ArtistDirect Says It Violated Securities Law

ArtistDirect Inc., which received a chilly reception from investors when it debuted on the stock market Tuesday, disclosed that it violated federal securities law by issuing more shares to investors and artists than it should have.

The violation, which could cost up to $27 million to remedy, would eat away a good part of the $60 million the Encino company raised with its initial public offering, according to a document filed late Monday with the Securities and Exchange Commission.

Company executives, who saw the stock drop 22% in the first day of trading, were not available for comment Tuesday.

In the filing, the firm said it issued stock and options to its staff and to the more than 100 artists with whom it has signed deals.

ArtistDirect provides music and multimedia content to fans through its myriad of Web sites and builds e-commerce shops for dozens of well-known acts, such as the Backstreet Boys, the Rolling Stones and No Doubt.

Many of the artists, as well as their managers, received an undisclosed chunk of equity in the company in exchange for letting ArtistDirect sell their merchandise and concert tickets directly to fans, according to the SEC filing.

Dozens of “dot-coms” have followed a similar business model, giving celebrities equity in a company in exchange for star-power endorsements.

Priceline.com Inc., the travel company that lets people name their own prices for airline tickets, agreed to give actor William Shatner 100,000 shares in exchange for providing radio voice-overs and appearing in newspaper advertisements. On the day the company went public, Shatner’s options were valued at $7.4 million.

Yet in the case of ArtistDirect, the artists and managers may not have been eligible to get the securities. According to the filing, the company issued 7.3 million options to directors, executive officers, employees, artists and consultants between August 1998 and last December.

But changes in federal laws, the company said, made the grants to artists and consultants questionable. “As a result, the company believes that a number of artists and other nonemployees who were granted options . . . may no longer qualify as consultants,” ArtistDirect said in its filing.

It also believes that the total dollar amount of the offering represented by the options granted under its plan may have exceeded legal limits.

The SEC limits share and option issuance by closely held companies to employees, directors, officers, general partners and consultants.

The company said that, so far, no one has asked it to buy back the options. But six months from now it will try to buy back shares and options issued to certain artists and consultants. Depending on the number of shares put back to the company, the cost could reach $27 million, it said.

The company did not disclose who would be affected by the mix-up or how many shares it issued incorrectly.

“Due to the nature of the persons who received these shares and options . . . the issuance of these shares and options did not comply” with federal securities law and may have also violated California securities law, according to the filing.

The news comes as a shock to some musicians, according to industry sources, who had expected ArtistDirect’s IPO to allow them a way into today’s market-driven Internet gold rush.

The company had the financial support of four of the five major record labels. Late last year, it attracted a total of $97.5 million in investments from Universal Music Group, BMG Entertainment, Sony Music Entertainment and Time Warner Inc., as well as Web powerhouse Yahoo and an affiliate of Cisneros Television Group, according to regulatory filings.

In its first day of trading, the stock dropped from its initial pricing of $12 a share to Tuesday’s close of $9.41 a share.

Analysts noted that, despite media buzz over the MP3 format and music being digitally distributed over the Internet, the sector and the companies within it remain very young.

Experts point to CDNow Inc., one of the industry’s leading online CD retailers, as a strong company with a loyal following, but with stock that is plummeting because investors still aren’t sold on the viability of online music. The company’s stock, which hit a high of $23.27 a share, closed at $5.06 a share on Tuesday, up 16 cents in Nasdaq trading.