Legacy Funding to End in 2003
Per the following WSJ article, and due to Section IX(e) of the 1998
Master Settlement Agreement (MSA) between tobacco companies
and State Attorneys General, it appears almost certain that
Participating Manufacturers will not be required to fund the American
Legacy Foundation after March 31, 2003. In drafting the MSA, the
tobacco industry correctly anticipated that competing Nonparticipating
Manufacturers could easily possess .05% of the US cigarette market
share by 2003, a level that exempts Participating Manufacturers from
making future payments to the American Legacy Foundation. This
is another reason why it is critical for State Legislatures to appropriate
significantly more settlement funds for tobacco control programs.
Source: Bill Godshall
Tobacco Settlement Causes a Rise In Makers of Low-Price Cigarettes
Page One Feature
by Gordon Fairclough / firstname.lastname@example.org
The Wall Street Journal Interactive Edition, Tuesday, 5/1/01
DENTON, Texas -- No sign hangs outside Alex Hemani's small factory
across from an auto-body shop in this Dallas suburb. "We're not doing
anything illegal," Mr. Hemani says. "But we like to keep a low profile."
Mr. Hemani makes cigarettes. Behind the doors of his beige, metal-clad building,
clanking 1960s-era machinery churns out packs of
discount smokes for customers around Texas.
A 34-year-old Pakistani immigrant, Mr. Hemani once ran a
convenience store and later a supply business serving other mom-and-pop retailers.
Since last year, he has poured more than $1 million
in savings into Patriot Tobacco Co.
Despite the tobacco industry's blackened reputation and the lawsuits
that have pummeled the big cigarette makers, Mr. Hemani sees gold
in Patriot's red-white-and-blue packs. "If I can make the cigarettes,"
he says, "I know that I can sell them."
Premium cigarette prices are up, making room for new discount
brands such as these.
The rise of Patriot and other small makers of low-price cigarettes is
an unintended consequence of the legal settlement reached between
the major manufacturers and 46 state governments in November
1998. In that landmark deal, the states sought to recoup the cost of
caring for sick smokers. The states and public-health advocates also
expected the sheer size of the settlement -- a combined $206 billion
over 25 years -- to discourage smoking by forcing the large tobacco
companies to raise prices. The big manufacturers have done just
that: Wholesale list prices, excluding taxes, have risen nearly 80%
since the settlement.
A New Swarm
In response, upstart cigarette makers have swarmed into the market,
reversing a century-long trend of industry consolidation. They are
selling cigarettes at or below prices available before the settlement.
Some cut-rate smokes are selling for as little as $1 a pack, compared
with an average retail price of more than $3 for big-name brands, such
as Marlboro. That's a powerful draw for penny-pinching smokers.
To feed the market for inexpensive cigarettes, tiny factories with
antiquated second-hand equipment are popping up across the
country. S&M Brands Inc. makes Bailey's and Tahoe cigarettes in
a brick former school house in rural southern Virginia, while Smokin
Joes pumps out bargain-basement smokes in a factory near
Lewiston, N.Y. Other companies are contracting to have discount
cigarettes manufactured abroad.
Scores of new brands, with names such as GT One, Money and Ol'
Smoothie, have hit the shelves of gas stations and convenience
stores. Small companies have grabbed nearly 4% of the U.S. retail
cigarette market, up from just 1% in 1997. Four percent represents
roughly 16.8 billion cigarettes a year.
"I am disturbed by the proliferation of little companies," says
Oklahoma Attorney General W.A. Drew Edmondson, who heads
a panel of state legal officials overseeing the settlement with the
industry. "They are able to sell a cheaper product, and all of the data
show that the price of cigarettes particularly impacts youth smoking."
The upstarts counter that their no-frills brands aren't intended to
appeal to status-conscious teenagers.
After the initial postsettlement spike in prices, cigarette consumption
dropped 7% in 1999. Since then, the annual decrease has settled
back to the 1%-to-2% rate that has been the norm for decades,
although that pattern can't be attributed to the recent success of
In another twist, the rise in small-company sales has already triggered
provisions of the 1998 settlement that reduce the payments states
receive from the major manufacturers -- by amounts that could reach
into the billions.
And in a maneuver that state officials complain subverts the settlement,
one big manufacturer, Brown & Williamson Tobacco Corp., is making
cigarettes that are sold under the label of one of the upstarts. B&W
denies it is doing anything wrong.
Although most public attention to the settlement was focused on the
four biggest manufacturers, provisions were made for the upstarts to
sign the deal, too. Those that did so promptly are effectively allowed
to make payments to the states at lower rates than their bigger
Small companies that decline to sign the settlement are required
under state laws to pay money into escrow accounts to cover any
future state claims against them. But state officials say that some
companies are failing to make escrow payments. At least six states
-- Missouri, Nevada, New Jersey, South Dakota, Utah and Washington
-- have gone to court to try to force these companies to pay.
The settlement pegs cigarette-company payments to sales. As smaller
companies that didn't sign the pact gain market share, the agreement
allows major manufacturers to pay less. The states have already felt
the sting of this arrangement. For 1999, states say their settlement
receipts fell by a combined $190 million because of the increase in
sales by nonsigning companies. So far there has been no comparable
reduction for 2000, but that could change as industry statistics are
"If these market shifts continue, the losses to the states could easily
run into the billions and billions of dollars," says William Sorrell, the
attorney general of Vermont. States have been using the settlement
money for a wide range of purposes, from health education to road
A separate provision of the settlement threatens funding for the
American Legacy Foundation, formed under the pact to wage a
national antismoking crusade. The Washington, D.C.-based
foundation has received about $270 million a year since 1999 from
cigarette makers to pay for health education. One foundation
television advertisement depicts body bags piling up in the streets
around the New York headquarters of industry titan Philip Morris Cos.
Cushioning the Bottom Line
Starting in 2003, however, if sales by nonsigning manufacturers in
any year amount to more than just 0.95% of the market -- a level that
has already been exceeded -- industry payments for the education
campaign for that year would cease. Thus, while the new competition
is taking revenue away from major manufacturers, the settlement
cushions the effect on their bottom line and embarrassing
anticigarette messages could be stifled.
Such provisions were included in the settlement to protect the major
manufacturers' sales and profits and their ability to pay the states.
Tobacco foes now say they simply failed to anticipate the magnitude
of the surge in discount competition. "It didn't occur to us" that
newcomers could gain as much market share as they have, says
Washington state Attorney General Christine Gregoire, who helped
draft the settlement. "It was a surprise to me that it really doesn't take
a lot of capital to start a cigarette company."
The big manufacturers express ambivalence about their tiny rivals.
"We've really been hit," says Susan Ivey, chairman and CEO of Brown
& Williamson, which is a unit of British American Tobacco PLC and
the country's third-largest cigarette maker. "We've certainly had
consumers trade down to those lower-priced options."
B&W has fared the worst among the major companies since the
1998 settlement. Its sales in the fourth quarter of last year, the latest
period for which figures are available, were 35% lower than in the
third quarter of 1998, just before the settlement was signed.
But B&W has found a way to soften the low-price threat by
establishing an unusual alliance with Star Scientific Inc., the largest
company that hasn't signed the settlement. B&W now makes two-
thirds of the off-price cigarettes sold as Star brands. Thus, while
B&W profits on its contract manufacturing for Star, it helps the smaller
company activate provisions that lower industry settlement payments.
The states object strongly to "Brown & Williamson essentially aiding
and abetting" a nonsigning company "in subverting the agreement,"
says Dennis Eckhart, California's senior assistant attorney general in
charge of tobacco enforcement. California and several other states
are contemplating legal action against Brown & Williamson, he says.
B&W denies trying to undermine the state settlement. Mark Smith, a
B&W spokesman, says the company is manufacturing cigarettes for
Star to earn extra money. "We're a business, and we've been hurt," he
Mr. Smith points out that B&W is also working with Star to support the
smaller company's efforts to develop potentially less-hazardous
cigarettes. B&W has helped Star to develop and test-market a product
called Advance, which the companies say contains lower levels of
cancer-causing chemicals than regular cigarettes. B&W also has lent
Star about $29.2 million, mostly for the construction of special barns
to cure purportedly less-dangerous tobacco.
Star got its start in 1991, but the business didn't really take off until
after the state settlement in November 1998. Soon, the company's
factory in Petersburg, Va., was running practically 24 hours a day,
seven days a week, struggling to keep up with orders. Star's discount-
cigarette sales grew more than eight-fold, jumping from $20.7 million
in 1997 to $176.8 million last year. The leap in demand prompted
Star to turn to Brown & Williamson.
Paul L. Perito, Star's chairman, says the company aims to leave
the traditional cigarette business entirely in about five years. In the
meantime, he says, revenue from cheap cigarettes funds a significant
part of the company's research on reducing carcinogens in tobacco.
Star says that this fall it intends to test-market mint-flavored lozenges
made from less-toxic tobacco that give users a nicotine fix when they
Other small tobacco companies don't boast such grand ambitions.
Patriot's Mr. Hemani says he will stick to making "something cheap --
that's what people are looking for." Less-expensive cigarettes don't
taste worse, he adds, "unless it's really bad tobacco."
The hardest part of getting into the inexpensive-cigarette business
often is obtaining the equipment at a reasonable price. CigTec LLC,
in Charles City, Va., found its first production lines last year in a
factory in Nicaragua that was being shut down by British American
Tobacco. The 30-year-old machinery now hums around the clock in
an industrial-park factory. Monthly production has grown to 69 million
cigarettes, compared with about 7 million last June, the company's
first month in operation.
That still isn't much compared with the big manufacturers. At its
Richmond, Va., plant, Philip Morris can crank out 672 million
cigarettes a day. The country's largest tobacco company, Philip
Morris, makes a profit of about $4.66 a carton, according to Martin
Feldman, a tobacco analyst at Salomon Smith Barney. Discounters
make 50 cents to 70 cents a carton.
Even though the national settlement led to higher prices and helped
expand the market for discount cigarettes, small companies still
complain that it unfairly penalizes them. Star has challenged the pact
on U.S. constitutional grounds in a lawsuit filed in federal court in
Richmond. The company contended that the escrow payments it has
had to make as a nonsigning company -- $13.1 million for 2000 --
amount to an "unlawful taking of private property" in violation of the
Fifth Amendment. A federal judge dismissed Star's complaint in
March, but the company has appealed.
In the meantime, Star is looking for legal ways to avoid making
escrow payments. For example, the company says it has shifted to
selling primarily in the four states that aren't part of the national
settlement agreement and, therefore, have no escrow-payment
requirements. Those states -- Florida, Texas, Mississippi and
Minnesota -- forged separate settlements and together account
for about 15% of the U.S. cigarette market. Some state attorneys
general object, however, that many of the cigarettes Star and other
small companies sell in the four states end up being resold elsewhere.
If, after 25 years, the states don't file new legal claims against the
industry, all escrow payments are supposed to be returned to the
companies. But Star and other small companies say they are being
unjustly punished now. "Why should I pay for something the big
companies did 40 or 50 years ago?" asks Malcolm L. Bailey, chief
executive of S&M Brands, in Keysville, Va.
The little companies typically don't advertise and have lower overhead.
They are too small and haven't been around long enough to attract
What's more, companies that haven't signed the agreement aren't
bound by its marketing restrictions. S&M, for example, promotes its
Bailey's brand on T-shirts, baseball caps and camping equipment.
Tobacco companies that have signed the settlement pact are barred
from putting their logos on any merchandise.
Says Mr. Bailey: "We're selling the cigarettes as fast as we can