Some of you may have heard of the recent enforcement action taken by the Montana Securities Commissioner against a start-up MLM program known as “Funky Shark”. Funky Shark was a penny auction MLM program based in Bozeman, Montana that began operations in the Fall of 2012, but never actually launched its auction website before being shut down.
In an effort to raise capital to support the launch of the new venture, the company recruited distributors to participate in its Founders Program. In exchange for a non-refundable payment of $1,000, “Founders” were entitled to receive a share of the profits generated by the company’s penny auction program. In addition, they earned bonuses for every new distributor that they recruited.
Before Funky Shark could launch its penny auction website, the Montana Securities Commissioner filed a lawsuit against it and its owners and obtained a Temporary Restraining Order (“TRO”).
At the time the TRO was granted, Funky Shark had already raised $1 million selling Founders shares. Shortly thereafter, Funky Shark, its owners, and the Securities Commissioner entered into a Consent Agreement in which Funky Shark and its owners agreed to pay a $40,000 fine and issue refunds in excess of $800,000 to the distributors who had purchased Founders shares. To see the Consent Agreement, click here.
So, what did Funky Shark and its owners do that was deserving of this action? In addition to potentially operating a pyramid scheme or Ponzi scheme (paying distributors for the mere act of recruiting additional distributors), they structured their Founders Program in such a manner that it was akin to the sale of Securities.
The sale of Securities in and of itself is not illegal, provided the Securities are properly registered with the applicable state and federal agencies and the persons handling the actual sale of the Securities are likewise registered. Neither Funky Shark nor its owners and operators had performed either of these necessary tasks. In addition, they failed to notify potential Founders that the shares were not registered as Securities in the state of Montana and that they were not registered as broker-dealers or salespersons in the state of Montana.
As a result, they were violating Montana Securities laws. Moreover, if Montana had a Business Opportunity law (about half of the states do), Funky Shark and its owners likely would have been in violation of those laws as well. To the company’s credit, they voluntarily halted the program upon being advised by their attorney that the Founders Program was legally problematic.
How, you might ask, was the Founders Program the sale of a Security? As consideration for the payment of a sum of money to the company (the $1,000), Founders were eligible to earn a share of the company’s profits. This type of arrangement is known as an “Investment Contract”. An Investment Contract is defined as a contract, transaction, or scheme whereby a person invests his or her money in a common enterprise and is led to expect profits primarily from the efforts of the promoter or a third party. Investment Contracts are a type of Security. Thus, the enrollment of distributors in the Founders Program constituted the sale of a Security.
Due to the challenges of raising capital through more traditional means, we have seen a fair number of entrepreneurs proposing to use any variety of founders programs to fund the start-up of their companies. It is important to note that not all founders programs are structured like the Funky Shark Founders Program. If you are proposing any type of founders program with the launch of your start-up direct selling company, it behooves you to consult with a competent legal advisor to ensure that you avoid the fate of Funky Shark and its owners.
For additional information about the interplay between Securities laws and direct selling, please see an excellent and comprehensive article on the topic written by Spencer Reese here.