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October,
2004

Where Are We Headed, and
Do We Want to Go There?

Government regulation of tobacco is already here. The question is, can we stomach it getting even worse?

By Bill Greiwe

Tobacco has a long history in America. The last 100 years have seen a peak in profitability and growth followed by a decline. Those years have also been marked by business practices that have increasingly been criticized. Is the current situation solely the result of the well-documented health risks of smoking, or has the behavior of the industry also played a role in developing the current public perception? The major tobacco companies have always acted to control the industry. Have they led us to the best place? Should we continue to follow?

In my previous article I gave an overview of my perspective of the Master Settlement Agreement (MSA) ["Dazed and Confused" August, 2004]. Here I will build upon that article with additional observations about the present situation as I see it.

The current environment is confusing, to be sure, but it is also frightening because companies are going out of business and profits are-squeezed. The fact that fewer people are smoking is an overriding issue. However, there are a plethora of other issues that will impact all of us. In the face of this situation, what is one to do?

"Leveling the Playing Field"
Lets start with the progeny of the MSA. Euphemistically called the "complimentary legislation," it sounds more like an after-dinner mint than what it is, a travesty of justice. Currently over thirty MSA states have passed the "Cap Release" legislation and other parts of the package. While the verbiage in the MSA itself states that the escrow requirements for nonparticipating manufacturers (NPM) "levels the playing field," apparently, it needed more "leveling." The cap release legislation requires that NPMs leave the entire amount they deposited in escrow. Given how the payments are calculated for Original Participating Manufacturers (OPM) and Subsequent Participating Manufacturers (SPM) in the states that have passed the law, NPMs now pay the most and don't get protection from lawsuits as do the others. OPM payments are adjusted downward, with significant penalties to states which let their market share go down. Original SPMs pay no MSA on sales up to their volume level when the MSA went into effect. This is significant; two SPMs were purchased based upon the value of these exclusions. If this is level, I guess this must be some "new math." Unfortunately for the states passing this legislation, it is also the most suspect under antitrust laws. It is also disruptive to distributors and retailers as well as significantly troubling to our end customers.

In addition, a few states have passed a differential excise tax where NPMs pay an additional or higher state excise tax, adding significantly to the cost. The result is predictable; it is far more difficult for new products to be introduced and more difficult for small companies in general. To understand why this has happened, all you have to do is read the now infamous September 12th, 2003 National Association of Attorneys General (NAAG) Memorandum # 03-111 or hang out at your state legislature and watch the legion of major tobacco company lobbyists at work. Major tobacco companies have enlisted the states' enthusiastic support through fear of loss of MSA payments and a disinformation campaign.

In response to the above, small manufacturers and distributors have attempted to make their position known to state legislators. However, the courts seem to be the place where this issue will be decided. All lawsuits currently filed allege that major tobacco companies have attempted to control the marketplace and or fix prices through the MSA and complimentary legislation and enforcement. The plaintiffs and supporters are small manufacturers, smokers filing class action lawsuits, and distributors. Pundits predict there will be a smoker class action lawsuit in virtually every state. The Freedom Tobacco lawsuit in New York has achieved high profile status because an appellate judge, considered an expert on antitrust matters, determined that claims the statute violated the Sherman Act and Equal Protection Clause of the constitution should not be dismissed. All of these lawsuits are informative and interesting reading.

The strict contracts introduced by the majors, along with restricting shelf space by moving to self service, drew significant fire. The majors backed down on some contract terms after the reaction, but not before lawsuits such as the Smith suit in Tennessee were filed. These suits are less likely to be effective. I know the contracts are voluntary. But if the major tobacco companies constitute 70% or more of your sales are they really voluntary?

What does this all mean? Well, I would say it's pretty clear that the major tobacco companies continue their efforts to control the marketplace and now they have enlisted some state governments. If successful, what are the potential outcomes? Higher priced tobacco products, fewer distributors and retailers of tobacco products, possibly lower margins on tobacco products for distributors and retailers, fewer consumer choices, and angry consumers. There is another issue: do we want government to be in the business of controlling competition? The impact of this current situation is far-reaching, and it's not just McDonald's who is worried. The only people benefiting are attorneys. But wait - there's more.

In addition to the lawsuits and potential lawsuits mentioned above, major tobacco companies have a number of other significant litigation issues. A new "Lights" lawsuit has sprung up in Massachusetts. My guess is that there will be others. Remember the threat of bankruptcy and no MSA payments that arose when the Illinois "Lights" suit began. The Florida Engle lawsuit has been revived. Finally, the Federal Department of Justice (DOJ) RICO lawsuit is moving forward seeking disgorgement of $280 billion. These numbers are mind-boggling; the total exposure appears to be over one-half trillion dollars by my rough estimate. Can the major tobacco companies absorb this cost on top of the MSA payments? I don't see how they could. But wait - there's even more.

The industry is now even more consolidated, despite the objections of Federal Trade Commission (FTC) staff. The knowledgeable and principled, but apparently powerless FTC staff also raised concerns about the MSA. Why hasn't the FTC stepped in? The FTC has always been one of the great American institutions that has righted wrongs and prevented abuses, including tobacco company abuses, in the past. Where are they now?

In the "be careful what you wish for" department, Congress is considering a Federal buyout of tobacco farmers' quotas that includes FDA authority over tobacco. When this was written, the Senate had passed a version of a tax bill with FDA authority which must be reconciled with the House version which does not. Here the major companies are at odds with each other. The company promoting FDA inclusion - through lobbying, drafting legislation, public relations, and working with the FDA to develop the regulatory process - hopes to gain more overall market share with the addition of low-tar and low-nicotine products and to raise a barrier to entry for others. Additionally, they hope to reduce their litigation risk exposure with the FDA imprimatur. I support farmers, especially small farmers. They are as fundamental to America as the "American spirit," the Constitution, and the Bill of Rights; they deserve our respect and our support. Personally, I think it is dangerous to believe you can control the Federal government. Also, low-tar and -nicotine products have been tried before, most recently by Vectra, and failed. Our customers must like the product; this is not the former Soviet Union, where you simply took your products the way the state provided them.

The World Health Organization has a tobacco initiative of their own, fueled in part by the information in the documents put up on the Internet by the major tobacco companies as part of the MSA. This far-reaching policy seeks further control over tobacco world-wide and could have a profound impact on major tobacco companies. The U.S. signed the treaty in May, 2004 and to my knowledge has not yet ratified it.

Our situation reminds me of the plot of a film noir movie, the largely black-and-white films popularized in the 1950s with hapless innocent protagonists plagued with a series of mishaps leading to their downfall. What is to be done?

Following are some first steps that might be taken by distributors and retailers:

  • Instead of letting major tobacco companies develop the initiatives that define you, take charge of your image. For example, given the health issues with smoking, none of us want underage people to smoke. Distributors, retailers, and their organizations, as well as publications focused toward them, should develop their own initiative to prevent underage smoking. They should let the public know that they are separate from Big Tobacco, and that they care about their customers.
  • Trade organizations should inform themselves of all the perspectives on issues and develop policy which benefits their core members, i.e. distributors and retailers. Distributor and retailer organizations and events focused on tobacco are heavily funded by major tobacco companies. These organizations often include representatives from major tobacco companies on their boards. At minimum, small tobacco company representatives should be invited onto the boards of these organizations to present a balanced approach to policy making.
  • Publications focused on tobacco distributors and retailers should present a fair and evenhanded perspective. I am very grateful for the vision and courage of the publisher and editor of this magazine.
  • Finally, in a time of uncertainty, Business 101 and our lessons from the rocky stock market tell us to diversify. The best risk management is to place several bets. I believe that distributors and retailers should identify products from small tobacco companies - such as ours, Cheyenne International - who follow the rules and have a long term approach to the business.
Given the situation major tobacco companies are in today it is prudent to take on products from companies which don't have those issues or the negative baggage. I do not expect our company to replace a major tobacco company, but I think it makes good sense to not limit your customer's options. After all, no one knows what the future holds - not even the major tobacco companies.

Bill Greiwe is founder and president of Cheyenne International, LLC, a compliant, non-participating manufacturer of cigarettes based in Grover, N.C.


SMOKESHOP - October, 2004