Here's a puzzler: How can a website sell a $10 Walmart gift card for 26 cents and still make money? Or sell an Apple iPod worth $100 for $3.30 and make an enormous profit?
Welcome to the wild world of penny auctions, where nothing is quite what it seems and everything costs money -- even the bids themselves.
Penny auctions have taken the Internet by storm. Ads for electronics products promising seemingly impossible 95 percent discounts appear on hundreds of popular websites. There are dozens of penny auction sites, with more popping up daily. One site, SkoreIt.com, recently engaged in an aggressive national radio campaign, bringing even more attention to this "new kind of auction."
Penny auctions aren't like eBay or any other real-world auction. Instead, their apparent deep discounts rely on a simple mathematical trick. Instead of one person paying $500 for an Apple iPad, a penny auctions can entice 1,000 people to pay $1 for that iPad. The catch: Only one of them wins it. The final price -- let's say $35 for the iPad -- is nearly irrelevant.
The concept is not unlike a 50/50 fundraiser, where 100 people might pay $1 for a raffle ticket; one of them wins $50, while the other $50 goes to charity.
Here's one example of how a penny auction works: Participants pay 60 cents for each bid they place, with each bid adding only one penny to the "sale" price. So an item worth $100 that begins at 1 cent and sells for $3.31 had 330 bids placed on it -- meaning the auction house collected $198 in bid fees. The auctions continue until bidding stops, so theoretically, the price could continue indefinitely.
Penny auctions are run by for-profit companies that believe they've hit on a new formula that is entertaining and offers a real chance at deeply discounted merchandise. Of course, paying a little money for a chance at a big prize sounds like gambling, but supporters of the concept say that additional elements they've added differentiate the format from what might otherwise be called an illegal lottery. Some observers aren't so sure.
Meanwhile, a class-action lawsuit filed late last year against one of the bigger sites, Quibids.com, has shed an unfavorable light on the industry.
An iPod for $2.82?
Facebook pages and advertisements all around the Internet sing the praises of auction sites. Quibids, for example, hawks itself as "shopping redefined" and places ads promising "up to 91 percent off."
"QuiBids is great!" says one review of Quibids' site, posted on a Web page called "Taj's blog." "My grandsons wanted iPods for Christmas, but I am out of work. Through QuiBids, I was able to get them, one for as little as $2.82; plus I won $475 in gift cards, one for as little as $0.60!"
But it's not hard to find criticism either. Some participants say they got carried away and spent more than they should have to win.
"The first auction I won was for an iPod Touch," a user calling himself Puzofan wrote about his experiences using Skoreit. "My kids want one for Christmas. I paid about $40 more for it than I could have gotten it for at Walmart, but once I got so deep I had to keep going. Something to show for my ignorance and money was better than nothing."
But others claim more nefarious things are going on at some auction sites. Carter Jaynes says he won a Walmart gift card at a penny auction site but it was never delivered.
"Too, too fishy," he told msnbc.com. He also believes the site he used employed shill bidders -- fake users who place bids simply to drive up the price -- a common complaint among users.
In fact, software packages used by some of the smaller auction sites even brag about offering shill bidding as an option. According to the Web site PennyAuctionWatch, one software maker brags about the power of such "scripts."
"You decide when your auctions finish. Price too low? Use the auto-extend feature. Not enough bidders? Use the auto-bidding feature. Making a profit has never been so easy," the auction site quotes from a virtual brochure selling the software.
Quibids was hit by a class-action lawsuit in its home state of Oklahoma late last year, alleging that the site has frequently engaged in fraudulent and deceptive business practices. The lawsuit doesn't allege fake bidders or failure to deliver, but instead maintains that Quibids doesn't disclose essential information to consumers.
"QuiBids.com does not tell its customers that they have virtually no chance to come out ahead financially," the lawsuit claims. "While QuiBids.com passes itself off as a legitimate auction house, its business operation is more akin to a casino or a lottery."
In one example, cited in the lawsuit, plaintiffs claim Quibids profits exceeded $12,000 from bidding on a $1,500 HDTV. The winner paid $228.59, but 22,859 bids were purchased by all bidders with a potential value of $13,700.
"The website is deceptive in that it lures people in thinking it's an auction site," said Roger Mandel, lead attorney on the lawsuit. "... In casinos, they have to post the odds. If they want to operate their business like a lottery, then they need to tell people the truth about their chances of winning. ... There should be more disclosure."
Officials at Quibids say the firm takes great pains to inform consumers about the real costs of using the site and the best strategy for winning, and firmly deny its auctions are akin to gambling.
"We call this entertainment retail," said Jeff Geurts, chief financial officer of Quibids. He says the site runs 15,000 auctions per day, and will soon ship its 2 millionth product to a winner. "We look at shipping products as a measure of our success."
Quibids includes an eBay-like "Buy It Now," feature that gives auction bidders a chance to simply buy items they are bidding on once the auction cost gets too high. The money spent during the bidding process isn't lost -- it goes into an account which can be used to make Buy It Now purchases.
People who want to buy an item like a new television can join an auction with the hope of getting deep discount on the item, and if they don't win it, they simply buy the item anyway, he said.
"In our setup, there is no way to lose," he said.
Geurts did concede that the penny auction industry suffered several black eyes during the past year, as dozens of new sites entered the category. Shill bidders, undelivered products and software glitches have all marred other sites, he said.
"Any time you can collect money potentially for nothing, you will attract those kinds of people," he said. "Folks came into the space thinking they could make a quick buck. Those have gone out of business now. Most didn't understand how hard it is to acquire new customers."
BUT IS IT GAMBLING?
Taking people's money and not delivering products is one thing -- fraud. But taking people's money for a chance to save a whole lot of money is another thing -- probably gambling, said gaming law expert Joseph J. Lewczak, a lawyer who consults with marketing firms about sweepstakes and lottery laws at Davis & Gilbert LLP.
"Doing something truly as a penny auction ... there's no doubt in my mind that's an illegal lottery," he said. "But I believe they could be conducted correctly. ... Are there some operators doing things in addition to bidding that means they (satisfy) sweepstakes and lottery laws? It's possible. Those things would have to be analyzed more deeply."
There are three elements to an illegal lottery -- prize, chance and consideration. In a basic penny auction, all three elements are satisfied, Lewczak said. The discount is the prize. There is chance involved, as the auction bidder does not know when an auction will end. And finally, there's consideration: The bid fees.
Generally, companies that promote their products with sweepstakes -- think McDonald's and its Monopoly game -- get around these rules by offering an alternate, free chance to enter, and by giving something of value to the participant (like a hamburger).
Penny auctions, however, don't offer free entry, meaning they can't use that defense.
But Geurts argues that his auctions are games of skill, not chance, eliminating the possibility that they would be called gambling.
"There is obviously a lot of skill in these auctions," he said. "We could prove it statistically because some customers do better than other customers by employing strategy."
More important, he says the "Buy It Now" feature means users gain something of value -- credit toward buying the item they are bidding on -- in exchange for their entry fee.
"There is no gambling whatsoever," Geurts said. "It's definitely not gambling or a lottery."
For the "Buy It Now" feature to exonerate penny auctions from a charge of gambling, the value proposition must be real, however, and commensurate with the cost. Most "Buy It Now" prices at Quibids are higher than retail. Apple products, which sell for the same price at most retail outlets, make for an easy demonstration. An iPad 3G with 64 Gigabytes of memory sells for $829 at most places. At Qbids, using "Buy It Now," it's $899 plus $16 shipping.
In other words, a contestant is risking either the loss of all their bids, or paying $70 above retail, for a chance to buy the item at a deep discount.
Geurts says a large number of auction participants -- perhaps more than 1,000 per day -- exercise the "Buy It Now" option, bolstering his argument.
The amount of the discounts advertised on penny auction sites also raises questions. In a recently closed auction, for example, Quibids sold an iPod Nano for $3. The site claims the retail value was $155, and that the buyer enjoyed a 98 percent discount. That discount doesn't include the price the buyer paid for the bids, however, which can often exceed the purchase price. In this case, the winner -- a player named milopicante -- placed four of the final 10 bids, which had a value of $2.40. It's possible that milopicante placed 20, 50, or even 100 bids in his or her quest for the item. Including the cost of the bids in the total cost of the item would severely reduce the real discount to the buyer.
But the math used to calculate discounts is complicated by the fact that users can bid on packages of bids -- a Quibids fan can sometimes purchase 50 bids at an auction for $1 or $2 -- dramatically reducing the cost of bids from their standard 60 cents each. These "won" bids are called voucher bids.
"We count voucher bids as if they are free bids for the calculation (of the discount)," Geurts said. "Sometimes the voucher bids are free bids. ... For example, you get seven free bids on your birthday."
Mandel, the class action lawyer who has become the voice of opposition against penny auction formats, said he says he isn't arguing that Quibids or other auctions should be shut down, but rather that they need to be regulated like lotteries or other games of chance.
"I'm not paternalistic guy," he said. "To the extent that casinos are allowed, maybe this should be allowed. But they ought to be upfront about what it is."