BurnLounge, a New York-based company that launched a decade ago, has failed in its bid to legitimize its novel method of selling music. On Monday, the 9th Circuit Court of Appeals affirmed a lower court's holding that certain aspects of the e-tailer represented an illegal pyramid scheme. The opinion provides warning to other companies whose success is tied to recruitment rather than products sales.

The Federal Trade Commission sued the outfit in 2007, three years after BurnLounge began operating a service that allowed its customers to double as independent retailers. Customers could buy different levels of packages and then spend extra to qualify as "moguls." Participants got customized web pages to sell music, merchandise and "right to sell" packages, and if they qualified as moguls, they were given the ability to redeem credits for cash rather than goods.

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BurnLounge preferred to think of its business model as "concentric retail bonuses" whereby customers in one ring of the hierarchy would sell to those in another. To qualify for bonuses, moguls had to meet certain targets in selling packages and albums.

Whether or not BurnLounge's multilevel marketing business constituted an illegal pyramid scheme came down to an interpretation of whether it satisfied the FTC's two-part definition: Participants pay money in return for (1) the right to sell a product and (2) the right to receive rewards for recruiting others into the program unrelated to the sale of the product to ultimate users.

The first part was easily satisfied. As for the second, evidence that participants were focused on recruitment included that 96.8 percent of those buying packages became "moguls," and that the moguls themselves bought the most premium packages to drive their bonus returns. Non-moguls were much more interested in basic packages.

Then there was the financial impact of a stipulated injunction. After the FCC raised a red flag about BurnLounge's approach, the company agreed to stop its mogul service. Before the shutdown in June 2007, the company's monthly revenue was at $476,516. By August, revenue had dropped to $10,880. The appellate court says the dramatic decline provides further evidence that participants were most interested in the mogul program, where it was once possible to earn cash rewards.

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In the opinion that is likely to be closely scrutinized by followers of controversial outfits like Herbalife, Circuit Judge Morgan Christen writes, "In practice, the rewards BurnLounge paid for package sales were not tied to the consumer demand for the merchandise in the packages; they were paid to Moguls for recruiting new participants. The fact that the rewards were paid for recruiting is shown by the necessity of recruiting to earn cash rewards and the evidence that the scheme was set up to motivate Moguls through the opportunity to earn cash. Rewards for recruiting were 'unrelated' to sales to ultimate users because BurnLounge incentivized recruiting participants, not product sales."

Email: Eriq.Gardner@THR.com

Twitter: @eriqgardner