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Copyright © 2005
Tobacco Outlet Business
Updated September 24, 2005

In 1998, as everyone in the industry knows, major manufacturers and 46 state attorneys general solved an intense and costly dispute by inking the complex $246 billion Masters Settlement Agreement (MSA). In the six years that have since passed, the MSA’s provisions accomplished pretty much what both parties had agreed on—namely lining state coffers with funds ostensibly earmarked for tobacco-related healthcare services, reducing overall smoking, and, arguably, penalizing major manufacturers without putting them out of business.

Yet, today the MSA is under fire, its constitutionality being questioned in courts. What’s more, a host of states have passed or considered passing "complementary" legislation—allocable share and equity assessment statutes that apply to non-MSA participating manufacturers—that will once again dramatically affect the tobacco landscape.

What’s fueling this renewed controversy and the need to "fix" the MSA? In short, it seems that in solving the dispute between Big Tobacco and 46 state attorneys general, the MSA laid the groundwork for today’s equally fierce battles.

These days, Philip Morris, B&W, RJR, and Liggett—or the original participating manufacturers (OPMs)—and their non-participating manufacturer (NPM) competitors don’t agree on much. But they do concur on the basic inception and structure—and to some degree, the intent—of the MSA agreement, which goes something like this:

In contemplating the sums involved in the MSA, the OPMs and state attorneys general (AGs) recognized that OPMs would have to raise prices to make their MSA payments. The resulting market share shift as consumers turned to lower-price, non-MSA brands would, in turn, jeopardize those payments, which are made on a per pack sold basis.

"The states were concerned that these [competitors] would be fly-by-night operations and there would be no money available in the event that those companies would later have to be sued for irresponsible business practices," asserts Mark Berlind, VP and legislative counsel for Altria. "The other aspect is that the states had and have an interest in preserving their MSA settlement payments, and those payments would decline as the volumes of the participating manufacturers decline."

To address that concern, the OPMs and AGs did two things:

• Recruited existing manufacturers with the option to join the MSA as subsequent participating manufacturers (SPMs) with a "market share exemption" that allows SPMs to sell 125 percent of whatever their cigarette sales were in 1997 or 1998 (whichever is higher) before being subject to the MSA payments.
  
• Outlined a statute that states would have to pass and enforce to receive their allotment of the MSA funds. Each of the 46 states in the settlement subsequently passed this statute, which mandates that NPMs pay a sum on par with the required MSA payment into escrow.

"Basically it’s a statute that fully and effectively neutralizes the cost disadvantages of the participating manufacturers vis a` vis the NPMs," explains Kevin Altman, a consultant to the cigarette industry working with the Coalition of Independent Tobacco Manufacturers of America (CITMA) on the compliance issues of NPMs. "In other words, they were saying, ‘You have to put a burden on people who don’t sign that equates to the burden participating manufacturers will have.’"

In theory, the statute would level the playing field—participating manufacturers would be subject to $3.92 per pack in MSA payments [2003 rate], while NPMs would pay $3.92 into escrow accounts. (The escrow funds would be refundable after 25 years unless the states pursued litigation against them.) "But the statute goes on to say that in the event an NPM pays more to a state on a per stick basis than the states would have received had they been a participating manufacturer, a refund shall be given to that NPM," says Altman.

And there lies the problem. That provision of the statute means that an NPM doing business only regionally is entitled to a refund—called the cap release—of the portion of its escrow payments that would be allocated to states in which it does not sell. An NPM, for example, which sells cigarettes only in Virginia, would pay the full $3.92 in escrow and then file for a refund or cap release of all but Virginia’s share—2.03 percent—of that money. In Virginia, that translates to an effective escrow payment of just 9.4 cents, which, in turn, translates to a big price advantage for NPMs.

Six years later, with smoking on the decline and NPM’s market share creeping up, participating manufacturers and state legislators are crying foul. "Some companies have exploited that allocable share loophole and are getting the vast majority of their escrow payments back," says Berlind. "It was intended as a gesture of fairness to make sure companies didn’t get overcharged by the sates. But by driving all of their volume to a few states, these companies are paying pennies on the dollar to what the states have been getting."

Needless to say, NPMs see it differently. "The National Association of Attorneys General (NAAG) is having everybody believe that years later we figured out this loophole," says Everett Gee, whose company, S&M Brands, declined to participate in the MSA in 1998. "That is bullshit. The statutes were clearly intended to operate that way. [That wording] was there because they were worried about constitutionality and antitrust issues."

"I don’t believe it was a loophole," agrees Ron Tully, a vice president at North Atlantic Trading Company, a premium brand NPM that chooses to pay the full escrow amount without filing for a refund. "It was negotiated at the time the MSA was put together, it is what the large tobacco companies, the SPMs, and the state attorneys general agreed to at the time."

Gee, Altman, and representatives from other NPMs are the first to concede that under the current wording their products have a price advantage over those of the OPMs, but in their view that’s justified. The settlement fees, they charge, were intended for companies, as Gee puts it, who "got away with egregious conduct for decades while making billions." Why, he asks, should NPMs have to pay those damages? After all, many of were not in business prior to 1998, and none participated in the behavior the big companies were charged with—namely covering up the health effects of smoking and advertising geared toward America’s youth.

As a relative newcomer on the tobacco landscape at the time, S&M’s market share was not large enough, he adds, for the market share exemption being granted to SPMs to be appealing. "We were .05 percent of the market, so we talked to the states and asked them, ‘Is this the deal or will there be changes?’ They said, no, it can’t be changed. So we gave up the market exemption we could have had on the reliance of that promise and now, five years later, they’re coming back and changing it."

That change is coming in the form of state legislation. In effect in Minnesota and Michigan and under consideration in several other states is a bill that would require all but the Big Four companies and Liggett to pay a 35 cent per pack fee. But by far more popular is "allocable share legislation," a measure that has already been passed by 19 states and essentially modifies the escrow statute described in the MSA. Supported by NAAG and by several OPMs—including Altria’s Philip Morris USA—this legislation eliminates the cap release for NPMs. OPMs and SPMs say it levels the playing field. But NPMs point out that what it really does is tip it in the other direction.

"They want to make non-MSA companies pay into escrow based on the full assessment, which this year was $3.92," says Bob Rowland, executive director of the Kentucky Association of Tobacco Outlets, who points out that, thanks to various conditions and exemptions, MSA payments average far less than that $3.92. "There are offsets and deductions that allow them to reduce their payments; last year, for example, the OPMs paid on average $2.70 a carton."

What’s more, significant tradeoffs are involved in paying escrow fees versus making MSA payments. First, MSA payments can be deducted as a business expense, escrow payments cannot. Second, NPMs face significant regulatory burdens and legislative risks as a result of their non-MSA status. "The barriers to entry are very high unless you’re a signator to the MSA," says Tully. "We have to go through a onerous and costly registration process in each state."

"Is there an advantage for an NPM against participating manufacturers who have to pay the full amount?" asks Gee. "Yes, there is. But what do they get for that advantage? They can never be sued by the states and I can. They also don’t have the hassle of being an NPM, having to register with each state and argue about stick counts."

Even as they dispute the so-called loophole, many NPMs are willing to compromise. "We have no culpability in the fraud and deceit that brought about the MSA, but we are realistic," says Rowland, whose association representing Kentucky outlet owners, manufacturers, and wholesalers, proposed an alternative to Kentucky’s legislature. "We know the states are having monetary problems right now, so we’re willing to pay—we just want to pay a fair amount.

"Manufacturers who sell cigarettes in the state of Kentucky agreed to be assessed at the average of what the SPMs are assessed," he says, "to pay to the state—not into escrow—$2.08 a carton, but they turned us down."

Similarly, CITMA attempted to propose an alternative to the allocable share legislation, says Altman. "We came up with a manufacturer assessment that would truly level the playing field," says Altman. "The way it works is that all manufacturers, in or out of the MSA, will pay the state an amount per carton for doing business. The states would then credit any MSA payments or escrow payments against that amount." With a manufacturer assessment amount of, say $4, OPMs and SPMs would receive a credit for their MSA payments and NPMs would be credited for any funds paid into escrow so that all manufacturers, one way or another, were brought to a $4 payment level.

While the manufacturer assessment is under consideration in Alabama, the OPMs oppose the idea. "What they would do is essentially convert the MSA into a tax, violate many core provisions of the MSA, and put the settlement in direct jeopardy of collapsing entirely," says Berlind. "The states can’t simply pass a statute that says we will take some of the provisions of the MSA and codify them, disregard others, and substitute a mechanism for a private contract."

"They say it’s a change to the MSA, but isn’t changing the way NPMs have to pay a change to MSA?" counters Altman, who also notes that with the MSA currently being challenged in a New York Court the assessment is a timely option. "Freedom Holdings sued the state charging an antitrust violation under the Sherman Act. If the judgment goes against the state, it faces losing its MSA payment. Our assessment offers them a seamless transition."

Meanwhile, Rowland argues that the refusal to consider either of these compromises reveals the true reason why the states and OPMs support the allocable share legislation "You would think these lawyers and lobbyists for the big manufacturers were Michael Jackson or Mikhail Baryshnikov the way they moonwalk and pirouette around this thing," he says. "You can slice and dice it anyway you want, but the intent of this legislation is to force these companies to have to raise the prices to a level which would make them unable to compete."

Why would state legislatures adopt a measure with a nefarious purpose? In the end, it all comes back to revenue, says Rowland. "Just as people get addicted to cigarettes, states get addicted to tobacco money," he asserts. "They go into DTs when that money starts getting cut off and lose sight of basic principles of free enterprise."

States, after all, receive funding from the MSA—little of which goes to funding the healthcare purposes for which it was intended—while escrow payments are just that—held in escrow, and therefore untouchable. "The states have a lot at stake to make sure that the big manufacturers’ share continues to be steady, if not to grow," points out Bonnie Herzog, a managing director at Smith Barney. "The MSA put them in bed with the manufacturers. Many of them are now dependent on that. It’s where they get the bulk of their money and they will fight for that."

Enormous budget pressures coupled with aggressive lobbying from large manufacturers are fueling the passage of the cap bills, agrees Louisiana Senator Fred Hoyt, a retail veteran and owner of a chain of tobacco stores. "The majority of states are in a financial hole looking for pocket change under the sofa any way that they can," he says. "And this is one politically easy way that somebody who, in the view of the legislators should be caught up within that MSA but is not, can be brought in."

In fact, that interest grows with every point of market share lost by the participating manufacturers, points out Berlind, who notes that the MSA includes a provision that a decline in market share for the OPMs would result in significantly lower MSA payments. "Under a complex formula written into the MSA, to the extent that, first, volume of participating manufacturers is supplanted by NPMs’ volume and, second, a state is failing to ‘diligently enforce’ its escrow statute, the volume adjustment could be multiplied by as much as three times," he says. "And if only a few states fail to maintain a valid escrow statute, or to ‘diligently enforce’ it, those states could bear the brunt of the entire nationwide volume adjustment.

A memo from NAAG supports that premise. "It should be stressed that NPM sales in any state hurt all states," states the memo, which estimates that of the $2.5 billion reduction in MSA payments due to states on April 15, 2004, approximately $600 million is the result of increased NPM market share. "All states have an interest in reducing NPM sales in every state."

"NAAG is pushing this legislation like you wouldn’t believe," says Rowland. "And there’s a provision in the MSA that says once the combined market share of OPMs and SPMs reaches 99 percent, guess who gets $300 million from the MSA? NAAG."

There’s more than money at stake for states, according to OPMs. "It is in the state’s interest to have those marketing and lobbying restrictions and the commitment not to misrepresent the issues of smoking and health, as well as the MSA payments observed," says Berlind, who also acknowledges that Philip Morris’ brands will benefit from the new legislation. "When the states are getting more settlement payments from the participating companies, it means that the participating companies are selling more volume relative to the NPMs."

But to NPMs, the end doesn’t justify the means—namely Big Tobacco, NAAG, and state legislators effectively teaming up to run NPMs out of business. "We have gone from being a favorite of the states—a company that brought jobs to our state and buys American tobacco—to being treated like bandits," says Gee. "It’s the saddest thing I’ve ever seen."

"They are doing this to force the NPMs out of business," asserts Altman. "And it is a sad day in this country, which was founded on free enterprise, when the Goliath companies have to go to the legislators to compete against the Davids." ¤

Copyright © 2005 Tobacco Outlet Business