WSJ 9/4/03

Mutual funds under investigation Banc One, Janus, Strong, Bank of America accused of helping hedge fund manager make illegal trades. September 3, 2003: 2:42 PM EDT NEW YORK (CNN/Money) - Four of the biggest U.S. mutual fund firms have engaged in illegal trading practices that may have cost mutual fund investors billions of dollars in the past four years, New York Attorney General Eliot Spitzer said Wednesday. Between 1999 and 2003, mutual fund managers at Bank One (ONE: Research, Estimates), Janus (JNS: Research, Estimates), Strong Financial and Bank of America (BAC: Research, Estimates) Nations Funds illegally gave a hedge fund special privileges to make illegal trades, in return for fees, Spitzer said in a complaint filed Wednesday with the New York Supreme Court. Spitzer did not offer specific figures about the costs to ordinary shareholders of these trades, which allow some traders to take advantage of market inefficiencies, but he cited academic studies that said the trades cost investors "billions of dollars per year." Read the complaint here New York vs. Canary Capital Partners, et al. (PDF) "What we have is a fundamental violation of the rights of shareholders and a violation of the duty of mutual funds to protect the interests of long-term shareholders," Spitzer told a press conference. Bank of America and Strong told CNN/Money they were cooperating with Spitzer's investigation, but had no other comment. Bank One said it would look into the complaint's allegations and cooperate with Spitzer. Janus told Reuters it was reviewing the complaint and cooperating with Spitzer's office. Wednesday's complaint was not filed against the fund managers but against Canary Capital Partners, a hedge fund based in Secaucus, N.J. Spitzer said Canary and its managing principal Edward Stern agreed to pay $30 million in restitution and a $10 million penalty to settle the charges against it, which included allegations that it had performed illegal trades of mutual fund shares. Specifically, Canary was accused of "late trading," the term for buying mutual fund shares at their closing price after the close of trading in U.S. stock markets at 4:00 p.m. ET, allowing the firm to profit from corporate news released after the closing bell. The law requires mutual-fund trades made after the close to be processed at the next day's share value, to keep late traders from having an advantage over others. "Late-day trading is like being permitted to bet on yesterday's horse races," Spitzer said. "You already know who's going to win." Despite the illegality of these trades, Spitzer alleged, Bank of America gave Canary special software that allowed it to circumvent the rules and make after-hours trades at closing prices, in return for "millions" in fees. Canary also was charged with "market timing" trades, designed to exploit the effect of time-zone lags on international mutual fund shares. Japanese stocks, for example, close 14 hours before U.S. stocks. If Japanese stocks fall, then an international mutual fund holding Japanese shares will still reflect those lower prices when they close 14 hours later. If traders are sure Japanese stocks will rise on the next trading day, they can buy the international fund, with its 14-hour-old, "stale," net asset value (NAV), and cash in the next day, when the NAV rises. Such trading is not illegal, but Spitzer said many fund managers, including Janus, are aware of the damage it can do to long-term investors and say in their prospectuses that they will try to stop such trades. Instead, Spitzer alleged, Janus and other fund managers took payments to allow such trades. "Mutual funds, who have a fiduciary duty to shareholders, who have made the representation that they will do what's reasonable to stop these trades, and then they take payments for allowing these trades to take place -- they're in deep trouble," Spitzer said. The attorney general did not indicate whether other charges will be filed and said he had no idea yet of the full extent of such trades, but he said his office's investigation is ongoing. "My office will take all reasonable steps to ensure that the ill-gotten gains of those who engage in this conduct are returned to investors, that wrongdoers are held responsible, and that the appropriate reforms are implemented to halt this egregious activity," Spitzer added. Hedge funds are largely unregulated funds that typically require large initial investments and regularly use leverage and short positions. They gained favor during the three-year bear market for their ability to profit on falling stock prices. Banc One has the 16th-largest mutual fund group in the United States and the third-largest bank-sponsored fund group. Janus has $149.8 billion under management. Nations Funds has $134 billion under management, and Strong has $42.1 billion under management. The Investment Company Institute, a Washington, D.C., lobbying firm representing fund managers, said, "Mutual funds and the ICI support strict compliance with and vigorous enforcement of the law on behalf of mutual fund shareholders."

Questions, Answers on the Spitzer Case

EVEN WHEN THEIR accounts were losing money -- as was often the case for stock investors in recent years -- the nation's 95 million mutual-fund customers at least could have confidence that they were getting a fair shake with their investments.

Apparently not. New York Attorney General Eliot Spitzer dashed those beliefs with the disclosure that some of the fund industry's biggest names -- Bank of America Corp.'s Nations Funds, Janus Capital Group, Strong Funds and Banc One -- had what he said were illegal trading arrangements with a hedge fund, Canary Capital Partners LLC, and its managing partner, Edward J. Stern. These deals allowed Canary and Mr. Stern to make rapid-fire moves in and out of various mutual funds, sometimes buying and selling fund shares at prices not available to other investors, according to Mr. Spitzer.

Fund investors have many questions about the trading arrangements and what those deals might have cost other shareholders. Here are some answers to questions fund investors might be asking today:

Q: What exactly was the hedge fund allowed to do?

A: Canary Capital and its sibling entities struck deals with several mutual-fund firms allowing Canary to practice two taboo mutual-fund trading strategies -- late trading and market timing, Mr. Spitzer said.

Both involve obtaining a more-favorable price, or net asset value, for sales and purchases of shares in various mutual funds than was available to other investors.

Typically, funds tally their NAVs at the end of each trading day. Any share purchases or sales requested by an investor before the trading day ends gets that day's closing price.

Orders to buy or sell shares made after the end of the trading day are supposed to be made at the next day's closing share price.

Allowing investors more time to buy shares at an old NAV gives them a chance to benefit from news occurring after the old NAV was set, so the NAV doesn't reflect that positive or negative news.

Say, for example, that a fund's NAV at the close of trading on Monday was $10 a share. But at 5:30 p.m., several of the fund's largest holdings reported higher-than-expected earnings.

An investor with the ability to trade late could pay the $10 share price with knowledge that securities would be poised to rise in value the next day and boost that day's NAV. The investor could then capture gains by selling the fund at Tuesday's higher closing price.

Mr. Spitzer said Canary did this trading through agreements with Bank of America and Security Trust Co., a Phoenix firm that processes trades for thousands of retirement investors among hundreds of funds daily.

Late trading, which in some cases occurred as late as 9 p.m. Eastern time, is prohibited by New York's Martin Act, a broad antifraud statute, and Securities and Exchange Commission regulations, Mr. Spitzer asserted, likening the practice to "betting on a horse race after the horses have crossed the finish line."

Q: What about market timing?

A: A far more widespread practice that Mr. Spitzer said involves many others besides Canary is market timing, the short-term darting in and out of a fund's shares, hoping to exploit a pricing inefficiency in the fund's NAV.

This is most commonly done with U.S. funds holding foreign securities in which trading ends long before the NAV is set at the end of the U.S. trading day. Any pricing-moving developments after the foreign markets close may not be reflected in the NAV, enabling market timers to buy or sell the shares at a "stale" price. That then allows them to benefit from price movements in the foreign markets the following day.

This type of trading is well known and is thought to be largely legal. But funds routinely say they prohibit investors from this in-and-out practice, spelling out antitiming policies in their prospectuses filed with the SEC.

Firms also often employ "timer cops" to identify and cash out market timers. While timing itself isn't against the law, funds may violate their own policies, on file with the SEC, if they tell investors they won't allow timing and then strike deals allowing timers into their funds. If funds reach agreements with investors to allow timing trades, they potentially are violating their fiduciary duty to their shareholders by permitting a practice they contend isn't in shareholders' interests.

Mr. Spitzer said fund companies had misled investors by contending they were at least attempting to discourage timing when some funds had agreements allowing the practice. As a result, the attorney general said such fund companies had lied to investors by entering into undisclosed agreements intended to increase their fees.

Q: How do these practices hurt long-term fund shareholders?

A: As Canary was allowed to play by different rules than other shareholders, Mr. Spitzer's allegations raise basic issues of fairness.

But the practices could also affect the value of individuals' accounts. A large investor buying at a lower price, either through late trading or market timing, and then booking gains the next day, could dilute the value of other investors' shares.

Q: Will mutual-fund shareholders affected be reimbursed?

A: Under its settlement in which Canary didn't admit or deny guilt, the hedge fund agreed to pay a $10 million fine that is required under New York law to be deposited in state coffers and to repay $30 million in profits generated from trading. That money will go into a restitution fund with the aim of repaying investors who were harmed by the schemes. But it is not yet clear how the restitution fund will work and who might be eligible for payments.

Now, Mutual Funds Under Fire

Charges Against Canary Capital Cast a Spotlight on the Sterns; A Journey From Hartz to Hedge

EVER SINCE MAX STERN boarded a boat from Germany in 1926, carrying 5,000 singing canaries and a business dream, the Stern family has had a knack for making big fortunes from small birds. Yesterday, however, a different kind of canary came crashing down on the family's fortunes.

Edward Stern, the 38-year-old son of pet-food and real-estate mogul Leonard Stern, and Max Stern's grandson, finds himself at the center of a sweeping investigation into the mutual-fund industry after paying a total of $40 million to settle illegal-trading charges made by the New York state Attorney General's Office. According to the settlement, Mr. Stern's hedge fund, called Canary Capital Partners LLC, allegedly obtained special trading opportunities with leading mutual-fund families -- including Bank of America Corp.'s Nations Funds, Bank One Corp., Janus Capital Group Inc. and Strong Capital Management Inc. -- by promising to make substantial investments in various funds managed by these institutions.

In a statement yesterday, Canary Capital Partners said it decided to enter into a settlement to "avoid protracted and complex litigation." Under that settlement, Canary, which admitted no wrongdoing, will pay $30 million in restitution of profits and $10 million in fines. As part of the settlement, in which he neither admitted nor denied guilt, Mr. Stern agreed not to trade in mutual funds or manage any public investment funds for 10 years.

The charges cast a spotlight on one of New York's 20 richest families, and its least-known scion. The family business that began with Max Stern's songbirds expanded into pet-care products, eventually becoming the well-known Hartz Mountain Corp., which included the Hartz brand and sold in more than 40,000 retail outlets. Max's son Leonard took over in 1959 and, along with managing Hartz, branched out into real estate and publishing, becoming one of New York's highest-profile business personalities.

Edward Stern, the younger of Mr. Stern's two sons, quickly emerged as the corporate heir. Brainy, whippet-thin and intensely private, Edward, called "Eddie" by friends and family, helped guide the family fortune and pioneer new areas of growth. While, his brother, Emanuel, was put in charge of the family's real-estate holdings, including the Soho Grand hotel and other glamorous properties, Edward helped invest the family fortune and run the giant pet-care business, according to people close to the family.

In 1989, fresh out of school, Edward joined Hartz, and in 1997 he was named president of the firm and helped lead the company on a spate of acquisitions, adding the Wardley and L/M brands and buying raw-hide manufacturing plants overseas.

In December 2000, he helped lead one of the Stern family's biggest business transactions -- a deal to sell Hartz Mountain pet-supply business to a fund managed by JW Childs Associates, the Boston-based private-equity firm. The family still controls Hartz Mountain Industries Inc., which owns more than 200 buildings in New York and New Jersey. Leonard Stern is CEO and chairman, and Emanuel is president and chief operating officer of the company. Terms weren't disclosed, but bank documents show that the Stern family had more than $100 million in liquid assets after the sale.

The cash allowed Edward to fund his longtime dream -- running a hedge fund, a private investment vehicle largely for the wealthy. He had already been trading on a small scale since 1998, using family funds. But in 2000, he devoted himself full time to the venture, known as Canary Capital Patrners, along with its management company, Canary Investment Management.

From the beginning, Mr. Stern kept a low profile -- even for the publicity-shy hedge-fund world. Canary isn't included in any of the major hedge-fund databases, and several major so-called fund-of-fund operators, including Merrill Lynch & Co. say they had no contact with Canary. According to court documents, Canary operated from a small office building in Secaucus, N.J. -- which also houses offices for Hartz Mountain -- as well as a trading floor in Manhattan.

From the outset, Mr. Stern started practicing mutual-fund timing -- a strategy that isn't unsual in the hedge-fund world. "A lot of hedge funds do mutual-fund timing," says Robert Watson, managing director of Lyster Watson & Co., a hedge fund of funds company. "They use very sophisticated models." (Mr. Watson adds that most hedge funds do not rely exclusively on that strategy however.)

What was unusual about Canary, however, was the performance. In 1999, Canary's return was 110%. The next year, he began to accept outside money and attracted a lot of high-net-worth individuals to his fund, consultants say. By early 2001, he had $184 million under management and by the end of the year, the fund had more than doubled to $400 million. He charged his investors a fee of 1.5% of the funds under management as well as taking 25% of the profits -- a fee structure on the high end of the hedge-fund business. His staff remained small, with only five employees as of 2001, according to bank memos.

The fund's return for 2001 dropped to 28.5%, though it still outperformed the major stock indexes. Canary's biggest growth came in 2002, when its assets ballooned to $730 million, according to the complaint. Canary returned 15%, less fees charged to investors, in 2002.

People familiar with the fund said Canary traders often worked late into the night on their trading floor. According to the state attorney general's complaint, Bank of America installed special equipment on Canary's trading floor that allowed the fund to make after-market trades more efficiently.

There are indications that Mr. Stern's activities may have been even more widespread than even prosecutors currently believe. In November of last year, a posting was made on a mutual-fund Web site called MutualFundsnet.com. Someone under the heading of "Timing Capacity" wrote that he was "Looking for Timers who need Capacity. Have negotiated deals in place for backward priced unds. Serious inquries only; minimum $50mm."

Three weeks later, Mr. Stern, using his phone number and an e-mail account with his name, posted a reply message expressing potential intrest. He wrote: "Run a very large timing pool. $2 Bn. Call me if this is for real. Don't waste my time if it isn't." Reached at his office yesterday on the number listed in the online posting, Mr. Stern wouldn't comment on his online posting, or whether he had contacted the individual. "I don't want to address anything other than what's in our comment," he said. The fact that individuals on a Internet site were openly discussing backward pricing a fund, and exchanging capacity to enable such a transaction, suggests to some that such activities could go beyond Canary.

In the first five months of this year, however, the fund registered only a 1.5% gain and Mr. Stern returned money to the outside investors. In a May 2 note to investors, Mr. Stern wrote: "We hope that you considered the ride to be a good one, and thank you again for your support."

Will California Prove Harbinger Of a Larger Revolt?

Economic Woes Behind Recall In Trend-Setting State Have National Parallels --- Matching Up on Jobless Stats

California's recall election for governor, with 135 candidates, has made the state the target of jokes across America. But the crisis behind the recall vote offers some important lessons about where the U.S. and national politics may be headed in coming months.

The movement to unseat Gov. Gray Davis was set off by a political chain reaction: A persistently lousy economy, with a chronically high jobless rate, soured public sentiment. An electricity crisis stoked the anxiety. Voters saw signs of a deeper malaise in lawmakers' inability to narrow the state's chronic budget deficit. Cynicism and political polarization grew. And voters found someone to blame in the aloof and unpopular Gov. Davis.

There are some clear parallels in the rest of the country. Local and state taxes -- in particular, property taxes -- are a growing irritant as more states, cities and counties boost levies to close yawning budget gaps. The federal budget deficit is widening toward a record $500 billion and becoming a major problem for President Bush. Complaints about jobs moving abroad are turning into a staple of the political debate for next year's presidential election.

And just as Arnold Schwarzenegger, considered a leading candidate to replace Gov. Davis if he is recalled, is trying to win California's recall race by stressing that he knows little about the people in the state's capital, the hottest national political figure is Howard Dean, a former governor who has never served in Washington and whose message is, in the words of Democratic pollster Mark Mellman, "I'm not part of all this. They are."

California has long been fertile ground for trends that went national: antismoking movements, clean-car rules, tax revolts, extreme sports. After California voters approved Proposition 13 limiting property taxes in 1978, 43 states limited or cut property taxes over the next two years.

Since February 2001, when national employment peaked, both California and the nation have seen the number of jobs decline by 2%. Both California and the nation have lost about 15% of their manufacturing jobs. Much of the nation's economic ills started with a high-tech meltdown that hit California earliest and hardest, but now its effects have spread across the land. California has lost 24% of its jobs in computer and electronics manufacturing, compared with a 25% decline nationally.

In an August survey by the Field Research Corp., an independent San Francisco polling group, 83% of Californians said they think the state is in bad economic times, the highest level since 1993. In the poll, 76% of Californians say the state is "seriously off on the wrong track," up from 54% a year ago and also the most negative finding in a decade.

Americans generally aren't so despairing for the nation, but their angst is growing along similar lines: In Wall Street Journal/NBC News polls, the share of people nationally who say the country is on the wrong track doubled, to 44% in July from 22% in April.

Bruce Cain, director of the Institute for Governmental Studies at the University of California, Berkeley, says the voter revolt was slow to form because government is usually slow in tough times to take the painful steps needed. For the first year or two of the downturn, state officials softened the blow by dipping into boom-era surpluses or by shifting funds among programs. But now, the squeeze on state finances has translated into teacher layoffs, higher college fees, reduced medical services and cuts in local police and fire departments. Car-registration fees are due to triple from Oct. 1, costing the average California motorist an additional $158 a year.

"Everything's being taxed. I just think it's crazy," says Suzan Spoden, a 50-year-old grocery clerk in the Los Angeles suburb of Lancaster. Ms. Spoden voted for Mr. Davis when he first was elected governor in 1998, but she backed his opponent, Bill Simon, last year. Now she supports the recall. State officials in Sacramento are "so old and set in their ways," she says. "I just think we need to get some new blood in there."

Fueled by economic anxieties, both California and the rest of the country have grown more polarized between the two main parties in recent years. The trend is somewhat more pronounced in California than elsewhere, in part because the state legislature is elected from districts gerrymandered with precise computer programs to make many districts safe for one party or the other -- a practice California pioneered and perfected.

Thus, state elections have tended to produce legislators who aren't so much in the middle but who hail from the strong liberal or conservative base of their parties. At the same time, California has adopted term limits for state representatives. Many think that also means there are fewer lawmakers who are experienced in the art of compromise. Combined with a two-thirds vote needed to pass budget or tax legislation, the result has been policy paralysis.

"The heart of democracy is compromise," says Steve Peace, the state finance director, who was a state legislator for 20 years. "We lost track of that."

The recall reflects the polarization, with Republicans overwhelmingly supporting it and most Democrats opposed.

"When Mr. Davis came into office, we had a surplus and that's all gone," says Larry Brant, 63, a retired farm manager in Kingsburg, near Fresno, Calif., and a Republican. "There just seems to be no control on spending."

Eli Rosas describes the recall as "dumb, stupid, silly." Mr. Rosas, 66, a retired maintenance supervisor at Hewlett-Packard Co. and a Democrat, has his complaints about Mr. Davis, especially regarding the electricity mess. But he views the recall as a Republican "conspiracy" to undo last year's election.

While California's polarization may be extreme, similar trends are playing out elsewhere. A copycat group has just formed in Nevada in the hope of punishing Republican Gov. Kenny Guinn for raising taxes. In Texas, Democratic lawmakers have left the state en masse to avoid voting on a redistricting plan drawn up by Republicans.

In Nebraska, as term limits begin to kick in for the state's traditionally nonpartisan legislature, antitax and other conservative groups with Washington ties are enlisting like-minded activists to run for newly opened seats. That already has incumbents of both parties predicting a hardening of political lines.

In the 2000 presidential election, the nation essentially split down the middle. Fierce partisanship has been a feature ever since in Congress, where the House of Representatives in particular increasingly is the home of strict party-line votes in which few or no members vote against the wishes of their party's leadership.

California's economic angst and voter polarization didn't produce a political explosion until the state's budget crisis helped ignite the combustible mixture. When Mr. Davis was re-elected in November, only about 36% of eligible voters went to the polls, the worst turnout ever in a California general election. Apathy more than anger seemed the order of the day.

But then Republicans, upset at losing the gubernatorial election to Mr. Davis last fall, charged afterward that he had lied to voters about just how sorry the state's fiscal picture really was. Indeed, estimates of the state's budget deficit ballooned rapidly to $38 billion in May from $21 billion after the election in November. Irate conservatives saw the recall as a chance to vent and then vote again.

"I think that California isn't being run right," says Ms. Spoden, the grocery clerk. "When Davis went in, there was money there, and there's no money there now."

A spokesman for Gov. Davis said the governor had used the surplus to cut taxes, as well as to increase spending. All of the spending was approved by both Republicans and Democrats, and most went to schools and health care, the spokesman said.

When Mr. Davis first took office in 1999, the state was flush. As recently as June 2001, California had a $7 billion budget cushion. Then, state revenue plunged along with income-tax payments that had been tied to the stock-market boom of the 1990s. Such payments have fallen by more than two-thirds, to a projected $5.3 billion in the fiscal year that began July 1, from $17.6 billion in the 2000-01 fiscal year.

Unable to agree on either tax increases or deep spending cuts, the legislature and Mr. Davis cobbled together a spending plan for the current year that relies heavily on fund transfers and borrowing. Fiscal experts say the state will face a budget gap of at least $8 billion in the year beginning July 1, 2004.

Now, the Field poll has found that 76% of Californians believe the financial condition of state government has worsened in the past year, more than at any time in the 21 years that the group has asked the question. Two-thirds of Californians say they are unhappy with the recently passed state budget.

California Republicans' strategy of using deficits and political turmoil against Democrat Davis isn't a good omen for President Bush. When he took office, the federal government had just recorded a $236 billion surplus for fiscal 2000. For fiscal 2004, which ends just weeks before next year's election day, the CBO in its midyear report projected a $480 billion deficit -- a swing of more than $700 billion downward in his term. The CBO's estimate doesn't include any new expenditures in the coming year, yet for Iraq alone the U.S. will spend billions.

Excluding current surplus Social Security tax revenues -- as Democrats have already begun doing in their attacks on Mr. Bush -- the annual deficits would be about $160 billion wider.

In 1992, the deficit became a kind of metaphor for a broken political system, producing the Ross Perot challenge to the re-election of Mr. Bush's father. Mr. Perot drew 19% of the popular vote as a third-party candidate and contributed substantially to the elder Mr. Bush's defeat. Karlyn Bowman, who tracks national attitudes at the American Enterprise Institute, a Washington think tank, says she sees no evidence yet in polls that the widening federal deficit is a national concern. Yet she is watching for signs of it.

Between distress over the economy and trouble abroad, "there's plenty of things for incumbents to worry about," says analyst Jennifer Duffy of the nonpartisan Cook Political Report.

Three states -- Louisiana, Mississippi and Kentucky -- elect governors this fall, but only in Mississippi will the incumbent, Democratic Gov. Ronnie Musgrove, be on the ballot to seek another term under the burden of bad times. He's facing well-financed former Republican Party Chairman Haley Barbour. Mr. Musgrove is trying to turn Mr. Barbour's Washington and corporate ties against him.

Next year, just 11 governor's seats are up for grabs, and perhaps five incumbents now occupying those seats won't seek re-election. As for the six other governors who are to face voters, four potentially are vulnerable, most notably Democratic Gov. Bob Holden, who has had continuing budget and tax battles in the swing state of Missouri.

The biggest incumbent of them all is President Bush. Bill McInturff, a Republican pollster who worked in 2000 for Bush rival Sen. John McCain, says Mr. Bush is in a much more enviable position than past presidents going into his re-election year. Unlike most Republican presidents -- including his father -- who didn't have the support of about 30% of their own party, Mr. Bush continues to have the backing of about nine out of 10 Republicans. "In our lifetime," Mr. McInturff says, "we have never seen that."

But in a 50-50 nation, that still isn't enough to elect him. In 2000, independents split their votes between him and Democrat Al Gore. Today's polls show just over a majority of self-described independents supporting Mr. Bush's performance as president overall. A slight majority opposes his economic policies, while support for his foreign-policy actions has slid from post-Sept. 11, 2001, highs amid mounting entanglements and casualties overseas.

Mr. Bush could get a warning shot if Democratic Lt. Gov. Ben Chandler wins Kentucky's governorship over Republican Rep. Ernie Fletcher in one of this fall's elections. Even in the Republican-leaning Bluegrass State, Mr. Chandler is running against "the Bush-Fletcher" federal deficit, blaming much of it on the Bush tax cuts that Mr. Fletcher voted for.

                     Parallel Lines
  California's economic troubles in some ways mirror those of the U.S.
as a whole.
                                      CALIFORNIA    U.S.
Unemployment rate (July)              6.60%         6.20%
Percentage of jobs lost (since 02/01)
  Total                               1.95%         2.03%
  In manufacturing                   15.40%        14.20%
Economic growth (12 mos ended June)   2.50%*        2.50%
Growth in personal income (2002)      2.25%         2.46%
Budget deficit as % of GDP (June)     2.61%**       2.88%
  *Estimate
  **Based on California budget deficit of $38 billion. Budget enacted 
since then closes that gap.
  Sources: Bureau of Labor Statistics; Department of Commerce;
Economy.com

Universal Slashes CD Prices in Bid to Revive Music Industry

IN A DRAMATIC move designed to jump-start sales, Vivendi Universal SA's Universal Music Group cut the suggested retail price of nearly all its CDs to $12.98, a drop of as much as 32%. In practice, many of its CDs will now sell for just $9.99.

The price-slashing is sure to roil the already unsettled music business and challenge other major labels to follow Universal's lead. The Vivendi unit is the world's largest music company, with nearly 30% market share in North America.

Executives at competing labels appeared to be caught off-guard and even incredulous about the announcement. "They are basically forever changing the record business today," said one. "It's a massively bold move; it's the kind of move we as an industry need to be making."

Consumers have long complained about the high price of compact discs. Many have made their displeasure plain by curtailing their music purchases and downloading songs free from illicit online services instead. Music buyers also have griped that DVD movies are often cheaper than music CDs.

Universal's top executives presented the plan as a central element of what they hope will be a revolution in the industry, which has been plagued by piracy, falling sales and other troubles. The CDs affected by the cuts currently carry suggested prices of $16.98 to $18.98, with the lion's share at the high end of that range, the company said.

"We're going to reinvigorate the record business in North America," said Doug Morris, Universal Music's chairman and chief executive. He said the price cut is part of a broad stategy that includes aggressive legal and technical assaults on online music piracy, and improved legal online music services. "We are making a very bold, strategic move to bring people back to music stores," he said.

The move is akin to the price cutting by AOL Time Warner Inc.'s Warner Bros. in the DVD market a few years ago. That prompted consumers to start buying DVD movies on a major scale instead of just renting.

The new CD pricing, set to take effect by the beginning of October, affects almost all of Universal's offerings, new and old, from Ashanti to Abba to Louis Armstrong. Only classical and Latin-music titles and multi-CD boxed sets are excluded. The music giant is achieving the price reduction by lowering the top wholesale price it charges retailers to $9.09 from $12.02. Wholesale prices on a handful of top-selling artists will be $10.10.

The company also will do away with so-called cooperative advertising -- direct payments it and other music companies have made to retailers to pay for local ads. "Co-op advertising was a misnomer," said Jim Urie, president of Universal Music & Video Distribution. "It was money that went to the retailers; they didn't cooperate in any way."

Instead, Universal will raise its own advertising budget "significantly." "We want to make people aware of the new price to drive them to the stores," said Zach Horowitz, Universal Music's chief operating officer.

The company set the target price after conducting a year's worth of market research that involved testing various prices, and concluded that the $12.98 suggested maximum was the "sweet spot" for shoppers. In practice, Mr. Morris added, retailers will be able to make a profit even at $10.

Mr. Morris denied that high retail prices had driven consumers to the illicit online file-sharing networks in the first place. Instead, he suggested that the price cuts were necessitated by the widespread online piracy. "If you had Coca-Cola coming out of your faucet for free, the Coca-Cola Company would be in trouble," Mr. Morris said. Mr. Horowitz added that the rampant piracy "doesn't change the underlying value of the music."

Nonetheless, Mr. Morris and his lieutenants admitted that shoppers believe CDs have been overpriced. "Retailers tell us stories about consumers going to the bins, picking up an older title, seeing that it costs $18, and putting it back," Mr. Urie said. "Now they'll see that it's $12, $11 or $10." He also conceded that DVDs have made music offerings look overpriced.

The new strategy has no bearing on the pending merger of General Electric Co.'s NBC with several Vivendi entertainment units, as Universal Music isn't included in that transaction. Vivendi has said it doesn't plan to sell the music unit now because music valuations are too low in the wake of the continuing sales plunge.

To offset the 30% cut in its wholesale revenue, Universal needs to see a commensurate increase in sales volume. Mr. Morris declined to specify the exact volume increase he was aiming for, but added, "If we meet the [target], our margins will be better." A lot is riding on the anticipated bump in volume. "This is our new pricing policy," Mr. Horowitz said. "We need an increase in sales to make it permanent."

It wasn't immediately clear how other major music companies would respond, and officially they declined to comment. Speaking privately, some executives at competing companies characterized the move as too radical, and predicted it would demand an impossibly large increase in sales volume to offset the squeeze it puts on profit margins.

Retailers praised the price cuts. Lloyd Greif, president of Greif & Co., an investment-banking firm handling the sale of Tower Records, said, "Anything that brings customers through the door who wouldn't otherwise have come through the door is a positive development for a retailer like Tower." He added that he expected the lowered prices to boost impulse buying.

Joe Nardone Jr., owner of the 11-store Gallery of Sound chain in Pennsylvania, said such a price cut was all but inevitable, though he expressed shock at the elimination of co-op advertising, which retailers rely on to promote their stores. "Prices had to come down for this to be a business," he said. Mr. Nardone added that being able to profitably price CDs at $9.99 would likely allow him to compete with mass merchandisers such as Best Buy Co. and Wal-Mart Stores Inc., which often take a loss to sell CDs at that price, making up the difference on sales of higher-priced goods. Even if those merchants now sell CDs for $8.99, he said, $9.99 is a "magic" psychological cutoff for consumers.

                  Shaking Up Business
  Universal holds the biggest share of the U.S. recorded-music market.
Year-to-date market share:
Universal                                 29.4%
Warner                                    16.6%
BMG                                       16.3%
Sony                                      13.0%
EMI                                        9.8%
All others                                14.9%
  Source: Nielsen SoundScan