The State Tobacco Settlements and Antitrust

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The American Bar Association Antitrust Spring Meeting, Omni Hotel

Washington, D.C.

Jeremy Bulow, Former Director, Bureau of Economics

I'm new to the FTC, new to antitrust litigation, and new to all of you. And, as I understand it, I'm not allowed to talk about anything we're working on right now. So Paul, Phil, and I agreed that the best thing was simply for me to talk about something I actually know a little about, hopefully somewhat related to antitrust, as a way for you to get to know me a bit.

What I'm going to talk about are the recent settlements between the states and the cigarette companies, and the ways in which those settlements create, in my mind, serious structural problems. Of course I speak for myself here and not for the FTC or any of its commissioners.

In 1997-98 four states settled lawsuits against the Big Four cigarette manufacturers. In November 1998 a multistate agreement (MSA) was signed with the remaining states. Both the individual state deals and the MSA, if allowed to stand, present major problems for antitrust regulators.

The initial four settlements, with Mississippi, Florida, Texas, and Minnesota, all worked this way: The four major companies, representing 98 percent of the market, each agreed to pay a relatively small amount in damages, in proportion to their market value. The rest of the money is paid by a national excise tax on each of the companies for the benefit of that one state. So Florida now collects a tax on almost every pack of cigarettes manufactured in Virginia and sold in California. Adding up the four states, the taxes come to 7 cents a pack. I'm not a lawyer, but it hardly seems possible that such an arrangement could stand legal scrutiny.

If you don't want to call the payments under the agreements taxes, they are still problematic. I fail to see how the deal would differ from the four firms jointly putting their debts into a trust, with the trust to be financed by a fee per unit sold on each of the producers. For much the same reason that cross-licensing agreements that involve no per unit licensing payments will generally be regarded as pro-competitive, these agreements are anti-competitive. After each settlement the marginal costs of every firm rose by the same amount, leading immediately to a similar increase in prices. It is true that the four firms did not receive most of the benefit from the higher prices, but they did get the benefit of having their lawsuits settled. This is the first place where I have an antitrust concern. Here I must emphasize again that this is strictly my view and not that of the FTC.

Deals like these have the potential for unbelievable mischief, especially as the lawyers get a little more sophisticated about putting them together. For example, assume that the coal industry was a tight oligopoly. The National Resources Defense Council sues all the firms in the industry for global warming damages. It settles on the following terms: Each firm must pay the NRDC $1 per ton for all the coal it produces in the future, with an exemption of 80 percent of base year sales. Then marginal costs, and presumably prices, would rise by $1. But average costs would rise by a bit less than 20 cents (less than 20 cents because the price increase would cut sales, so that less than 20 percent of all sales would be taxed). The NRDC would get some free money, the companies' profits would soar, and everyone would be better off except the consumer.

Of course, as with cigarettes, there are many people who think an increase in the price of coal would be a good thing, precisely because of global warming. But concern with global warming does not mean that we should be in favor of firms colluding to get the price up. If it did, we certainly wouldn't have bothered with second requests in any of the recent oil mergers!

In November the MSA encompassed the remaining 46 states. A national tax of about 35 cents a pack was imposed, for the benefit of the participating states. One might say, given that all the states were now on board, isn't the national tax problem significantly muted, in practical terms? To see why not, it is important to recognize the coercive nature of the agreement. Assume that an individual state did not wish to sue the industry. North Carolina's legislature, for example, passed a bill prohibiting the Attorney General from filing such a suit. Then the state was left with the following options: (1) Participate in the settlement and have local consumers pay their share of the national tax, while the state government received its share of the revenue, or (2) Do not participate, in which case local consumers would still pay their share of the national tax but the state would not receive its share of the revenue. Some choice! Furthermore, even if a state did wish to opt out and sue on its own it would have to hope for a settlement like the first four, which was likely to become increasingly difficult to obtain.

The artifice of describing the tax collections as damage payments meant that on its face the smaller cigarette manufacturers would be exempt from the multistate agreement. But giving these companies an additional 35 cent price advantage would have been exceptionally damaging to the Big Four. Therefore the small companies were economically cajoled and threatened to sign the multistate agreement, limiting the damage to the Big Four, and as part of the deal the states are each required to pass special legislation or risk losing their share of the national tax revenues.

The small companies were paid off by a provision that said that if they agreed to become subject to the MSA they would be allowed to pocket the tax revenue produced on all their sales up to 125 percent of base year volume. Since the price of generics, net of federal excise taxes, was about equal to the subsidy per pack, this means that a small mom and pop cigarette manufacturer, with gross sales of $100,000 per month, will now be eligible for a $1.5 million annual tax subsidy for selling their uniformly high tar and nicotine cigarettes. Liggett, which sold 322 million packs in 1997, will be eligible for subsidies on up to 400 million packs. And while prior to the deal Liggett had claimed repeatedly that its plans were to raise prices with the majors and not use any per pack price advantage to increase market share, I would bet my house that they were just funning us, and in fact will get to 400 million packs as fast as economic theory says they will.

These subsidies raise two questions. First, what will the effect of subsidizing all these small firms be on competition? And second, why should a firm sign the deal if by refusing it might be eligible to sell an infinite number of packs without being subject to the deal's taxes?

Ironically, the effect of subsidizing the small firms is that, while their share will rise, their role in holding down margins will be diminished. Now, within a wide range of prices, the Big Four are certain that the small manufacturers will get a fixed market share, equal to 125% of their previous share. So the Big Four will be less concerned that raising prices cooperatively will cause them to lose share to the small firms. The general point is that a carve-out that guarantees a small firm a larger market share than it would have in a competitive market can serve to reduce rather than increase competition.

As to why the small companies would settle for only 125 percent, a crucial part of the deal is that each state is required to pass a model statute that forces any non-participating manufacturer, or NPM, to pay huge amounts into escrow, where the money would stay for decades. The money would supposedly be held against potential future liability judgements, with the practical effect of driving non-signatories out of business.

Any state that does not pass a model statute will be at risk to lose up to 100 percent of its share of the tax revenue. If the state passes a model statute but it is declared illegal in state court, then the state still may lose up to 65 percent of its tax revenue. So there is a financial incentive to appoint judges who will rubber stamp the statute.

If the companies lose more than 2 percent of the market to NPMs, which would happen if enough states failed to pass model statutes, then for every extra pack sold the states will pay the companies a little over a dollar, up to the total revenue at risk from the states that do not have valid model statutes. The terms are somewhat complicated, but a consequence is that RJR and Brown & Williamson may make more money when a smoker purchases a pack of NPM cigarettes than when he purchases their own brands. In this case, these companies will have a tremendous financial incentive to make sure they do not gain market share, and this will free Philip Morris and Lorillard to raise prices without worrying about whether their lower-priced counterparts will follow.

The settlement appeared to leave two glaring loopholes. The first applied to Liggett. Even if the model statutes could be made to apply to other companies, remember that the supposed purpose of the escrow was to act as a reserve against the settlement of liability from future lawsuits by the states. In Liggett had earlier settled with the states by turning state's evidence, the states accepting de minimus payments in return for Liggett turning over secret industry documents. So when the MSA was announced it threatened not to sign, arguing that since it had already settled with the states it would be exempt from the escrow requirements.

Essentially Liggett was trying to blackmail the other deal participants into buying it off, threatening that otherwise it would flood the market with cheap smokes. Guess what? It succeeded. Liggett received $300 million from Philip Morris for three dying brands, with annual sales of $40 million per year. $150 million was payable immediately upon Liggett signing the MSA, and non-refundable even if the FTC blocked the sale of the brands. By signing the MSA Liggett was also released from its financial obligations under its earlier deals with the states. The stock market value of Liggett's parent tripled. It is one thing to get off with a light sentence for turning state's evidence, quite another to be handed a subsidy of hundreds of millions of dollars.

Furthermore, paying a company hundreds of millions of dollars to sign a deal so that it won't flood the market with lots of cheap product is not the kind of thing that is generally endorsed by antitrust policy makers.

The second loophole is the dramatic expansion of the gray market for cigarettes. For reasons of price discrimination, the major tobacco companies have traditionally sold their export cigarettes at a discount. This problem has been exacerbated because cigarettes that are sold for export and re-imported are counted as sales by the importer rather than by the producer. So if the importer is not itself a signatory to the multistate agreement it will not be subject to the multistate tax.  While this problem will ultimately be fixed, it is currently causing a significant market distortion.

My view of the appropriate way for the multistate agreement to have been formulated is as follows:

The deal could contain the same marketing restrictions and the same $2.4 billion in damage payments as under the current MSA. For the rest, the companies could agree to not object to a 35 cent or so per pack increase in the excise tax on cigarettes in every state. States that had contingency fees with their lawyers would be obligated to honor those contracts, with fees determined by the damage payments. I estimate that this would lead to a total fee for all the lawyers involved of about $250 million. Still an enormous amount of money, but only about three percent in present value of what the lawyers will collect under the MSA. Of course, if any state wished to revise its contract and pay its lawyers more, that would be up to that state's legislature. And if any state wanted to give Liggett or other small companies a tax subsidy up to the amount in the MSA, the legislature would have the authority to do that as well.

So why do we have the byzantine MSA instead of the relatively neat agreement that I've just described?

As best I can tell, four reasons. First, there may have been some concern that if the structure that I proposed was used not all states would have passed the tax increase. This would have led to more smuggling across state borders and reduced revenues for the participating states. Second, the lack of transparency is a key to paying the lawyers so well since there would be a tremendous hue and cry about literally paying them a percentage for getting a tax increase passed. Third, there may have been a view that it would be easier to pass the requisite model statutes than the comparable excise tax increases. Fourth, it was in the interests of everyone including the producers to claim that the companies had been hit hard by the settlement, an easier claim to make if the revenues are characterized as damage payments from the companies rather than tax payments by consumers.

Going forward, the Justice Department is now suing the tobacco companies. I regard this as an opportunity to fix the problems with the multistate deals. A new more global settlement covering both the federal claims and the state claims could be negotiated and then endorsed by Congress. Such a settlement could displace the existing state settlements. If Congress signs off on a deal that includes a national tax, that's fine by me. At the same time, the loopholes for small companies and importers, and the exorbitant fees being paid to the plaintiff's bar could be fixed. But the probability of all this happening is not as great as I would like.

Another possibility is that someone will file a class action suit against the MSA and the four individual state settlements, on behalf of smokers, on some of the grounds I have suggested. Perhaps such a suit would lead to a much desired restructuring of these deals. But there has only been limited legal activity objecting to the settlement. Why can't we find a good trial lawyer when we really need one?

1. This speech represents the opinion of the author. It does not represent the opinion of the Federal Trade Commission or any of its Commissioners.