The Ninth Circuit Court of Appeals upheld an earlier verdict in FTC v BurnLounge yesterday, ruling that the now defunct multi-level marketing (MLM) music company was a pyramid scheme, but Herbalife Ltd. (NYSE:HLF) longs are still happy with the ruling because it addressed the issue of internal consumption for the first time and didn’t dismiss the notion out of hand.

“Today’s decision by the United States Court of Appeals for the Ninth Circuit in the FTC v. BurnLounge, Inc. validates product consumption by participants as a legitimate measure of demand for multi-level marketing companies and rejects Bill Ackman’s fundamental thesis against Herbalife,” Herbalife Ltd. (NYSE:HLF) wrote in a statement.

Herbalife Ltd. HLF
Herbalife Ltd. (HLF)

Herbalife Ltd. (NYSE:HLF) – MLM industry ruling to go against BurnLounge

“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,” Judge Morgan Christen wrote in the Court’s opinion.

The ruling that BurnLounge was a pyramid scheme wasn’t much of a surprise, even to people within the MLM industry, but the details of the case have big implications for Herbalife. BurnLounge had argued that new recruits were ultimate users and that counting their purchases towards distributor rewards is legitimate, while the FTC argued that internal sales can never be counted as sales to ultimate users. According to Judge Christen, “Neither of these arguments are supported by the case law.”

Herbalife Ltd. (NYSE:HLF) – Ruling doesn’t set a clear standard on internal demand

Judge Christen said that internal consumption can be a legitimate source of sales, though he avoided setting specific criteria, and simply distinguished between pyramid schemes and legitimate MLM companies (such as Amway) by the presence of consumer demand for the products. Just as the presence of retail sales don’t protect an MLM company from being designated as a pyramid scheme (a major part of the Omnitrition ruling), the presence of internal consumption doesn’t mean that it is one. In both cases, the motivation behind sales is what matters.

“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,” Judge Christen wrote.

Different motivations at different levels of MLM opens up new issues

One other interesting angle that this ruling brings up is the possibility of a pyramid scheme with a retail base. BurnLounge had two levels of participation, Retailers and Moguls. Both groups paid to participate in the program and sold merchandise for points, but only Moguls (who paid more) could exchange those points for cash. The FTC allegations focused on the Mogul program, tacitly accepting that Retailers were ultimate users because they weren’t interested in getting cash from the company, and successfully argued that Moguls were primarily motivated to recruit new people into the program not to move product.

If the FTC accepts that Herbalife Ltd.’s (NYSE:HLF) Nutrition Clubs represent legitimate consumer demand, it could argue that the distributors above that level are primarily motivated by recruitment instead of sales, dividing the organization into two components as it did with Moguls and Retailers in the BurnLounge case.