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Tobacco Arbitration Begins with Chicago Hearing

An arbitration proceeding involving a potential reduction in payments of over a billion dollars to the states—and the first opportunity to clarify key sections of the landmark 1998 tobacco Master Settlement Agreement (MSA) entered into by more than 50 tobacco manufacturers (known as Participating Manufacturers or PMs) and 52 states and territories (known as Settling States) -- began in earnest July 20 in Chicago. That is when representatives of the Settling States and the PMs met for their first in-person arbitration hearing. The hearing outlined the contours of the arbitration, touching on everything from scheduling to venues for future hearings and discovery. The arbitration is being overseen by a three-member panel of former federal court judges: Abner Mikva, Fern Smith, and William Bassler. Panel selection was completed July 1.

The arbitration centers on a portion of the MSA known as the “Non-Participating Manufacturer (NPM) Adjustment.” Under the MSA, the Settling States released the Participating Manufacturers from claims for the health care costs incurred by the States caused by sales of the Participating Manufacturers’ cigarettes in exchange for (i) a broad array of restrictions on the advertising, marketing and promotion of cigarettes and (ii) annual payments made in perpetuity by the PMs to the Settling States. An annual payment– which in 2010 totaled $6.3 billion -- is the result of a “base payment” in the MSA as adjusted upward and downward according to MSA formulas.

For instance, an annual inflation adjustment, which causes a minimum 3 percent increase in the payment amount, ensures that the value of the settlement is not eroded over time. Other provisions, like the aforementioned NPM Adjustment, are designed potentially to reduce payments. Because of incentives under the MSA, all Settling States enacted legislation known as Qualifying Statutes or Escrow Statutes. These Statutes require a cigarette manufacturer who did not settle (referred to as a Non-Participating Manufacturer or NPM) to make escrow deposits, roughly equivalent to the per stick MSA payment, for all cigarettes manufactured by the NPM and sold in an MSA state. The purpose of these escrow deposits is two-fold: first, they provide a source of funds from which a Settling State could satisfy a potential judgment against, or a settlement with, an NPM for smoking-related health care costs, and secondly, they help to level the playing field so that the price of NPM cigarettes includes some of the same health care costs embedded in the price of PM cigarettes by virtue of PM MSA payments. In this way PMs are not put at an unfair competitive disadvantage, and the marketplace is not flooded with artificially cheap NPM cigarettes that undermine the public health goals of the MSA.

PMs can qualify for reducing their annual payment by an NPM Adjustment only if they can show that the following conditions occurred in a given year: (i) they lost more than 2 percent of the market share they possessed collectively in 1997, (ii) the MSA’s disadvantages were a “significant factor” resulting in this market share loss, and (iii) at least some Settling States either did not have in effect Escrow Statutes or did not diligently enforce such Statutes.

The PMs and the Settling States settled all disputes pertaining to NPM Adjustments for 1999 through 2002. Disputes exist over whether the PMs are entitled to NPM Adjustments for 2003 through 2009, but only disputes over the 2003 NPM Adjustment are being arbitrated. For the annual payment made in 2004 but that related to cigarette sales in 2003, the MSA’s “Independent Auditor,” PricewaterhouseCoopers (PwC), found that the PMs had incurred a market share loss of 6.2 percent during 2003, and an economic consulting firm determined that the MSA’s disadvantages were a significant factor contributing to this loss. However, because every state had an Escrow Statute in effect in 2003 and because no tribunal had made a finding as to whether any state had diligently enforced its Statute during that year, the Independent Auditor calculated the amount of the potential NPM Adjustment (approximately $1.1 billion), but declined to apply the Adjustment.

The PMs have objected to this decision not to apply the Adjustment, and also have contended that – subject to further discovery – no state diligently enforced its Escrow Statute in 2003. These issues lie at the heart of this historic arbitration. Whatever its outcome, the arbitration is likely to have a lasting impact on subsequent administration and implementation of the MSA.

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