano, Direct Selling
Association, Washington, D.C.; Deborah T. Ashford, Philip
C. Larson, and Catherine E. Stetson, Hogan Lovells US LLP,
Washington, D.C., for Amicus Curiae Direct Selling
Association.
FTC V. BURNLOUNGE, INC. 5
OPINION
CHRISTEN, Circuit Judge:
BurnLounge, Inc. operated a multi-level marketing
business that offered participants the ability to become
“Independent Retailers” of music and other merchandise.
Independent Retailers could earn points redeemable for music
or merchandise, or they could pay an additional fee to
become “Moguls” and earn cash rewards. The Federal Trade
Commission filed suit against BurnLounge alleging violation
of § 5(a) of the Federal Trade Commission Act (FTCA).
Section 5(a) states: “unfair or deceptive acts or practices in or
affecting commerce, are hereby declared unlawful.”
15 U.S.C. § 45(a)(1). The operation of a pyramid scheme
constitutes an unfair or deceptive act or practice in or
affecting commerce for the purposes of § 5(a). See In re
Koscot Interplanetary, Inc., 86 F.T.C. 1106, 1178, 1181
(1975).
BurnLounge, Juan Alexander Arnold (CEO and creator of
BurnLounge), and John Taylor (participant in the
BurnLounge scheme) appeal the district court’s order
granting a permanent injunction against BurnLounge’s
continued operation based on the court’s finding that
BurnLounge was an illegal pyramid scheme. BurnLounge
and Arnold also appeal the district court’s denial of their
motion to exclude the testimony of Dr. Peter Vander Nat, the
FTC’s expert. We have jurisdiction over this appeal pursuant
to 28 U.S.C. § 1291. We agree with the district court that
BurnLounge was an illegal pyramid scheme in violation of
the FTCA because BurnLounge’s focus was recruitment, and
because the rewards it paid in the form of cash bonuses were
tied to recruitment rather than the sale of merchandise. We
6 FTC V. BURNLOUNGE, INC.
also hold that the district court did not abuse its discretion by
admitting Vander Nat’s testimony because his testimony was
relevant and reliable. Accordingly, we affirm on these issues.
We discuss the district court’s consumer harm calculation and
the FTC’s cross-appeal in a separate memorandum
disposition.
I. BACKGROUND
BurnLounge operated from 2005 to 2007 and sold music,
music-related merchandise, and packages of music-related
merchandise. Customers could participate in BurnLounge in
three ways: they could buy music and merchandise; they
could buy a package to become an Independent Retailer with
the ability to earn credits redeemable for music and
merchandise; or they could buy a package and pay an
additional fee to become a Mogul with the ability to earn
credits redeemable for cash. In 2007, the FTC commenced
this action and the parties stipulated to a preliminary
injunction that prohibited BurnLounge from continuing to
operate its Mogul program. After a bench trial, the district
court concluded that BurnLounge and the individual
defendants had violated FTCA § 5(a), issued a permanent
injunction, and imposed monetary awards against the
defendants.
A. BurnLounge’s Business
1. The basics of BurnLounge
The evidence at trial showed that BurnLounge’s business
had two primary aspects—its Retailer program and its Mogul
program. Individuals could become Independent Retailers of
online music by purchasing one of BurnLounge’s three
FTC V. BURNLOUNGE, INC. 7
packages: Basic ($29.95 per year); Exclusive ($129.95 per
year plus $8 per month); or VIP ($429.95 per year plus $8 per
month). Each package provided the Retailers with access to
a ready made and customizable web page, called a
“BurnPage.”1 A BurnPage was the vehicle through which
Retailers sold music, music-related merchandise, or packages
of music-related merchandise to customers in return for
“BurnRewards.” More expensive packages included more
merchandise for personal use by the Retailer.2 Individuals
who participated as Retailers could redeem BurnRewards for
music or merchandise.
Retailers could pay an additional monthly fee of $6.95 to
become Moguls. Once qualified, Moguls could redeem
BurnRewards for cash rather than music or merchandise.3
The Mogul program was the only aspect of BurnLounge that
the district court found to be a pyramid; accordingly, this
opinion focuses on the Mogul program.
1
These web pages were technically called “BurnLounges,” but the
district court called them “BurnPages” to avoid confusion. We follow that
convention.
2
For example, the Basic package included a sample copy of
BurnLounge Magazine and an annual subscription to BurnLounge’s online
publication; the Exclusive package added a monthly DVD and other
merchandise; and the VIP package added an event pass and the
BurnLounge University DVD set.
3
In addition to buying a package and paying the monthly Mogul fee, to
become qualified to redeem BurnRewards for cash a Mogul had to:
(1) sell two Exclusive or VIP product packages; (2) sell two music albums
to non-Moguls; and (3) on a continuing basis, have sold at least two
albums to non-Moguls in the previous month.
8 FTC V. BURNLOUNGE, INC.
2. BurnLounge bonuses
BurnLounge offered Moguls the opportunity to earn three
types of BurnRewards bonuses that could be redeemed for
cash. Each type of bonus had a separate set of requirements
that had to be met before Moguls were eligible to receive the
bonus.
a. Concentric Retail Bonuses
Moguls received “Concentric Retail Bonuses” for music,
merchandise, and package sales made through their own
BurnPage and through the BurnPages of their downline
recruits. Downline recruits included participants recruited by
Moguls and those recruited by earlier recruits. This sequence
created a hierarchy, with those whom a Mogul directly
recruited in the first “Ring” of the hierarchy, those whom the
recruits recruited in the second Ring of the hierarchy, and so
on, for up to six Rings. To qualify for a Concentric Retail
Bonus for sales made by recruits in each Ring of the
hierarchy, a Mogul had to sell at least the number of packages
corresponding to that Ring number. For example, to qualify
for Concentric Retail Bonuses for sales made by recruits in
the fourth Ring, a Mougl had to sell at least four packages.
The Mogul also had to have made a certain number of music
album sales in the previous month, and the Mogul’s hierarchy
must have made a certain number of album sales in the
previous month.
b. Product Package Bonuses
Moguls received “Product Package Bonuses” for selling
product packages. Moguls received these bonuses in
increasing amounts for the sale of Basic, Exclusive, and VIP
FTC V. BURNLOUNGE, INC. 9
packages ($10, $20, and $50 respectively). To qualify for
this bonus, Moguls must have sold at least two music albums
to non-Moguls in the previous month and have a positive
BurnRewards account.4
c. Mogul Team Bonuses
Moguls earned “Mogul Team Bonuses” by accruing
“Mogul Team Points.” Mogul Team Points were accrued by
selling premium packages (Exclusive or VIP). Once a Mogul
accrued enough Mogul Team Points, the points were
automatically converted into a Mogul Team Bonus paid in
BurnRewards, which could be converted to cash. The amount
of cash earned for each Mogul Team Bonus depended on the
type of package the Moguls originally purchased and the
amount of music the Moguls sold. A VIP Mogul, who paid
the $429.95 yearly fee, could earn a $50 bonus with no
additional music sales. An Executive Mogul, who paid the
$129.95 yearly fee, could earn a $25 bonus, or a $50 bonus if
that Mogul also sold $500 worth of music. A Basic Mogul,
who paid the $29.95 yearly fee, was not eligible for a Mogul
Team Bonus unless that Mogul sold $500 worth of music (for
a $25 bonus) or $1,000 worth of music (for a $50 bonus).5
4
All Retailers and Moguls had BurnRewards accounts, which were like
bank accounts for the BurnRewards they earned or purchased with a credit
card.
5
BurnLounge argues on appeal that the district court did not take into
account the fact that, in 2006, it made a major policy change to the sales
requirements for receiving bonuses. BurnLounge failed to raise this issue
until its Rule 59 motion. The district court rejected it because
BurnLounge could have raised the issue at trial. Even though this issue
was not fully litigated in the district court, we have considered it and
conclude that it does not change our analysis.
10 FTC V. BURNLOUNGE, INC.
B. District Court Proceedings
After a bench trial, the district court issued a statement of
decision. It provides a comprehensive review of
BurnLounge’s merchandise, bonus system, and advertising
materials. The district court described BurnLounge’s bonus
system as “a labyrinth of obfuscation.” It found there was a
93.84% failure rate for all Moguls, meaning 93.84% of
Moguls never recouped their investment. The district court
also found that BurnLounge’s marketing focus was on
recruiting new participants through the sale of packages. The
district court ruled that BurnLounge’s expert, David Nolte,
provided estimated values of the merchandise in the
BurnLounge packages that were not credible or supported by
the evidence. It found that BurnLounge’s products had some
value, but concluded that the evidence did not support a
finding that the products were worth what was charged for
them.
The district court found that because purchasing a
package was required for participation as a Retailer or Mogul,
and because Moguls earned cash for selling packages,
“[Moguls] by default received compensation for recruiting
others into the program.” The district court concluded that “a
majority of the BurnLounge business (consisting of the
Mogul program and related elements) was a pyramid
scheme.”
II. STANDARD OF REVIEW
We review a district court’s findings of fact after a bench
trial for clear error. See Fed. R. Civ. P. 52(a)(6); Allen v.
Iranon, 283 F.3d 1070, 1076 (9th Cir. 2002). Under this
deferential standard “we will accept the [district] court’s
FTC V. BURNLOUNGE, INC. 11
findings of fact unless we are left with the definite and firm
conviction that a mistake has been committed.” Allen,
283 F.3d at 1076. We review the district court’s conclusions
of law de novo. FTC v. Garvey, 383 F.3d 891, 900 (9th Cir.
2004). We review the district court’s decision to admit expert
testimony for abuse of discretion. Gen. Elec. Co. v. Joiner,
522 U.S. 136, 143 (1997).
III. DISCUSSION
In Webster v. Omnitrition International, Inc., our court
approved the FTC’s test for determining whether a multi-
level marketing (MLM) business is a pyramid scheme: a
pyramid scheme is “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 sale of the product to
ultimate users.” 79 F.3d 776, 781 (9th Cir. 1996) (quoting
Koscot, 86 F.T.C. at 1180). Not all MLM businesses are
illegal pyramid schemes. To determine whether a MLM
business is a pyramid, a court must look at how the MLM
business operates in practice. See id. at 783–84; see also
United States v. Gold Unlimited, Inc., 177 F.3d 472, 479–82
(6th Cir. 1999); In re Amway Corp., 93 F.T.C. 618, 716
(1979).
A. Prong 1: Participants in the BurnLounge business
paid money in return for the right to sell a product.
Moguls were required to purchase a package (Basic,
Exclusive, or VIP) in order to access a BurnPage. BurnPages
provided Moguls with the ability to sell music, merchandise,
and packages. The sale of packages thus conveyed “the right
12 FTC V. BURNLOUNGE, INC.
to sell a product,” which satisfies the first prong of
Omnitrition. 79 F.3d at 781 (citation omitted).
B. Prong 2: BurnLounge participants paid money in
return for the right to receive rewards for recruiting
other participants into the program, which were
unrelated to the sale of the product to ultimate users.
Satisfaction of the second prong of the Omnitrition test is
“the sine qua non of a pyramid scheme” and is characterized
by “recruitment with rewards unrelated to product sales.” Id.
at 781. In Omnitrition, this court found that a MLM business
was a pyramid scheme because “[t]he mere structure of the
scheme suggests that Omnitrition’s focus was in promoting
the program rather than selling the products.” Id. at 782(emphases in original). The FTC has explained that in a
pyramid, “participants purchase the right to earn profits by
recruiting other participants, who themselves are interested in
recruitment fees rather than the sale of products.” Amway,
93 F.T.C. at 716–17.
Here, the FTC presented ample evidence to support the
district court’s finding that BurnLounge was an illegal
pyramid scheme. It did so by showing that: (1) Moguls were
required to recruit new members in order to become eligible
for all three types of cash bonuses and (2) Moguls were
motivated by the opportunity to earn cash rewards, as shown
by data illustrating the sharp difference in package purchasing
patterns of Moguls and non-Moguls, and by the fact that
BurnLounge’s sales plummeted after the Mogul program was
enjoined.
We agree with the district court that the FTC provided
sufficient evidence to prove that BurnLounge’s focus was
FTC V. BURNLOUNGE, INC. 13
recruitment and that the rewards it paid, in the form of cash
bonuses, were primarily for recruitment rather than for sales
of merchandise. Recruiting was built into the compensation
structure in that recruiting led to eligibility for cash rewards,
and more recruiting led to higher rewards. For example,
Moguls could not convert their rewards to cash until they
became qualified Moguls, and Moguls had to sell two
premium packages to become qualified. Selling packages
was a way of recruiting new Moguls—in fact, it was the only
form of recruitment—because purchasing a package was
necessary to become a Mogul and earn cash rewards. Also,
96.8% of the participants who bought packages became
Moguls, which is strong evidence that package purchases
were motivated by the opportunity to earn cash.
Moguls were required to sell packages to receive
Concentric Retail Bonuses at each level of their downline
hierarchy. Product Package Bonuses were cash rewards
received for selling packages to new members. Moguls
received more lucrative bonuses if they sold premium
packages. Moguls were also eligible to receive Mogul Team
Points, with the goal of receiving Mogul Team Bonuses, by
selling packages to new participants. The district court found
that Mogul Team Bonuses were “[t]he most lucrative.” This
finding is supported by the record: in 2006, BurnLounge paid
a total of $2,726,965.50 in Concentric Retail Bonuses and
four times that amount, nearly $8,480,975.00, in Mogul Team
Bonuses. Concentric Retail Bonuses were paid for the sale of
music and packages (though the bonus was based on only a
percentage of the first $29.95 of each package). In contrast,
Mogul Team Points accrued only for the sale of packages, so
they primarily rewarded recruiting new participants. The fact
that BurnLounge paid approximately four times more in
Mogul Team Bonuses than Concentric Retail Bonuses
14 FTC V. BURNLOUNGE, INC.
supports the district court’s finding that Moguls had a strong
incentive to recruit new participants. This incentive was the
danger our court warned of in Omnitrition, where we stated,
“The promise of lucrative rewards for recruiting others tends
to induce participants to focus on the recruitment side of the
business at the expense of their retail marketing efforts,
making it unlikely that meaningful opportunities for retail
sales will occur.” Omnitrition, 79 F.3d at 782 (citing Koscot,
86 F.T.C. at 1181).
That BurnLounge motivated Moguls through cash
rewards earned by recruiting other participants is exemplified
by the sharp difference between Moguls’ and non-Moguls’
package purchase patterns. BurnLounge’s own data showed
that 67% of Moguls bought VIP packages, 28.8% bought
Exclusive packages, and just 4.2% bought Basic packages.
In contrast, 17.3% of non-Moguls bought VIP packages,
17.2% bought Exclusive packages, and 65.5% bought Basic
packages. If package purchases were driven by the value of
the merchandise included in the packages rather than by the
opportunity to earn cash rewards, one would expect to see
comparable numbers of Moguls and non-Moguls buying the
same packages. Further, 96.6% of non-Moguls (56,017
people) did not purchase any of the packages at any
time—they just bought music and other merchandise.
The district court’s finding that BurnLounge paid rewards
for recruitment unrelated to product sales is also supported by
the effect the preliminary injunction had on BurnLounge’s
revenues. After the parties entered into a stipulated
preliminary injunction in July 2007 that stopped BurnLounge
from offering the ability to earn cash rewards, BurnLounge’s
revenues plummeted. BurnLounge still offered packages, but
its revenues decreased from $476,516 in June 2007 to
FTC V. BURNLOUNGE, INC. 15
$10,880 in August 2007. The dramatic decline in revenue
after the ability to earn cash rewards was eliminated provides
further evidence that the sale of BurnLounge packages was
primarily directed at participants who were interested in the
Mogul program, where it was possible to earn cash rewards.
Recruiting and rewards for recruitment were integral to
BurnLounge’s business structure, and there was ample
evidence that Moguls were meant to be, and were, primarily
motivated by the opportunity to earn cash rewards for
recruitment. As in Omnitrition, the evidence in this case
shows that BurnLounge’s “focus was in promoting the
program rather than selling the products.” Omnitrition,
79 F.3d at 782 (emphases in original). The district court did
not err by holding that BurnLounge was an illegal pyramid
scheme.
1. The Omnitrition test does not require that the
rewards be completely unrelated to the sale of
products.
BurnLounge argues that the second prong of the
Omnitrition test “requires that the rewards be completely
unrelated to sales of bona fide products.” The second prong
of the pyramid test requires the FTC to show that the scheme
provides “the right to receive in return for recruiting other
participants into the program rewards which are unrelated to
sale of the product to ultimate users.” Id. at 781 (citation
omitted). This test does not require that rewards be
completely unrelated to product sales, and BurnLounge
provides no support for its argument that the test should be
interpreted this way.
16 FTC V. BURNLOUNGE, INC.
First, reading “completely” into the test would be
inconsistent with the outcome in Omnitrition. See id. at 782(holding Omnitrition was likely a pyramid scheme because
of its recruitment focus, notwithstanding the fact that
Omnitrition made some retail sales).
Second, courts applying the Koscot/Omnitrition test have
consistently found MLM businesses to be illegal pyramids
where their focus was on recruitment and where rewards were
paid in exchange for recruiting others, rather than simply
selling products. See Gold Unlimited, 177 F.3d at 476, 481(affirming conviction based on finding that participants
bought gold and received cash payments for recruiting others
to both buy gold and recruit others to do so, because rewards
were paid for recruitment rather than product sales); Stull v.
YTB Int’l, Inc., No. 10-600-GPM, 2011 WL 4476419, at *4–5
(S.D. Ill. Sept. 26, 2011) (denying motion to dismiss where
plaintiffs adequately alleged that pyramid existed by showing
focus on recruitment and payment of rewards in return for
product sales, because buying the product was synonymous
with being recruited into the scheme); FTC v. Equinox Int’l
Corp., VC-S-990969HBR(RLH), 1999 WL 1425373, at *6
(D. Nev. Sept. 14, 1999) (ordering preliminary injunction
after finding Equinox was likely a pyramid because “rewards
are received by purchasing product and recruiting others to do
the same”); In re Holiday Magic, Inc., 84 F.T.C. 748,
1028–30 (1974) (finding a pyramid where rewards were paid
to participants when they recruited others, and recruits also
had to purchase product); Peterson v. Sunrider Corp., 48 P.3d
918, 930 (Utah 2002) (“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.”) (applying federal law to interpret Utah’s
Pyramid Scheme Act); cf. Amway, 93 F.T.C. at 715–17
FTC V. BURNLOUNGE, INC. 17
(finding no pyramid where rewards were paid for product
sales and not for the mere act of recruiting others).
Third, in Koscot, participants joined the scheme by
buying inventory, and participants earned rewards by
recruiting others to join the scheme, i.e., by getting recruits to
buy inventory. Koscot, 86 F.T.C. at 1178–79. BurnLounge
participants joined the scheme by buying packages, which
included a BurnPage and merchandise. Participants earned
rewards by recruiting others to join the scheme, i.e., by
recruiting new participants to buy packages. In each of these
scenarios, the participants sold something (inventory or
packages), but the rewards the participants received in return
were largely for recruitment, not for product sales.
In contrast, in Amway the FTC found that a MLM
business was not an illegal pyramid scheme. Amway, 93
F.T.C. at 716–17. 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. Id. at 716. BurnLounge
argues that “[t]he only difference between Amway and
BurnLounge is that BurnLounge did not require inventory
purchases.” This argument is unpersuasive because
BurnLounge required Moguls to purchase a product package
to get the chance to earn cash rewards, provided cash rewards
for the sale of packages by a Mogul’s recruits, and had no
rules promoting retail sales over recruitment.
The second prong of the Omnitrition test does not require
that rewards for recruiting be “completely” unrelated to the
sale of products. If it did, any illegal MLM business could
save itself from liability by engaging in some retail sales.
18 FTC V. BURNLOUNGE, INC.
Such an outcome would be clearly contrary to our case law:
a pyramid scheme “cannot save itself simply by pointing to
the fact that it makes some retail sales.” Omnitrition, 79 F.3d
at 782.
The rewards BurnLounge paid were primarily for
recruitment, not for the sale of products. Because the
outcome in this case is clear under the Omnitrition test, we do
not need to decide the degree to which rewards would need to
be unrelated to product sales in a case presenting a closer
question.
2. The meaning of “ultimate users.”
BurnLounge also argues “that the existence of internal
consumption (in this case a Mogul’s purchase of a product
package for use, not resale) does not constitute proof of a
pyramid.” Likewise, the Amicus and Appellant Taylor argue
that if internal sales do not count as sales of products to
ultimate users for the purpose of calculating rewards, then
many legitimate MLMs will be incorrectly characterized as
pyramids. These arguments also arise from the second prong
of the Omnitrition test: “the right to receive in return for
recruiting other participants into the program rewards which
are unrelated to sale of the product to ultimate users.” Id. at
781 (citation omitted).
BurnLounge claims that when recruits bought packages,
they were “ultimate users” and it argues that since these sales
were to “ultimate users,” any rewards paid on these sales
were related to the sales of products to ultimate users. The
FTC counters that “internal sales to other Moguls cannot be
sales to ultimate users consistent with Koscot.” Neither of
these arguments are supported by the case law.
FTC V. BURNLOUNGE, INC. 19
In Koscot, the FTC found a cosmetics MLM business was
a pyramid scheme because it focused on recruiting new
participants, rather than encouraging retail sales to
consumers, and new participants had to buy large amounts of
inventory, ostensibly for resale. 86 F.T.C. at 1179. When
participants in Koscot bought inventory, they could have used
some of it personally, arguably making them “ultimate
users.” In Amway, though some internal consumption of
inventory was common, Amway was not found to be an
illegal pyramid scheme. See Amway, 93 F.T.C. at 716–17,
725 n.24. BurnLounge is correct that when participants
bought packages in part for internal consumption (to obtain
the ability to sell music through BurnPages and to use the
package merchandise), the participants were the “ultimate
users” of the merchandise and that this internal sale alone
does not make BurnLounge a pyramid scheme. But it is
incorrect to conclude that all rewards paid on these sales were
related to the sale of products to ultimate users.
Whether the rewards are related to the sale of products
depends on how BurnLounge’s bonus structure operated in
practice. See Omnitrition, 79 F.3d at 781. In practice, the
rewards BurnLounge paid for package sales were not tied to
the consumer demand for the merchandise in the packages;
they were paid to Moguls for recruiting new participants.
The fact that the rewards were paid for recruiting is shown by
the necessity of recruiting to earn cash rewards and the
evidence that the scheme was set up to motivate Moguls
through the opportunity to earn cash. Rewards for recruiting
were “unrelated” to sales to ultimate users because
BurnLounge incentivized recruiting participants, not product
sales. The FTC and other courts have consistently applied the
Omnitrition test in this way. See Gold Unlimited, 177 F.3d at
476, 481; Stull, 2011 WL 4476419, at *4–5; Equinox Int’l,
20 FTC V. BURNLOUNGE, INC.
1999 WL 1425373, at *6; Holiday Magic, 84 F.T.C. at
1028–32; Peterson, 48 P.3d at 930.
BurnLounge and Arnold cite a passage from an FTC
advisory letter, Exhibit 3 at trial, to argue that proof of
internal consumption does not establish that BurnLounge was
a pyramid. Read in its entirety, the relevant passage of the
letter is consistent with the district court’s analysis. The
relevant passage reads:
Much has been made of the personal, or
internal, consumption issue in recent years. In
fact, the amount of internal consumption in
any multi-level compensation business does
not determine whether or not the FTC will
consider the plan a pyramid scheme. 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.
As discussed above, the rewards BurnLounge paid to Moguls
were primarily in return for selling the right to participate in
the money-making venture—the Mogul program. The
merchandise in the packages was simply incidental.
The district court correctly applied the Omnitrition test
and its conclusion that BurnLounge was an illegal pyramid
scheme was amply supported by the evidence. The fact that
some sales occurred that were unrelated to the opportunity to
earn cash rewards does not negate the evidence that the
FTC V. BURNLOUNGE, INC. 21
opportunity to earn cash rewards was the major draw of the
BurnLounge Mogul scheme.
C. Vander Nat’s Testimony
BurnLounge and Arnold moved to strike the testimony of
FTC expert Dr. Peter Vander Nat as inadmissible under
Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579(1993).6 The district court denied the motion. The district
court did not abuse its discretion by admitting Vander Nat’s
testimony, and we affirm its ruling.
The admission of expert testimony is governed by Federal
Rule of Evidence 702. The Supreme Court in Daubert held
that “the trial judge must ensure that any and all scientific
testimony or evidence admitted is not only relevant, but
reliable.” 509 U.S. at 589. This is a flexible inquiry and
several factors must be considered. Id. at 593–94. In Kumho
Tire Co., LTD v. Carmichael, the Supreme Court held that the
trial court’s gatekeeping function explained in Daubert
applies not only to scientific testimony, but to all expert
testimony. Kumho Tire, 526 U.S. 137, 147 (1999). And the
Court emphasized that the Daubert factors are not an
exhaustive checklist; rather, the trial court must base its
inquiry on the facts of each case. Id. at 150. When we
consider the admissibility of expert testimony, we are mindful
that there is less danger that a trial court will be “unduly
impressed by the expert’s testimony or opinion” in a bench
trial. Shore v. Mohave Cnty., State of Ariz., 644 F.2d 1320,
1322–23 (9th Cir. 1981).
6
Although Taylor briefed this issue on appeal, we can find no record
that he joined the motion in the district court.
22 FTC V. BURNLOUNGE, INC.
Vander Nat’s testimony was relevant because he testified
about whether BurnLounge was a pyramid and about the
amount of consumer harm. His testimony was also reliable
given his doctorate in economics and advanced degree in
mathematics, which he called on to interpret BurnLounge’s
sales data; his previous experience analyzing pyramids; his
previous experiences testifying in court in five similar cases
and providing expert deposition testimony in seven similar
cases; his published article on the difference between
pyramids and legal MLMs; and his personal experience
spending several weeks analyzing BurnLounge’s business
model.
BurnLounge and Arnold argue that the district court’s
reliance on Vander Nat’s mathematical projections and
formulas was an abuse of discretion because “Ger-Ro-Mar
teaches that the math is not itself sufficient.” BurnLounge’s
reliance on Ger-Ro-Mar, Inc. v. FTC, 518 F.2d 33 (2d Cir.
1975), is misplaced. In that case the Second Circuit found
that the FTC “relied solely upon an abstract mathematical
theorem without any attempt to relate the theory to the
marketplace.” Id. at 38. Here, the FTC used Vander Nat’s
analysis of BurnLounge’s own data to show how
BurnLounge’s business worked in practice. BurnLounge’s
data convincingly illustrated the disproportionate rate at
which Moguls were motivated by the chance to earn cash
rewards rather than the merchandise BurnLounge included in
the packages. Vander Nat was qualified to testify and it was
proper for the district court to decide that his testimony would
be helpful to the trier of fact (here the court). See Daubert,
509 U.S. at 591–92.
BurnLounge and Arnold also argue that Vander Nat did
not base his analysis on the definition of “pyramid” accepted
FTC V. BURNLOUNGE, INC. 23
by this court in Omnitrition, and that he used his own four-
pronged test. This argument fails because Vander Nat
testified about pyramids in terms that do not materially differ
from those used by this court in Omnitrition: he explained
that a “pyramid scheme is an organization in which the
participants obtain their monetary rewards primarily through
enrolling new people into the program rather than selling
goods and services to the public.” The “four-prong test”
referred to by Appellants included Vander Nat’s
consideration of BurnLounge’s terms and conditions,
marketing materials, an optimal scenario for the BurnLounge
model (illustrating the results if all participants performed at
their best), and BurnLounge’s sales data. This was not a new
four-prong test, and Vander Nat’s consideration of these
characteristics of the business was permissible. The Sixth
Circuit relied on similar expert testimony regarding a MLM
business’s “marketing materials, organizational structure, and
recruiting policies” in another pyramid case. See Gold
Unlimited, 177 F.3d at 475, 481.
Finally, BurnLounge had a sufficient opportunity to cast
doubt on Vander Nat’s testimony at trial because it cross-
examined him for two days. See De Saracho v. Custom Food
Mach., Inc., 206 F.3d 874, 880 (9th Cir. 2000).
We conclude that the district court did not abuse its
discretion by admitting Vander Nat’s testimony given the
flexible inquiry permitted by Daubert and Kumho’s
instruction that trial courts base their inquiry on the facts of
the case.
24 FTC V. BURNLOUNGE, INC.
IV. CONCLUSION
We affirm the district court’s holding that BurnLounge
was an illegal pyramid scheme, in violation of § 5(a) of the
FTCA. BurnLounge’s scheme satisfied both prongs of the
Omnitrition test because Moguls paid for the right to sell
products, the rewards BurnLounge paid were primarily for
recruitment, and Moguls were clearly motivated by the
opportunity to earn cash rewards from recruitment. We reject
the argument raised by BurnLounge and Arnold that the
district court abused its discretion when it admitted Vander
Nat’s testimony because the testimony was relevant and
reliable. The district court’s decision as to these two issues
is AFFIRMED.7
7
We discuss the district court’s consumer harm calculation and the
FTC’s cross-appeal in a separate memorandum disposition.