The AuQuest Case: A Wake-Up Call to the Industry

By Jeffrey A. Babener
November, 1996

LITTLE COMPANY - BIG IMPACT

It was a burst of MLM history, over in a nanosecond - a little known company locked antlers with the government for a moment in time. However, the outcome will resonate for this company and others for years to come.

Why?   Why is it that an obscure company selling gold coins and phone cards will so impact a $20 billion industry?   And, is there a message?

The answer is that in this case there are many messages - messages about binary compensation plans, messages about the importance of retail selling, messages about personal use by distributors, messages about front-loading, and messages about the legal climate in California and network marketing companies.

A BRIEF HISTORY

AuQuest International started business in 1995 out of Houston, Texas. Among the products in its marketing materials were gold coins, gold jewelry, prepaid phone cards and offshore trusts in Belize. The company operated as a binary compensation plan allowing individuals to leverage up to seven retail business centers with $200 personal BV qualifications. Business centers were subject to periodic pre-qualification requirements.

In May, 1996, AuQuest was sued by the state of California and the Monterey County District Attorney's office. It was charged with conduction a pyramid or endless chain scheme as well as failing to register for sales tax. The state brought three lawsuits, including criminal felony charges against the owners, an injunction lawsuit against the company, as well as a separate lawsuit seeking to confiscate $328,000 seized in Houston bank accounts. The company countered with its own lawsuit against the government officials for violation of their civil rights. The Monterey County Superior Court issued a temporary restraining order and a preliminary injunction.

THE GOVERNMENT'S POSITION

The government set forth a number of points that it found troubling:

  1. The government could find no evidence of retail selling, asserting that everyone bought product in the program solely to qualify in the compensation plan.
  2. The government accused the company of front-end loading with individuals expending $1,400 to qualify for seven business centers.
  3. The government questioned the value of the product and asserted that it was overpriced with no evidence of sales outside the network.
  4. The company gave credit for its sale of sales aids.
  5. The company's buyback policy was substandard in the industry being a 60-day, 50 percent buyback policy.
  6. The government asserted that the company had no retail customer rule as in the Amway case, or that which it had was of no effect (the company's materials provided for one retail sale per 13-week period).
  7. The government asserted that a point of the program was to cause individuals to purchase business centers and get other distributors to do the same.
  8. There was no tracking of retail sales.
  9. the government asserted that the emphasis of the program was to "purchase multiple business centers" rather than the purchase of product for resale to the ultimate nonparticipant retail consumer.
  10. The government complained that there was no demonstration of enforcement of safeguards to deter inventory loading or to encourage retail sales.
  11. The government argued that the recent Omnitrition appellate court decision did not permit payment of commissions based upon personal use, but required commissions to be based only on the sale of sales to nonparticipants.

THE SETTLEMENT

In August, 1996, all four lawsuits were settled in an integrated fashion. The company agreed to forfeit the $328,000 seized in Houston. The company entered into a permanent injunction and judgment. The owners of the company pled guilty to misdemeanors, rather than felonies. The company dismissed its civil rights action.

The Terms of the California Judgment

"Every step you take, I'll be watching you." [The Police - (album) Synchronicity].

On the one hand, the owners of AuQuest had to be jubilant that their lawsuit was settled, that they could continue to do business in California, and that the felony charges had been reduced to misdemeanors. On the other hand, the terms of the settlement, which would allow them to do business, were so onerous to the company that it is difficult to see why the company would wish to continue to do business in California. And, if applied to other major direct selling companies, the terms would also impose onerous restrictions on operation in California. This point is of significance to companies in that the California court requested Attorney General's office to apply the principles of this settlement on an evenhanded basis to other direct selling companies in California.

Industry executives get dizzy reading through the restrictions imposed upon AuQuest, including the following:

  1. Commissions could not be paid on sales unless they were sales to ultimate consumers (i.e., nonparticipants in the AuQuest program).
  2. The company could not "require purchase of any quantity of inventory in order to earn commissions" (this could be viewed as a direct threat to personal activity requirements of all direct selling companies).
  3. The company could not pay commissions unless it had received proof of sales to ultimate consumers, although the judgment did allow in calculating commissions to count up to $65 per month for personal use purchases by distributors as "valid sales" if the distributor also made four retail sales in the commission period.
  4. The company could not require initial or subsequent inventory purchases, although sales quotas are deemed to be acceptable.
  5. The maximum inventory purchase at any one time could be $1,600.
  6. The company must verify at the time of reorder the amount of inventory on hand by the distributor, using a verification form signed by the distributor.
  7. No earnings representations or examples could be used without disclosure of (1) the total number of distributors in California, (2) the number at each rank and (3) the median income.
  8. No representation could be made that distributors could expect to recruit or retain distributors unless every six months updated disclosures were made regarding (1) average number of distributors recruited, (2) average length of time in downline and (3) average retail value sold to ultimate consumers.
  9. The company was mandated to pay a 100 percent refund to California distributors for returned product in resalable condition, less commissions paid to that distributor on that product.
  10. In order to obtain commissions, a distributor must file retail records showing the name, address, phone number, date and description of products sold.
  11. The company must audiotape or videotape all meetings with attendance greater than 25 and keep the tapes for two years.
  12. All company literature must be kept for one year and upon notice, be made available to the government.
  13. The company must keep quarterly records showing:
    1. the total number of verified retail sales to ultimate consumers as reported to the company,
    2. the total number of products purchased by distributors,
    3. the number of distributors,
    4. the names and addresses of all distributors who earned commissions and the amounts earned, and
    5. and all of the above records must be kept and made available to the Monterey County District Attorney or Attorney General.
  14. The company is required to conduct random audits in compliance and have it available to the government.
  15. The company in the future was required to have a 100 percent, ten-day buyback policy and a 90 percent, 12 month buyback policy.
  16. The company is required to maintain an escrow account for buyback in which it escrows a monthly deposit of 2-1/2 percent of sales up to a maximum of $100,000 with the court retaining jurisdiction over the fund.
  17. The District Attorney and Attorney General will have access to all the books and records of the company.
  18. In addition to the $328,000 forfeiture, the company would be subject to an additional $100,000 penalty with a possibility of $50,000 credited for refunds made.

LESSONS TO BE LEARNED

It is obvious from the tenor of the court documents that the government viewed the AuQuest case as an egregious case and, therefore, it was very stern. Nevertheless, there are many messages here for the rest of the industry:

  1. Gold coin programs are persona non grata
  2. Offshore products are persona non grata
  3. Overpriced prepaid phone cards are personal non grata
  4. Binary compensation programs will be looked at very carefully as to whether the emphasis is on the business opportunity, i.e. font-end loading distributors with the purchase of multiple business centers for purposes of qualifying in the program, as opposed to the orderly sale of products for resale to ultimate consumers.
  5. The state of California wants to see retail sales, retail sales, retail sales.
  6. Companies should adopt an ongoing retail sales requirement for distributors.
  7. AuQuest is part of the unfortunate legacy of the Omnitrition appellate court decision which questioned granting credit for personal use by direct selling distributors. The industry will need to continue to take further steps both in court and legislatively to overcome the unfortunate language in the Omnitrition case because personal use by distributors is and always has been an important feature of leading direct selling companies. In fact, in one of its last major settlement agreements involving Herbalife, the Attorney General of California agreed that personal use was to be recognized. The AuQuest decision represents a setback from the Herbalife standard limiting credit for personal use to $65 per month. In addition, the court's request to the state of California to apply such rules evenhandedly to other companies, raises questions for the future.
  8. Not only should companies mandate a retail customer rule, but they should adopt audit verification programs.

IN SUMMARY

Were there problems with the AuQuest program? Probably. Did the government overreact in this particular case? Probably. Is the answer somewhere in the middle? Probably. Is there a message for the rest of the industry, and in particular companies with binary compensation plans? Most definitely. The key for both the industry and government is to learn from this case and to apply what they have learned positively. As Yogi Berra said, "The future ain't what it used to be."


For the brave of heart or chronically detail-oriented we have for your review the complete text of the AuQuest International, Inc. stipulated final judgment and permanent injunction.

Jeffrey A. Babener
Babener & Associates
121 SW Morrison, Suite 1020
Portland, OR 97204
Jeffrey A. Babener, the principal attorney in the Portland, Oregon law firm of Babener & Associates, represents many of the leading direct selling companies in the United States and abroad.

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