US: A Smoke Ring? That'll Cost you $280 Billion

Publisher Name: 
The Economist

The hearings began on September 21st. America's federal government
charges its top cigarette makers--Philip Morris, R.J. Reynolds, Brown &
Williamson (an arm of British American Tobacco that is now merging with
Reynolds), Lorillard and Liggett Group--plus a British arm of BAT, with
lying to the public about the hazards of smoking, of trying to fiddle
or hide the scientific evidence, of deliberately getting people
addicted to nicotine, of selling knowingly to people below smoking age,
of pushing low-tar cigarettes as safer than others, while knowing they
were not; and more. All untrue, say the companies. For them, it better
had be: the government says they made $280 billion in "ill-gotten"
profits and wants it disgorged.

To the tobacco firms, this looks like double jeopardy. In 1998, the
four biggest reached a deal--the "master settlement agreement"
(MSA)--with 46 state governments that accused them of pushing up the
states' health-care costs. They agreed to pay $206 billion over the
first 25 years, via a levy that is by now almost 50 cents a pack; four
other states had already settled, for $40 billion over 25 years. Other
companies have signed up. Problem solved.

Not so. The Clinton administration soon launched a federal suit,
heavily reliant on a law meant to help the government recover
health-care costs if someone injures a soldier. The judge threw out
this part of the case, but left in another, based on the Racketeer
Influenced and Corrupt Organisations Act of 1970.

This law, originally aimed at the mob, makes normal business a crime
when it is part of an illegal conspiracy. That is what the tobacco men
were up to, says the government, when they met on December 15th, 1953
in a doubtless smoke-filled room in a New York hotel, and schemed to
mislead the public about the risks of smoking.

But did not the government itself once distribute cigarettes to GIs?
Does not it still prop up tobacco prices and collect taxes on cigarette
sales? It does indeed: about $8 billion a year. On top of that federal
rake-off, states' excise taxes take about $9 billion. In addition, the
46 MSA states alone used to get about $8 billion a year from that
agreement, though this has slid to an estimated $5.2 billion in
2003-04. Securitisation of the revenues has brought some states huge
short-term windfalls.

It is hard to see the government really wanting to butcher this milch
cow, even if it can persuade a court to lend a hand. And if the tobacco
barons were "defrauding the public", as it alleges, what was it doing
itself as it raked in tax revenues? Were its own scientists duped too?

Yet the industry has reason to worry. In pre-trial hearings, it argued
that the MSA shielded it from the federal case. The judge disagreed.
She also refused to cap the size of the government's claim, though that
ruling is under appeal. However, to make the firms pay up, the
government will have to prove that they not just defrauded the public
but are likely to go on doing so. Since the MSA also imposed strict
limits on their marketing, that will not be easy.

Expect no swift conclusion to this case. If the companies lose, they
will certainly appeal. At which point a re-elected George Bush might
call off the suit. And even if they were to lose all the way up--some
sort of deal is more likely--it is (as stockmarkets agree) by no means
sure that they would have to cough up the full $280 billion.

Meanwhile, the industry itself is volunteering to become even more
virtuous than it claims to be already. More exactly, Philip Morris is.
Along with the rest of big tobacco, it fought regulation tooth and nail
in the 1990s. But now it is promoting legislation to give the Food and
Drug Administration jurisdiction over tobacco. Why? Critics suspect the
aim is not virtue, but protection for Philip Morris. They call the
measure the "Marlboro Monopoly Act".

Tobacco growers want to get rid of the Depression-era production
quotas that keep crop prices high, but invite cheap imports. They want
compensation, however, some $12 billion of it, for their quota
certificates. And lo, Philip Morris has volunteered the cigarette
makers to pay the cost--but only in return for FDA regulation.

Both chambers of Congress have passed a tobacco-buyout bill this year.
But while the Senate goes along with Philip Morris, the House has
passed a taxpayer-funded version with no FDA regulation. The two have
soon to hash out agreed details of a corporate-tax bill to which the
legislation is attached. Philip Morris says it will withdraw its
support if the bargain it struck in the Senate is tinkered with.

But why should taxpayers look this gift horse in its nicotine-stained
teeth? What is the company after? FDA regulation would spell big
changes for the industry: larger warning labels and more disclosure of
toxins on cigarette packs; marketing--already banned from radio and
television--limited to simple black-and-white print ads and retail
displays; no flavoured cigarettes (bar menthol brands); FDA-set limits
on tar and nicotine, and pre-approval to market cigarettes as "light"
or "low-tar". Has Philip Morris caught masochism of the throat? No, say
its rivals: it is just trying to lock in its half-share of the American
market. Tight marketing rules would hurt lesser brands more than they
would Marlboro.

Maybe, but newcomers to the market find it odd to hear any bit of big
tobacco carping about anti-competitive tactics: the big boys have done
well enough under the MSA, which some see as a state-sponsored cartel.
It forced signatory firms to pay up, and accept marketing restraints.
But it also gave states less of the cash if they did not pass laws to
hit non-signatories too. Even if these were not to blame for past
smoking-related ill-health, they had to sign up, or pay up just as if
they had, into escrow accounts held by the states. Within days of the
MSA deal, the big firms raised prices by 45 cents. Further rises
followed fast.

Yet things have changed, which may explain why Philip Morris has
changed tack. Discount firms have pushed into the market, undercutting
the high-priced leading brands by as much as $1 a pack, and they have
still made a profit, despite the escrow costs--or simply evaded these.
The discounters' market share has climbed from 2% in 1997 to about 12%
now. In 2001, Philip Morris's share began to slip, though this year it
is creeping up again.

Importers have done well: witness the recent threat from Vector Group,
Liggett's parent, to sue the 46 MSA states for the allegedly over-easy
signing-up terms that they allowed to an importer of Colombian
cigarettes that sold 3m packs in 2000 and 380m last year. And after
several failed attempts to challenge state laws, importers who do not
want to sign up saw a New York appellate court in January reinstate one
such case, writing, in an unusually candid opinion, that the MSA
"threatens to become a permanent, nationwide cartel." If the importers
eventually win, similar suits could burgeon across the country.

How could FDA regulation help the big boys? A nicotine limit would aid
makers who already have low-nicotine cigarettes. Many small firms lack
the technology to make these. And Philip Morris would not weep at a ban
on cigarettes that appeal to the young: Brown & Williamson and R.J.
Reynolds have invested in sweet-flavoured brands, which do just that.

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