MEMORANDUM To: File

From: John G. Narkin Re: Chocolate Conspiracy and Industry Overview

Date: December 31, 2007 ______________________________________________________________________________ I. The Investigations On November 28, 2007, news media reports revealed that the Canada Competition Bureau (Canadian Bureau) commenced an investigation into allegations that the Canadian divisions of the Hershey Company (Hershey), Mars, Inc. (Mars), Nestl SA (Nestl) and Cadbury Schweppes plc (Cadbury) engaged in a scheme to fix the price of chocolate products and potentially other types of candy. A collection of relevant articles is attached to this memorandum at Exhibit A. Among other things, these articles reported: Statements from John Pecman, an assistant deputy commissioner in the Canadian Bureaus criminal branch, which confirmed that (1) the Canadian Bureau is investigating alleged anti-competitive practices in the chocolate confectionery industry, (2) [t]he volume of commerce affected is definitely potentially in the billions of dollars per year; (3) the Ontario Superior Court of Justice granted search warrants based on the evidence that there are reasonable grounds to believe that a number of the suppliers in the chocolate industry have engaged in activities contrary to the conspiracy provisions, that's a cartel, of the Competition Act; (4) the searches are underway, but in a preliminary stage, and it could take months or

years before charges are brought or the investigation is dropped; (5) the Canadian Bureau often takes action after receiving information from whistle blowers and informants and (6) the fact that the Canadian Bureau is prepared to expend its limited resources on this matter speaks for itself. A statement that files for the search warrant obtained by the Canadian Bureau were under seal; Confirmations of the investigation by chocolate manufacturers and promises of cooperation therewith; and A statement that Canadians consume about $ 2.5 billion worth of chocolate and other candy every year, which was attributed to the Confectionary Manufacturers Association of Canada. On December 20 and 21, 2007, news media reports revealed that the United States Department of Justice commenced its own investigation into alleged anti-competitive pricing practices in the chocolate confectionary industry. A collection of relevant articles is attached to this memorandum at Exhibit B. Among other things, these articles reported: Confirmations of the investigation by chocolate manufacturers and promises of cooperation therewith; A statement that Americans buy about $13 billion worth of chocolate each year, which was attributed to the National Confectioners Association; and Observations that chocolate manufacturers have been hurt by soaring commodity costs for crucial ingredients, particularly milk, which have been cited as a justification for price increases.
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On December 21, 2007, an Ottawa judge entered an order unsealing the affidavits submitted by the Canadian Bureau in support of its application for a warrant to search the files of chocolate manufacturers. The next day, December 22, news media reports described the contents of those affidavits in detail. A collection of relevant articles is attached to this memorandum at Exhibit C. Among other things, these articles reported: Individuals from one unidentified company supplied a lawyer at the Canadian Bureau with e-mails and information about telephone calls and private meetings involving Hershey, Mars, Nestl and ITWAL Ltd., a Canadian candy distributor. These unidentified witnesses applied for immunity from prosecution. The Canadian Bureau filed with the court separate 57-page and 24-page affidavits in support of its request for a warrant to search Canadian offices of Hershey, Mars, Nestl and ITWAL. Cadbury was not named in the request and is presumably an amnesty applicant. As a result of the warrant, which was issued on November 21, 2007, thousands of corporate documents and computer files were seized from Hershey, Mars, Nestl and ITWAL. Daniel Wilcock, a lawyer at the Canadian Bureau, wrote in one affidavit that "[t]he price-fixing communications were often at the most senior levels of the companies involved, and they have continued over a number of years." (The alleged collusion reportedly began in February 2002, and continued until late in 2007). The affidavits further disclosed that: Senior executives at Hershey, Mars and Nestl met secretly in coffee shops, restaurants and at industry conventions to set prices. ITWAL helped to facilitate the exchanges of information.
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The collusion was initially coordinated by ITWAL. ITWAL worked with the chocolate companies to force retailers to stop cutting prices for chocolate bars. Stores that didn't comply were cut off. In a memorandum to chocolate makers dated Feb. 21. 2002, a Mr. Stevens of ITWAL wrote, At the end of the day' it is only the suppliers' control and discipline of the [discounting] that can restore the functionality of the marketplace. Nestl Canada Chief Executive Officer Robert Leonidas was a leader of the pricefixing conspiracy. Among other things, (1) he approached one competitors representative during the Confectionery Manufacturers Association of Canadas annual meeting in June 2005 and "said words to the effect of 'We are going to take a price increase and I want you to hear it from the top,' " after which Leonidas handed the representative an envelope containing a document about Nestl's planned price increase for chocolate in 2005; (2) the competitors representative sent his assistant to a Nestl office in Canada on July 6, 2005, at which time Leonidas met the assistant in the lobby; Leonidas gave the assistant another envelope containing a document about Nestl's planned price increase, saying something to the effect that it was better not to be seen in his office. A different representative of the competitor met Sandra Martinez de Arevalo, president of Nestl Canada's confectionery business, for lunch at Auberge du Pommier, a restaurant in Toronto, at which time Martinez suggested that the competitor "lead a price increase in 2007, as Nestl wanted to take a price increase in the third quarter"; the representative answered that his company wasn't prepared to take a price increase in 2007, but might in 2008.
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At a September 27, 2007 trade association meeting dinner, Eric Lent, General Manager of Hershey Canada, approached another representative of the competitor. Lent said Nestl was "taking a price increase" and "so we should take advantage" or "we should increase our prices too." Lent also stated, "Bob [Leonidas] and I talk about it all the time. It's public knowledge that Nestl is taking its prices up." Other similar meetings took place took place in 2007 at food conventions in Vancouver and Niagara-on-the-Lake, Ontario. For further relevant details, we are now in the process of attempting to obtain copies of the 57-page and 24-page affidavits filed by the Canadian Bureau. II. The Chocolate Industry The United States Department of Commerce, through the U.S. Census Bureau, publishes annual reports containing relevant data for the confectionary industry, broken down according to its individual segments, including the chocolate sector. Reports for the years 2002 through 2006 are available in both .pdf and Excel formats at http://www.census.gov/cir/www/311/ma311d.html. A National Confectioners Association summary of the sales and consumption data is appended to this memorandum at Exhibit D. The following chart illustrates the 2006 consumption data:

U.S. Department of Commerce 2006 311D Report

Apparent Consumption Total Confections Chocolate Candy Non-chocolate Candy Gum Not specified Retail $28.2 billion $15.6 billion $8.9 billion $2.7 billion $0.8 billion Wholesale $18.3 billion $10.2 billion $5.8 billion $1.8 billion $0.5 billion % Increase +0.9% -0.9% +2.3% +8.3% +0.1% 2006 lbs 7.7 billion 3.6 billion 3.3 billion 0.5 billion 0.2 billion % Increase 1.4% -0.8% 2.9% 7.7% 0.5

According to Newsweek, in 2003, Hershey had a 43% share of the market in the U.S. chocolate candy segment, as compared to 27% share for Mars and 9% for Nestl. http://www.businessweek.com/magazine/content/03_39/b3851089_mz017.htm. More recently, the Wall Street Journal reported that Hershey had a 42% share of the market, as compared to 27 % for Mars. Jargon, At Hershey, Sweetness is in Perilously Short Supply, The Wall Street Journal (October 10, 2007),

http://online.wsj.com/article/SB119193680025353375.html?mod=mm_media_marketing_hs_left Although Cadbury is the global leader in the confectionary industry, its presence is relatively

modest in the United States chocolate market, where Hershey exercises licenses to distribute Cadbury products, including York, Peter Paul/ Almond Joy and Mounds, and Cadbury Caramello, http://www.oligopolywatch.com/2007/06/16.html; Hershey 2006 10-k at 2, 6. This contrasts with the situation in Canada, where Cadbury maintains a more prominent market position. See http://www.cadburyschweppes.com/EN/InvestorCentre/BusinessValues/StructureOrganisation/OurR egions/americas.htm (We are also the largest confectionery company in Canada, the world's 11th largest confectionery market, with an overall 24% market share and leading market positions in gum, candy and cough confectionery, and a top three position in chocolate). One online research report summarizes the competitive environment for Hershey in the United States as follows: Competition Hersheys enjoys the largest share of the US chocolate market and is the leader in both single-serve and bulk (boxes/large bars/bags) chocolate products. The singleserve segment, defined as products which weigh less that 3.5 oz, has higher margins and account for 20 percent of the overall chocolate market. The bulk segment accounts for another 48 percent. Hersheys has a market share of 47 percent in both segments. Its closest competitor in the US market is Masterfoods (Mars), which
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owns well-known brands such as Mars, Snickers, M&M's, Milky Way and Twix. Nstle is third in both segments.

Several observers have noted that both Nstle and Mars have become more aggressive in recent years. Both of these companies have increased their spending on advertising and introduced new products; however, there is no clear indication that their campaigns have been successful. Perhaps, the greater threat for Hershey's is cannibalization of its established products by its new products. Hersheys recently acquired the brands Joseph Schmidt (November 2005) and Dagoba (November 2006). This move reflects Hersheys plan to expand into premium chocolates, i.e. chocolates which sell for more than $7 per pound. This also puts Hersheys into head-to-head competition with brands such as Toblerone, Ferrero Rocher and Lindt. Currently, Hersheys has a 5 percent share of this segment. Premium chocolates enjoy higher margins than basic items. Continued growth in this segment should postively affect Hershey's gross margins. The threat of competition in North America from powerful global confectionary companies such as Nstle and Cadbury Schweppes is effectively mitigated through Hersheys licensing agreements. In the case of Nstle, Hershey's owns exclusive US licensing rights to Kit Kat one of Nstle strongest brands. Without the Kit Kat platform it will be difficult for Nstle to gain a competitive edge in the US market. Hersheys also owns the US licensing rights to all the Cadbury brands thus preventing Cadbury from entering the US market. Nevertheless, both Cadbury and Nstle will make it difficult for Hersheys to make forays into other markets, notably in Asia.

Retrieved from http://www.wikinvest.com/stock/Hershey_Foods_(HSY) Viewed from a broader worldwide context, the following table complied by the International Cocoa Association summarizes the top 10 global confectionery companies that manufacture some form of chocolate by total confectionery sales value in 2005: Total Sales 2005 US$millions 9,546 8,126 7,973 5,580 4,881 2,250 1,693 1,673 1,427 1,239

Company Mars Inc Cadbury Schweppes PLC Nestl SA Ferrero SpA Hershey Foods Corp. Kraft Foods Inc. Meiji Seika Kaisha Ltd. Lindt & Sprngli Barry Callebaut AG Ezaki Glico Co

See http://www.icco.org/about/chocolate.aspx Viewed from an even broader global confectionary market context, Cadburys 2006 Annual Report and Accounts provides the following information:

Market share in the global confectionery market (US$ share)

Global confectionery market Cadbury Schweppes Mars Nestl Wrigley Hershey Ferrero 9.9% 9.0% 7.8% 5.8% 5.5% 4.4% 8

Chocolate 7.5% 14.8% 12.6% 8.2% 7.3%

Gum 25.7% 0.1% 35.9% 1.1%

Candy 7.2% 3.0% 3.2% 2.7% 2.7% 1.5%

Global confectionery market Kraft

Source: Euromonitor 2005

Chocolate 7.7%

Gum 0.1%

Candy 0.4%

4.3%

See http://www.investis.com/cadburyschweppes/reports/anr2006/pso/tbt.html#4 For further detailed data and analysis, there are available a number of seemingly excellent commercial research studies that analyze the chocolate industry in the United States on a comprehensive basis. Descriptions of these studies, along with corresponding web page references, are appended to this memorandum at Exhibit E. III. Price Increases A. Hershey

Hershey, the largest chocolate manufacturer in the United States, announced three general price increases since 2002: (1) On April 4, 2007, Hershey announced an increase of approximately 4-5 percent on the Company's standard bar, king-size bar, 6-pack and vending lines, effective immediately. According to Hersheys press release, These products represented roughly one-third of the Company's portfolio. This action will help offset the Company's input costs, including raw and packaging materials, fuel, utilities and transportation. While there has been no change in list prices on these impacted items since December 2004, over this period costs have continued to rise. See http://www.thehersheycompany.com/news/release.asp?releaseID=981846 (2) On December 16, 2004, Hershey announced (a) a 5.8% increase on the company's standard bar, king-size bar, 6-pack and vending lines, effective immediately. (During the eight-week period ending February 14, 2005, existing customers could, based on
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their historic order patterns, order and take delivery of up to 12 weeks of inventory of these items at pre-increase prices); and (b) a 4.1% increase on packaged chocolates, effective February 14, 2005. (During the six-week period from February 14 to March 28, 2005, existing customers could, based on their historic order patterns, order and take delivery of up to 10 weeks of inventory of these items at pre-increase prices). According to Hersheys press release, The changes approximate a 3% price increase over Hershey's entire domestic product line and will help offset increases in areas of the company's input costs, including raw and packaging materials, fuel, utilities, transportation and employee benefits. See http://www.thehersheycompany.com/news/release.asp?releaseID=655434 (3) On December 11, 2002, Hershey announced an increase of 10.8% in the wholesale price of its domestic standard size, king size, variety pack, 6-pack and 10-pack lines, effective January 1, 2003. According to its press release, The effect of all the increases translates into an approximate 3 percent increase over the entire domestic product line and This is the first price change Hershey Foods has made on its standard size bars since 1996. See http://www.thehersheycompany.com/news/release.asp?releaseID=363316. These press releases, together with related news media reports, are appended to this memorandum at Exhibit F. While the press releases indicate that the price increases were aimed at the companys domestic confectionary line, the following excerpts from Hersheys 2006 Form 10-K (at page 1) state that the companys marketing and sales organizations in the United States and Canada are combined into a single operating entity:
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Selling and Marketing Organization Our selling and marketing organization is comprised of the North American Commercial Group, the International Commercial Group and the Global Growth and Innovation Group. This organization is designed to: Leverage our marketing and sales leadership in the United States and Canada; Focus on key strategic growth areas in global markets; and Build capabilities that capitalize on unique consumer and customer trends. North American Commercial Group Our North American Commercial Group has responsibility for continuing to build our confectionery leadership, while capitalizing on our scale in the U.S. and Canada. This organization leverages our ability to capitalize on the unique consumer and customer trends within each country. This includes developing and growing our business in our chocolate, sugar confectionery, snacks, refreshment, food and beverage enhancers, and food service product lines. Hersheys financial results for the United States and Canada are similarly consolidated: For segment reporting purposes, we aggregate our operations in the Americas, which comprise the United States, Canada, Mexico and Brazil. We base this aggregation on similar economic characteristics, and similar products and services, production processes, types or classes of customers, distribution methods, and the similar nature of the regulatory environment in each location. We aggregate our other international operations with the Americas to form one reportable segment. Id. As of the time of this writing, we are attempting to determine whether the price increases implemented by Hershey and other producers in the United States coincided with the increases implemented in Canada. B. Mars (also known as Masterfoods USA) and Nestl

Together, Hershey and Mars account for approximately 69 % of the total United States chocolate market. See supra at 6. Price increases announced by both Hershey and Mars correspond in both timing and amount. On March 23, 2007, about two weeks before Hersheys April 4, 2007 announcement of a 4
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5 price increase, Masterfoods USA announced a 5 % increase in the wholesale price of chocolate bars, which a Masterfoods spokesperson attributed to rising costs and to help support continued investment in driving category growth." See http://www.flex-news-food.com/console/PageViewer.aspx?page=8147&str=Hershey%20USA and collection of other news articles appended at Exhibit F to this memorandum. While the exact amount of price increases by Nestl in or about April 2007 has not been fully determined, Nestle did increase its prices at this time, something that Nestl executives touted publicly as a reason for the companys positive financial performance. See Nestl press release dated April 23, 2007, Nestle: Strong First-Quarter Sales 2007 Positive Outlook for the Full Year. See http://www.nestle.com/MediaCenter/PressReleases/AllPressReleases/FQ2007_PublicationResults.htm?Tab=2007 and Exhibit F. This press release quotes Peter Brabeck-Letmathe, Nestls Chairman and CEO as stating, Input costs remain high, but our strong brands enable us to continue to adjust prices. The press release also noted that 1.7% of the companys strong organic growth of 7.4 %. was attributable to price increases. See also Nestl press release dated October 18, 2007,
http://www.nestle.com/MediaCenter/PressReleases/AllPressReleases/9Month2007Results.htm?Search=k%3dincrease%2 6PN%3d1 and Exhibit F (The strength of Nestl's brands allowed the Group to raise prices to offset

rising raw material costs. These price increases, together with the resulting slight dip in real internal growth, reflect the Group's commitment to profitable growth regardless of market circumstances and Zone Americas (+7.5%) and Zone Asia, Oceania and Africa (+8.7%) both experienced strong organic growth, partly as a result of price increases to compensate for higher raw material costs, especially milk). The December 2004 and December 2002 price increases announced by Hershey also coincide with those announced by Mars and Nestl. See CNN Money, Chocoholic Beware: Prices
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Going

Up,

December

16,

2004,

http://money.cnn.com/2004/12/16/news/fortune

500/Hershey/index.htm, Exhibit F (linking Hershey and Mars increases); Elliot Mara, Masterfoods USA, Hershey Foods Corp. and Nestle Confections and Snacks Raise Candy Prices, Automatic Mechandiser (January 1, 2003), http://goliath.ecnext.com/coms2/gi_0199-2522020/MasterfoodsUSA-Hershey-Foods-Corp.html#abstract, Exhibit F (noting that the price increases have raised quite a stir among vending operators and that they are big hits to take); Masterfoods, Hershey and Nestle All Raise Candy Prices, Automatic Mechandiser (January 1, 2003),

http://goliath.ecnext.com/coms2/gi_0199-2522033/Masterfoods-Hershey-and-Nestleall.html#abstract, Exhibit F; Big-Three Hike Wholesale Prices. Candy Watch (January 2003), Exhibit F. This is an important area of inquiry that requires further factual investigation. III. Industry Players Hershey is a Delaware corporation located at 100 Crystal A Drive, Hershey, Pennsylvania 17033, Tel: 717. 534.4200. Hershey, whose shares are traded on the New York Stock Exchange, employs over 14,000 people throughout the world. Hershey reported revenue of $ 4.9 billion in 2006, with a net income of $ 50.6 million and a net profit margin of 7.1%. Mars is a privately held company located at 6885 Elm Street, McLean Virginia 22101, Tel: 703.824.4900. Mars, whose most famous products are M&Ms and Snickers, had $21 billion in total sales in 2006. Mars food, snack and pet care business is conducted through Masterfoods USA, which is located at 700 High Street, Hackettstown, New Jersey 07840-1502, Tel: 908.852.1000. Nestl is a multi-national company located at Avenue Nestl 55 CH-1800 Vevey, Vaud, Switzerland, Tel: +41-21-924-2596. Nestl, which employs about 265,000 worldwide, had global revenue in 2006 of approximately $87 billion, with net income of about $4.7 billion. Nestls ADRs
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are traded in the United States over-the-counter market. It operates in the United States through Nestl USA, Inc. (Nestl USA), located at 800 North Brand Boulevard, Glendale, California 91203, Tel: 818.549.6000. In 2006, Nestl USA had $8.5 billion in sales, more than 15,500 employees nationwide and 20 manufacturing facilities, 5 distribution centers and 12 sales offices across the United States. Cadbury, a British public limited company whose ADRs are traded on the New York Stock Exchange, maintains its principal place of business at 25 Berkeley Square, London, England W1J 6HB, Tel: +44 20 7409 1313. Manufacturing and marketing a wide variety of beverages, candy and other food products, Cadbury reported 2006 revenue of $ 15 billion and net income of $2 billion. Cadbury operates in the United States through Cadbury Schweppes Americas, located at 5301 Legacy Drive, Plano, Texas 75024, Tel: 972.673.7000. As described above, supra at 3-5, the Canadian chocolate cartel in which Hershey, Mars, Nestle and Cadbury allegedly engaged was facilitated and coordinated by ITWAL, a prominent food service wholesaler and distributor with headquarters at 440 Railside Drive Brampton, Ontario L7A 1L1, Tel: 905.840.9400. The conspiracy was also effectuated at meetings sponsored by a trade association known as the Confectionery Manufacturers Association of Canada (CMAC), which is located at 885 Don Mills Road Ste # 301 Don Mills, Ontario M3C 1V9, Tel: 416.510.8034. Id. The activities of both ITWAL and the CMAC, which are described in the web site material appended to this memorandum at Exhibit G, appear to be confined to the geographic limits of Canada. Although there is nothing in the public record that suggests any involvement in a price-fixing conspiracy, one possible counterpart to ITWAL in the United States is the American Wholesalers

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Marking Association, located at 2750 Prosperity Drive, Fairfax, Virgina 22031, Tel: 800.482.2462. See http://www.awmanet.org/about.html, Exhibit G. The National Confectionary Association (NCA), located at 8320 Old Courthouse Road, Suite 300, Vienna, Virginia 22182, Tel: 703.790.5750, purports to be one of the oldest, most respected trade associations in the world. See http://www.candyusa.org/about, Exhibit G. The operations and functions of the NCA appear to parallel the CMAC in most material respects. Notably, the NCAs web site lists a full calendar of events for its members, at which competing producers no doubt attend regularly. See http://www.ecandy.com/eventcalendar.aspx, Exhibit G. Operating out of the same offices as the NCA is the Chocolate Manufacturers Association of the United States of America (CMA), whose mission is to provide industry leadership to promote, protect, and enhance the chocolate industry's interest through legislative and regulatory programs and communications. http://www.candyusa.org/About/CMA.asp, Exhibit G. Also at the same address is the American Cocoa Research Institute, the scientific research arm of CMA.

IV.

Trouble At Hershey As the dominant leader of the chocolate industry in the United States, Hershey has for the

past several years faced enormous challenges to its market position, not only from ostensible competitors, but from an unusual ownership structure and corporate mismanagement. The difficulties confronting Hershey have been the subject of extensive coverage in the international financial media. A sample of that coverage is appended to this memorandum at Exhibit H. Briefly summarized, Hershey has been under extreme pressure to deliver financial results commensurate to its market leadership, and it has failed to do so. This has rendered Hershey
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vulnerable, perhaps to the extent of adopting the expedient solution of participating in the chocolate industry cartel under investigation by the Canadian Bureau and the DOJ. Among the headlines on this issue are: In November 2007, the charitable trust that controls Hershey removed almost the entire board of directors of the company, one month after Hersheys chief executive officer resigned suddenly. The trust replaced these board members with members of its own designation, including former Pennsylvania governor and former U.S. Department of Homeland Security chief Tom Ridge. Prodded by the trust, in October 2007, Hershey apparently reinstituted merger talks with Cadbury, whose products Hershey distributes in the United States and elsewhere through licensing agreements. (In 2002, Hershey received a combined $10.5 merger bid from Cadbury and Nestle and a $ 12.5 billion merger bid from Wm Wrigley Jr. Co., but Hershey terminated the auction after it encountered heavy community and political opposition). According to Hershey Trust Board Chairman LeRoy Zimmerman (Pennsylvanias first elected Attorney General), Hershey recently lost more than $1 billion in market value, notwithstanding a sweeping reorganization that included major employee layoffs, plant closings and a shift of some manufacturing operations to Mexico. (As an interesting aside, Zimmerman is also a member and past chairman of the Board of Governors of Penn States Dickinson School of Law, which is currently chaired by alumni Laddie Montague, who recently made a $4 million endowment for a law library to be named after himself).
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Hershey is a company in turmoil. Given the U.S. and Canadian investigations, which appear to be based on credible direct and circumstantial evidence of price-fixing, Hershey does not seem to be in an optimum position to defend an aggressively prosecuted antitrust class action through summary judgment and trial. # # #

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