Key Issues

“There have been modest tax increases at the federal and provincial levels since the tax rollbacks of February 1994 that resulted in significantly lower retail prices in the major provinces of Eastern Canada. These rollbacks have been very effective in bringing about the virtual elimination of international smuggling of tobacco products into Canada from foreign jurisdictions. RBH is adamantly opposed to such activity as it undermines the legitimate Canadian tobacco industry, its employees, shareholders, wholesalers, retailers and consumers, as well as government tax coffers.”

—1999 Annual Report of Rothmans Inc., the majority shareholder of Rothmans, Benson & Hedges Inc. (RBH).

Introduction

On Dec. 21^st, 1999, the Canadian federal government announced that it had filed a civil suit, under the United States Racketeering-Influenced Corrupt Organizations (RICO) statute, against Canada’s No. 3 cigarette company, RJR-Macdonald (now JTI-Macdonald), the Canadian Tobacco Manufacturers’ Council, the R.J. Reynolds Tobacco Company and various related companies. This suit stems from allegations of direct tobacco industry involvement in the smuggling of cigarettes into Canada in the early 1990s, and in particular from the U.S. criminal conviction of an RJR subsidiary, Northern Brands International, in December 1998. The federal government provided an initial estimate of damages of $1 billion U.S.; under RICO law, this would almost certainly be tripled in any award, for a potential liability of $3 billion U.S.

The federal lawsuit focussed public attention on the potential civil and criminal liability of the entire Canadian tobacco industry. Indeed, a recent in-depth investigative piece in the Montreal Gazette claimed that all three major tobacco companies could be linked to smuggling activity. (See William Marsden, “Tobacco insider talks: major firms were deeply involved in cross-border smuggling, former executive says” Gazette, Dec. 18^th, 1999.)

With the exception of Marsden’s work, virtually no specifics have been mentioned publicly with respect to RBH’s potential liability. In part, this is because the company that ultimately controls RBH, Rothmans International B.V. of the Netherlands, has few substantial interests in the United States and has therefore largely escaped the document discovery process that has forced open many of the secret files of British-American Tobacco, R.J. Reynolds, etc. Moreover, no whistle-blower has yet emerged publicly to talk about RBH involvement in smuggling, as occurred with RJR-Macdonald.

However, the largest US-based multinational, Philip Morris, has a 40% stake in Rothmans, Benson & Hedges — and many of its formerly secret documents are subject to various court orders requiring public disclosure. Moreover, in November 1998, Philip Morris disclosed in an SEC filing that it had been subpoenaed as part of grand jury investigations in the United States with respect to the alleged smuggling of Canadian-brand cigarettes. This filing does not make it clear whether the investigations are related to Philip Morris’ partnership with Imperial Tobacco with respect to making Canadian-style Player’s available in the United States, or whether they stem from Philip Morris’ relationship with RBH.

What information about RBH involvement in smuggling can be gleaned from Philip Morris documents? The following sections set out the evidence.

Canadian Cigarette Exports (in billions) to the United States, 1980-1998

Graph from Surveying the Damage: Cut-rate tobacco products and public health in the 1990s, a report of the Canadian Cancer Society, the Non-Smokers’ Rights Association, Physicians for a Smoke-Free Canada and the Québec Coalition for Tobacco Control. Sources: Statistics Canada, Exports by Commodity, Catalogue 65-004, December issues, 1980-1998. See Appendix A. Table J.

Getting over the trademark hurdle

“Early in the fiscal year, the federal government suspended the export tax on tobacco products, recognizing that the imposition of yet another tax did not represent a solution to problems created in the first instance by high taxes. At considerable expense to RBH and the industry, special markings were incorporated on all duty-free and export tobacco products, in an effort to assist law enforcement officials and government authorities in their anti-smuggling activities. While this and other efforts were undertaken by RBH and the industry to deal with the smuggling problem, none of the initiatives to date proved effective. We remain convinced that the only workable solution will ultimately prove to be lower taxes.”

— 1993 Annual Report, Rothmans Inc.

“During the year, RBH entered into contract manufacturing agreements with Philip Morris and Tobacco Exporters International for certain trade-marks controlled by each of the companies in the United States. The marketing, sale and distribution of these trade-marks in the U.S. market are handled by these two Corporations. The increasing demand for Canadian tobacco products in the lower tax U.S. environment has resulted in significantly increased exports of these trademarks to these two customers.”
— 1993 Annual Report, Rothmans Inc.

In the spring of 1992, according to Philip Morris documents, complicated negotiations were already underway between Philip Morris USA, Philip Morris International (PMI, responsible for duty-free sales in the U.S., as well as exports to other countries), RBH, Rothmans International, and Tobacco Exporters International (TEI, a Rothmans International subsidiary) with a view to ensuring that Canadian-made, RBH-brand cigarettes would continue to be available in the United States. Several trademarks used by RBH in Canada were controlled by TEI in the United States, but were scheduled to revert back to Philip Morris in November 1992. [*See memo from Mark Kilpatrick, Operations Planning, Philip Morris USA, dated June 15, 1992 — in Adobe PDF format.]

Crucial issues included who would have control of the trademarks in the US and what price RBH would charge its various partners for exports of its cigarettes to the United States — from where, of course, most cigarettes would be smuggled back into Canada.

In April 1992, Philip Morris USA employee Tim Beane prepared an analysis of a negotiating position proposed by Philip Morris International:

“As I understand it, the joint venture’s profits would be divided as follows: PM would keep 100% of the profit from volume destined for the U.S. and 50% of the profit from volume destined for Canada.”

[*Memo from T.P. Beane to H.G. Steele, April 17, 1992 and attachment thereto]

However, Beane noted, between 74.5 and 93% of the two billion cigarettes involved in the proposed deal could be expected to “go back to Canada,” making the proposal a bad idea in his opinion.

By October, the various parties had clearly come much further in their negotiations. A Philip Morris document indicates that RBH U.S. volume was expected to amount to 4 billion cigarettes per year, of which Philip Morris would distribute 75% (brands: Rothmans, B&H, Mark 10 and Viscount), while TEI would handle the rest (brands: Craven “A”, Number 7 and Belvedere). [*“Pricing Scenarios: RBH U.S. volume,” chart dated October 1992]

The only remaining issue to be thrashed out was the price RBH should charge Philip Morris and TEI for cigarettes being shipped south of the border. One fascinating document, by an unidentified author, but found in the files of Philip Morris CEO William Campbell’s office, examines RBH and Philip Morris proposals in detail. In particular, both companies proposed different prices for three categories of sales:

• U.S. Domestic (i.e. RBH cigarettes sold fully taxed in the United States)
• U.S. Duty Free, “Accounts with verifiable U.S. retail sales (airports, border shops, etc.)”
• Other U.S. Duty Free.

Now, what are U.S. duty-free accounts with no verifiable U.S. retail sales? There are two obvious possibilities:

• Cigarette exports in transit to third countries (but why would they go through the U.S., rather than ship directly from RBH’s factory in Quebec City?)
• Smugglers, or distributors who supply to smugglers.

The same documents provide a breakdown of RBH’s estimated “U.S.” volume. According to Philip Morris, RBH booked only 10.9% of its 1992 “U.S.” volume in categories 1) and 2), i.e. as tax-paid U.S. sales or sales to duty-free accounts with verifiable U.S. retail sales. Fully 84.7% (=1.6 billion cigarettes) was attributable to category 3), “other” U.S. duty-free accounts. (The balance went to the Bahamas.)

Another anonymous document, dated Oct. 16, 1992, indicates that at least some Philip Morris executives were leery about setting different prices for cigarettes supplied to smugglers and those distributed through “accounts with verifiable U.S. retail sales.”

One issue is how we will distinguish between the duty free components when ordering from RBH. To avoid this, we could go with one fee for all duty free…

Later, the same writer noted:

Since RBH would get higher fees for duty paid (domestic U.S.) business, it would encourage RBH to support our efforts to migrate the business from duty free to duty paid channels.

Less than two weeks later, a Philip Morris employee nonetheless recommended accepting the principle of setting different prices for cigarettes destined for accounts with “no verifiable U.S. retail sales.” [*“Comments on RBH,s Offer, October 27-28, 1992”]

Philip Morris and RBH appear to have scheduled a meeting to finally hammer out the issue on Nov. 9, 1992. In preparation, Philip Morris prepared a document entitled “Possible Negotiating Strategy for 11/9 RBH Meeting.” This document contains the following startling recommendations as to how Philip Morris should respond to RBH’s latest offer:

• State that focus of the discussion should be on Other Duty Free since nearly 90% of the volume is through that channel.
• State that, upon further review, we do not believe a significant portion of Other Duty Free can be shifted to domestic…
• State that we would prefer one duty free price, at a level which allows us some profit for the “retail” duty free portion.

No copy of the final agreement between Philip Morris and RBH could be found in the Philip Morris discovery documents.

RBH’s contingency plan to beat the export tax

On Feb. 12, 1992, the federal government slapped an $8 per carton export tax on Canadian cigarettes in an attempt to cut off supply to smugglers on the U.S. side of the border. Exports of Canadian cigarettes slowed to a trickle, but the Canadian tobacco industry lobbied heavily (and successfully) to have the tax repealed, promising to co-operate with the government to find other ways to thwart smuggling.

In 1993, given the lack of results from this industry “co-operation,” the federal government seriously considered re-introducing the export tax. RBH developed a contingency plan, outlined by Joe Heffernan in an April 19, 1993 letter to Philip Morris CEO William Campbell:

RBH has been working for several months on a contingency plan to ensure continued supply to Philip Morris U.S.A. and T.E.I. should manufacturing in Canada become prohibitively expensive. We have now managed to reach a general understanding with Rothmans International Tobacco Limited regarding manufacture of all brands in the U.K. and the Republic of Ireland (see attached letter)… Import duty, currently paid by Philip Morris U.S.A. and T.E.I. on all domestic volume, would increase due to higher duty rates from the U.K. and Ireland than from Canada. RBH proposes that this difference in duty be absorbed by RBH, as a credit on our invoice, or a price adjustment.

Conclusion

Formerly secret Philip Morris documents, obtained through lawsuits in the United States, indicate a multi-million-dollar potential liability for Rothmans, Benson & Hedges of Canada with respect to cigarette smuggling. Why?

• RBH shipped large quantities of cigarettes — up to 1.6 billion in 1992 alone — to the United States, apparently in full knowledge that these were destined for duty-free accounts “with no verifiable U.S. retail sales.”
• When Philip Morris decided to muscle in on RBH’s business by re-taking control of popular RBH trademarks in the U.S. market, the two companies began negotiating frantically to divide up the spoils. Philip Morris USA appears to initially have believed it could convert RBH shipments to the United States into legitimate, duty-paid sales (e.g., to Canadian visitors). Later, Philip Morris USA appears to have accepted that this was not going to happen, and clearly believed that it was possible to distinguish between U.S. duty-free accounts with and without “verifiable U.S. retail sales.”
• When faced with the prospect of an export tax, RBH publicly maintained that it was doing everything possible to help authorities defeat the smuggling problem. At the same time, it was secretly preparing a contingency plan to continue supplying Canadian-style cigarettes to Philip Morris USA, and to Tobacco Exporters International, by moving production off-shore.
• RBH consistently maintained in public that the only solution to cigarette smuggling was to slash taxes. At the same time, the Canadian Tobacco Manufacturers’ Council, of which RBH is and was a member, was commissioning “studies” indicating that high taxes did not reduce youth smoking or overall cigarette consumption. When taxes were slashed, RBH benefitted handsomely, and can expect to profit for many year hence, from a rapid increase in youth smoking in Ontario, Québec and other provinces.