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Copyright © 2005
Tobacco Outlet Business
Updated September 24, 2005

On November 23, 1998, the major U.S. tobacco companies and 46 states signed the Master Settlement Agreement (MSA). As a result, lawsuits against the major manufacturers filed by the states were eliminated, advertising and marketing of cigarettes became much more limited, and the major tobacco manufacturers agreed to pay up to $246 billion over the next 25 years to the states to be used to support anti-smoking efforts.

Since the MSA was signed, the non-Big Four manufacturers’ share of the U.S. cigarette industry increased from around 2.4 percent in 1998 to around 10 percent in 2003, or a compound annual growth rate of 27 percent. One of the main reasons for this exponential growth is due to the wide price gap between the premium and deep discount brands, which was exacerbated by the MSA structure. In our view, the MSA opened the doors and created opportunities for new entrants into the cigarette marketplace. Many of these new manufacturers fell into one of three categories:

• Those that signed the MSA as a subsequent participating manufacturer (SPM).
• Those that became non-participating manufacturers (NPMs) of the MSA, and pay into the state escrow accounts, which were established.
• Those that became non-participating manufacturers (NPMs) of the MSA, but do not comply with the state escrow accounts, or are "illegal."

Due to the lack of compliance by many new entrants into the cigarette industry, states have been losing money as the compliant manufacturers’ market share declines have led to lower MSA payments. Therefore, as more non-compliant manufacturers enter the market, states have started to enact more stringent laws and regulations to prevent these "illegal" manufacturers from slipping through the cracks of the MSA and thereby achieving a significant cost advantage.

Allocable Share Legislation: Currently the NPM (non-participating manufacturer) model statute (Exhibit T of the MSA) states that if a NPM pays more to a state on a per unit basis than the state would have received if that NPM were a signor on the MSA, then the state must refund the difference. This is often referred to as the "cap release."

Allocable Share legislation modifies the Model T statute of the MSA and eliminates the cap release, thus requiring a compliant NPM to absorb additional costs or pass them on in the form of higher prices. The current per carton escrow deposit required for the NPMs under the Model T statute is around $3.90 (which includes inflationary adjustments), which is close to the current national average MSA payment required for OPMs and SPMs.

Eighteen states passed this type of legislation in 2003, and an additional 13 (Colorado, Connecticut, Georgia, Kentucky, Maryland, Massachusetts, Michigan, Nebraska, New Mexico, South Dakota, Tennessee, Utah, Wyoming) have passed it so far this year. Eight additional states have proposed this legislation.

Quarterly Escrow Payments: Currently, non-participating manufacturers (NPMs) are required to make annual escrow payments. However, under the Quarterly Escrow Payment legislation, states have now begun to require NPMs to make quarterly payments to further ensure compliance. Requiring more frequent payments from a free cash flow standpoint, puts pressure on NPMs to increase their cigarette prices. Over the past two years, 29 states have passed this legislation; six states have proposed this legislation this year, (So far, Kentucky is the only state that has passed quarterly escrow payment.)

Stamping Prohibitions: States have also started to enact legislation to prohibit stamping agents from affixing tax stamps to cigarettes of non-compliant manufacturers, with 40 states passing this legislation over the past two years. In addition, four states have proposed stamping prohibitions.

Reporting Requirements: State law requests certain types of information by tobacco manufacturers and/or distributors in order to remain in compliance with the MSA. 40 states have passed this legislation over the past two years, and six states have proposed reporting requirement legislation. (Click here to see table for a summary of 2002, 2003, and 2004 legislation passed and pending.)

Other Legislation: In addition to the proposals mentioned above, there is also the threat of additional taxes or fees being placed on the non-Big Four manufacturers in the form of a fee. So far, Michigan and Minnesota are the only two states that have passed this type of legislation. On May 27, 2003, the governor of Minnesota signed into law a bill stating that NPMs would have to pay a $0.35 per pack fee to Minnesota. Minnesota was the first state to levy a fee against nonparticipating manufacturers. (Minnesota was one of the four states that independently settled with large cigarette companies and did not participate in the MSA.) On January 8, 2004, the governor of Michigan signed into law a bill requiring all nonparticipating manufacturers (NPMs) of the MSA to pay an "equity assessment" at a rate of $0.35 per pack of 20 cigarettes. The "equity assessment" is in addition to all other fees, assessments, and taxes levied by law and will be collected on April 15 of each year based on cigarettes sold in the previous calendar year.

We believe these bills are good news for the premium producers in these states as they raise these prices for the smaller manufacturers and narrow the absolute and relative price gap between the premium and discount brands.

Although stricter MSA legislation seems to be good news for many manufacturers, some of the compliant manufacturers (both SPMs and NPMs) feel that increased legislation could penalize those who do not deserve to be penalized and these voices seem to be getting louder and louder on the subject. Small manufacturers have either made changes to their businesses as a result of this legislation or have filed lawsuits. Below are some interesting comments from the small manufacturers about the stricter MSA legislation:

"All the new legislation is forcing NPMs to sign on as SPMs."

"Compliance requirements by the attorneys general; pricing at every little item, requesting every article in reference to our operating business. [We] can not satisfy some states—even our attorney can’t reason with some of their requests, right down to not accepting verbiage."

"States are becoming fanatics!"

"We are building our pricing strategy based on the assumption that most states will pass allocable share legislations during 2004."

"The NPMs continue to proliferate while the states are slow in enacting legislation and providing a level playing field as the MSA requires. Two previously settled states (Minnesota and Florida) have or are considering legislation that basically doubles taxes of the SPMs, creating a further disadvantage."

"Being an SPM, we believe we have greater growth potential if the playing field is leveled with the NPMs. The question is if the legislation is enacted will the states enforce the law or do little as in the past to enforce the MSA provisions?"

"We are SPMs so this new legislation will help us sell more products. Before, NPMs were a problem—some do not pay escrow. Now everybody will be in the directory list. It’s good news."

Although many of the compliant small manufacturers applaud the increased MSA legislation, many of the non-compliant manufacturers see this as a major threat. However, many of the compliant manufacturers feel that increased legislation could always backfire, like in Minnesota with the increased fee levied on all of the non-big four manufacturers (compliant or not). According to our small manufacturer respondents, Quarterly Escrow Payments and Allocable Share legislation are the two proposals they are the most concerned with.

Other small manufacturers have decided to bring lawsuits against the attorneys general that have enacted some of these pieces of legislation. One piece of legislation in particular that is meant to enact more stringent regulations, the MSA Escrow/Allocable Share legislation, is resulting in several lawsuits from the smaller manufacturers, who claim that this legislation is anti-competitive.

As stated previously, under the Master Settlement Agreement, the NPM model statute (exhibit "T" of the MSA) states that if an NPM pays more to a state on a per unit basis then the state would have received if that NPM has signed the MSA, then the state must refund the difference. This is known as the "cap release." However, the MSA Escrow/Allocable Share legislation modifies the Model T statute of the MSA and eliminates the "cap release," thus requiring a compliant NPM to absorb the additional costs. We are aware of two lawsuits that have been filed contesting this legislation:

Xcaliber, Cig Tec, and Carolina Tobacco v. Richard Leyoub (attorney general of Louisiana): On January 12, 2004, three small cigarette manufacturers (Xcaliber International of Pryor, Oklahoma, CigTec Tobacco of Charles City, Virginia, and Carolina Tobacco Co., of Portland, Oregon) filed suit against the attorney general of Louisiana contesting the MSA Escrow/Allocable Share legislation. The suit accuses the state of Louisiana of enacting legislation to preserve "Big Tobacco’s" market share and artificially propping up the major producers’ settlement payments to the states. The lawsuit, which was filed in the U.S. District Court in New Orleans, asked the court to declare the Louisiana law unconstitutional. These three small manufacturers believe this legislation was designed to increase the costs on NPMs and "thereby squeeze them out of business or, at least, inhibit their business development." The National Association of Attorneys General says such laws closed a loophole that gave upstart cigarette companies a price advantage over companies that signed the MSA.

Freedom Tobacco v. Elliot Spitzer (attorney general of New York): Freedom Holdings Inc., a company that imports cigarettes from foreign manufacturers for resale in New York, sought to enjoin (to legally prohibit or restrain by injunction) enforcement of the Contraband Statutes, which were passed to address cigarettes manufactured abroad, on behalf of itself and similarly situated parties.

The action was filed on April 16, 2002, against the State of New York in the United States District Court for the Southern District of New York. Freedom alleged a number of constitutional violations as grounds for invalidating the Contraband Statutes. In response, the State filed a motion to dismiss. Judge Alvin K. Hellerstein (District Court Judge) concluded that Freedom’s complaint failed to state an actionable claim and dismissed the case on May 14, 2002.

Freedom pursued an appeal in the U.S. Court of Appeals for the Second Circuit. On January 6, 2004, the Second Circuit reversed the district court and sent the case back to the district court.

On May 24, 2004, oral arguments took place before Judge Hellerstein. However, because it took so long to get through the the mechanics of the MSA, the Judge set another date for oral arguments. Our legal counsel, which will be attending that session, believes that since the appellate court overruled Judge Hellerstein’s decision to dismiss the case (the Judge hearing the oral arguments was the same judge who dismissed this case originally), he wants to be very careful that he understands exactly what is going on and that is why he focused so much on the details of the Master Settlement Agreement.

In our opinion, although we believe these cases will eventually be dismissed, we are slightly concerned with the increase in "chatter" among the small manufacturers that are interested in participating in suing the states and attorneys general. We have heard anecdotally that other small manufacturers may be getting retailers and wholesalers together to file suit against other states as well. We will be monitoring this situation closely. •

Copyright © 2005 Tobacco Outlet Business