FTC v. Futurenet By Jeffery A. Babener Copyright © 1998
Run a carbon-black test on my jaw And you will find It's all been said before R.E.M., "Hairshirt" Album: Green

"WE'RE BACK" - THE FTC

Like a drumbeat, the direct selling industry has heard again from the FTC. Same scenario, same song - no notice, restraining order, asset freeze, receiver, settlement quickly reached under duress.

In February 1998, the FTC filed a lawsuit in the U.S. District Court in Los Angeles, California against Futurenet, a Valencia, California based direct selling company that sold internet access devices (Web TV) and internet access, and deregulated electrical power. The FTC claimed that Futurenet and its distributors did not make money primarily from the sale of goods and services, but rather through the sale of distributor "positions" whereby recruits paid "fees" ranging from $195 to $794, and upon which upline commissions were paid. The FTC claimed it was a pyramid headhunting recruitment scheme. The FTC obtained a restraining order, asset freeze and injunction. Futurenet denied the allegations.

In April 1998, the case was settled, with Futurenet paying $1,000,000 for consumer redress and agreeing to resume business pursuant to stringent rules in a permanent injunction and final judgment.

THE FUTURENET SETTLEMENT

The April, 1998 Futurenet Consent Agreement continues a trend of FTC cases which started with the Fortuna Alliance case, and which was immediately preceded by the FTC JewelWay case. Although the FTC's position seems to change from case to case, every case has in common a number of factors, including:

1. the FTC trial by ambush approach in which, without notice, it sues a company in federal court, obtains a receiver, freeze of corporate and personal assets, restraining order on company operations, and thus total leverage in achieving a forced settlement which occurs generally within a one to three month period;
2. the FTC's insistence on the 50% plus rule, i.e. that commissions are paid on sales revenue that comes "primarily" from retail sales; (In JewelWay, defined as sales to non-participants) (In Futurenet, defined as sales to non-participants plus personal distributor use of up to $30 per month);
3. mandated one-year buy-back policy;
4. prohibition on earning claims without disclosing: (a) the number of participants in the program who make at least the same earnings and (b) the percentage of all participants who earn the represented amount;
5. the payment of a substantial sum of money for refund which will be forfeited to the FTC if it is not consumed by refunds (JewelWay $5,000,000) (Futurenet $1,000,000) (In addition, Futurenet is required, for three years, to post a bond of $100 per new distributor up to a maximum of $1,000,000 with an initial bond of $100,000.); and
6. onerous financial reporting requirements that go on for years from the company, company owners and company officials.

FTC - TO ITS CREDIT

To its credit, and cause for some relief to the industry, most of the FTC pyramid prosecutions disclose some truly "troubling" facts in the presentation and implementation of the "target" company, i.e. there was "smoke," if not "fire" present, and the company's own behavior invited investigation.

In particular, the FTC called some of the Futurenet promoters "pyramid recidivists," who were associated with earlier pyramid schemes, including the Bestline program. The FTC believed that the "payment for recruiting" aspects of earlier schemes were reincarnated in the Futurenet program. In fact, a close look at the two programs would raise issues for discussion.

FTC AMBUSH LITIGATION - JUSTIFIABLY CRITICIZED

It should be kept in mind that the FTC stipulated injunctions and judgments, on their face, provide that they are neither adjudications nor admissions of liability by the parties. They do not serve as a case precedent. In reality, the last significant FTC case precedent on this subject was the 1979 Amway decision, in which Amway prevailed and the FTC lost on its contention that Amway was an illegal pyramid scheme. Nevertheless, each time the FTC goes to court seeking a restraining order against an MLM company, it cites the previous consent agreements as if they we precedent.

Since almost all federal judges are unfamiliar with multilevel marketing or generally accepted industry standards, federal courts almost all automatically accede to the requests of the FTC at the time of filing, which virtually puts the company out of business, and effectively deprives the company of the ability to adjudicate the matter in a reasoned and deliberate fashion. Under the gun, companies accept, for the most part, the FTC's position, which becomes a permanent injunction.

THE FTC ALLEGATIONS

Although the FTC approach has been difficult to defend, many of the FTC concerns about Futurenet were legitimate, and the problematic aspects of this program were the responsibility of Futurenet, which made the business opportunity "deal like" in appearance and promotion. Among the FTC allegations were:

1. There was an absence of retailing requirements to non-participants;
2. On its face, unlike other leading direct selling companies, the program appeared to pay commissions on either training fees or fees that were not the result of the sale of product or service, but rather were recruitment fees from finding new distributors - purchase of the various consultant positions yielded handsome commissions for the upline sponsor;
3. The company promoted the sale of electricity and appeared to pay commissions relating to its electricity program even before the electricity supply was available to customers;
4. The FTC maintained that the program was a headhunting recruiting scheme in which individuals made money by recruiting others who paid fees or purchased "positions";
5. The company failed to control earnings claims and earnings hype in which recruits were led to envision thousands of dollars of earnings in short periods of time;
6. The FTC maintained that the company's refund policy for terminating distributors was so short (a matter of days) that it was illusory, and that it was inadequate by industry standards;
7. Some of the principal promoters had historical affiliation with other marketing programs accused of being pyramid schemes.

THE FUTURENET POSITION

Obviously, Futurenet took exception to the FTC's criticisms. It maintained that more than half of the customers for its Web TV were non-participants. In addition, Futurenet rightly took exception to the affidavits of FTC experts that appear to be "trotted" out case after case, by the FTC. As a general matter, the testimony offered by the FTC "experts" indicate that they know very little about the direct selling industry, and that they use whatever was the previous FTC consent as the "base line" for their opinion on "legitimate MLM" versus "Pyramid." In addition, the opinions asserted in recent FTC cases by FTC experts on saturation were rejected in the FTC Amway case and subsequent court decisions long ago. And yet, the FTC fails to apprise courts that the "saturation" argument has been rejected. In addition, the FTC typically does not inform courts that long established and well respected direct selling companies regard "personal use" by distributors as "retail sales," and that this position is followed by the Direct Selling Association as well as recently adopted multi-state legislation.

THE "NEW AND IMPROVED" FTC RULES

Although the FTC position is a bit like a shadow, and quite difficult to catch, several salient points should be noted in attempting to assess what the FTC might now call its "current" position arising from the Futurenet case:


1. FTC RECOGNIZES PERSONAL USE

   As in JewelWay, the FTC continues to demand that the majority of sales revenue upon which commissions are based, come from retail sales, which the FTC generally defines as sales to non-participants. In the JewelWay case, the majority of the sales revenue approach was applied to the entire company, but in Futurenet, the majority sales revenue approach is applied to individual distributors, i.e. compensation to the individual distributor must be based primarily on retail sales - potentially, an accounting nightmare.

   In Futurenet, however, the FTC finally begins to retreat from its position that retail sales means only sales to non-participants. In Futurenet, the FTC recognizes that retail sales also include reasonable distributor purchases for personal or family use or demonstration purposes not to exceed $30 per month (service contracts) or $360 per year (single purchase items). In Futurenet, the FTC has finally budged from its absolute prohibition on recognition of personal use to recognition that $30 per month of personal use is a valid retail sale.

   Heaven help, however, the company where distributors purchase $31 per month or $361 per year. On one side of the line, the FTC has denominated personal purchases as "retail sales" and on the other side of the line, personal purchases are viewed as "recruitment" based - thus ineligible for credit as a legitimate sale. To show that it really knows how to "micro manage" the direct selling industry's business, the FTC graciously allows Futurenet to increase the monthly purchase exemption to keep pace over the years with inflation. This micro management approach from an agency that does not seem to understand the industry, bears a striking resemblance to the California state Auquest settlement, in which a monthly lid was placed on personal use exemptions ($65 per month). Although this is finally a step in the right direction, the FTC would do better to accept the industry's position that the personal use exemption should apply to "purchases in reasonable amounts" so long as they are in fact reasonable amounts and so long as the product and service is actually consumed.

2. A SALE IS A SALE

   The FTC appears to take another positive step forward in revising language that appeared in the JewelWay case regarding purchases by customers who later become distributors. In JewelWay, the FTC required the company to disqualify, as a retail sale, any purchase by a customer who then became a distributor within 90 days. This language is absent in the Futurenet case, and thus, it would appear that the purchase by a customer of Futurenet who subsequently becomes a distributor constitutes a retail sale to a non-participant so long as the customer did not purchase the product or service as part of a recruitment pitch.

3. HEADHUNTING FEES ARE OK - FOR A WHILE

   Although the FTC continues to oppose the direct selling industry's recognition of personal use as a legitimate retail sale, in an ironic twist, the FTC, in the Futurenet case, gives recognition and blessing to a practice that the industry does not condone and which has been held by federal and state cases as well as state and federal legislation for more than 20 years to be an element of a pyramid scheme, namely headhunting or recruiting fees. Nevertheless, in the settlement, the FTC approved the payment of recruitment fees so long as they were paid one level deep. The FTC specifically noted that if a new recruit pays training fees, the personal sponsoring distributor may be paid commissions on those training fees.

   This approach is at odds with both the operation of virtually every major direct selling company as well as the state of the law during the last two decades. Companies that seek to embrace this approach based on this particular FTC settlement will probably not be well served. It is only a matter of time before the FTC realizes that it has made a mistake. Paying commissions to upline distributors on products or services (such as marketing materials or training fees or other sales tools) that do not relate to those products which are marketed by a company, has always been regarded as problematic. Although customer acquisition bonuses in some telecom programs may find training fees as their funding source, at least the payment relates to the finding of and the acquisition of customers. The approach approved by the FTC, however, is a classic headhunting recruitment fee found to be an element of pyramid schemes.

   Irrespective of its apparent approval of headhunting fees, it should be noted that the FTC did adopt a position in the Futurenet case that a program would be a "prohibited marketing scheme" if compensation came "primarily" from (1) recruitment or (2) non-retail sales.

4. DISTRIBUTOR REFUNDS

   In Futurenet, the FTC continued in its policy of requiring a 100% 60-day refund policy for terminating distributors, as well as a one-year 90% policy. The Futurenet language appeared to be applicable only to products which could be returned in resalable condition, and therefore differs somewhat from the Direct Selling Associations mandate that training fees also be subject to a refund policy.

IT'S ALL CONFUSING - MAYBE IT IS LIVABLE

The language in the Futurenet settlement is very confusing. For instance, it is difficult to tell whether the FTC requirement is that (1) compensation based upon retail sales must be greater than 50%; or (2) that sales to non-participants must be greater than 50%; or (3) that compensation based upon retail sales must merely be in excess of either non-retail sales or in excess of fees based upon recruiting (selling of training, etc.). The better assumption would be that the FTC intended that more than 50% of compensation should derive from retail sales, as newly defined in the Futurenet settlement to allow for some recognition of personal use as a retail sale.

Of course, when the FTC allows up to $30 per month of personal use to count as retail sales, the FTC 50% rule may be adjusted downward to be something like the FTC 20%, 30% or 40% rule. For instance, it is interesting to look at the arithmetic in the following example: assume a company with 1,000 distributors has sales of $1,000,000 in one year. Under the FTC Futurenet rule, up to $360 per year in personal use may count as a retail sale. Therefore, out of $1,000,000 in annual sales from the 1,000 distributors, $360,000 in personal use would be considered retail sales. If distributors sold just over $140,000 in non-distributor sales, then total resale sales, as defined, would exceed $500,000 or more than 50% of total sales, and thus commissions would be primarily based upon retail sales. This would be the case even if the balance of $500,000 were represented by personal purchases by distributors. Under this scenario, the retail sales would appear to be a 14% rule and not a 50% rule (i.e., 14.1% in non-participant sales and 36% in personal use exempted sales that have retail sales status equals 50.1%).

However, the language is very confusing, and it would not be surprising that the FTC would argue that, irrespective of the inclusion of the $360,000 per year of personal use as retail sales, it would still expect the majority of sales volume to be to non-participants. The settlement is filled with so many ambiguities that only time will tell what the FTC really means.

AN ODD AMBIGUITY

One ambiguity in the settlement agreement is the FTC's definition of payment. Some legal observers might suggest that the language in the agreement requires the payment of money for the right to receive compensation before the FTC rules are triggered, Some observers may suggest that a company may avoid FTC involvement if a company does not require the purchase of a sales kit to participate in the multilevel. This analysis, however, has been rejected in the past in pyramid cases. In such cases, courts have consistently looked at the types of purchases made in an MLM program, and the benefits that could be obtained by purchase requirements. Almost all leading direct selling companies have mandated at-cost sales kits. It would not appear to be advisable to drop the requirement of an at-cost sales kit merely to try to meet a technical loop hole that has been rejected by courts in the past. Courts are concerned about pyramid issues, not $25 sales kits.

CONCLUSION

Can existing companies draw guidance from the Futurenet case? It is hard to say. Although the FTC's draconian ambush litigation style does not change from case to case, to its credit, it does tend to pick on "problematic" programs. In addition, the FTC appears to be softening on the primary issue of concern to the industry - recognition of personal use as a legitimate destination for the products and services of direct selling companies. Perhaps with the Futurenet litigation concluded, the FTC and the direct selling industry, primarily through the Direct Selling Association, can engage in a dialog that will lead to a workable standard of the sort that has been adopted in such forward thinking states as Oklahoma, Texas and Louisiana. Those states all recognize personal use in reasonable amounts so long as other abusive behavior is curbed through buy-back requirement and prohibitions on earnings misrepresentations. And, perhaps during the dialog, the FTC can be persuaded to "back off" from its "ambush type" litigation which leaves little room for a reasoned discussion of disputes with company marketing programs.

A complete copy of the Stipulated Final Judgment (in PDF format) and FTC Press Release are available from the FTC Website.

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Jeffrey A. Babener, is the principal attorney in the Portland, Oregon, law firm Babener & Associates, represents many of the leading direct selling companies in the United States and abroad.