Wednesday, August 03, 2005

Master Settlement Agreement Threatened by Lawsuit

The Competitive Enterprise Institute yesterday filed a lawsuit in a U.S. District Court in Louisiana which challenges the constitutionality of the 1998 Master Settlement Agreement (MSA) between 46 states and the major tobacco companies.

The suit, filed on behalf of a distributor, two small tobacco manufacturers, a tobacco store, and an individual smoker, alleges that the MSA created a state-Big Tobacco cartel that harmed consumers and small businesses by inhibiting competition in the cigarette market. Specifically, the suit claims that the MSA violated Article I, Section 10 of the Constitution - the Compact Clause - which decrees that: "No State shall, without the Consent of Congress ... enter into any Agreement or Compact with another State."

The Competitive Enterprise Institute's complaint alleges that: "The States became business partners in establishing one of the most effective and destructive cartels in the history of the Nation."

CEI explained that: "The Compact Clause was meant to prevent states from collectively encroaching on federal power or ganging up on other states. The tobacco settlement set up a national government/tobacco cartel that harmed consumers and small businesses by increasing cigarette prices and restricting competition. According to the terms of the settlement, major tobacco companies would make annual payments to the states in perpetuity, with an estimated cost of $206 billion over 25 years. Small tobacco companies that were never part of the settlement are nonetheless required to make separate payments to the states."

The Rest of the Story

This is a pretty complex issue, so let me do my best to try to explain what I think is going on here and what it all means:

First, we need some background. As I explained in a May 16 post, the MSA contained a clause known as the Non-Participating Manufacturer (NPM) Adjustment, a complex provision described in section IX(d)(1) of the Agreement. Basically, the provision states that if the market share of the participating manufacturers in any given year falls to more than 2 percentage points below the baseline aggregate market share for 1997, then MSA payments for the following year are reduced by a percentage equal to the amount of the market share loss exceeding 2 percentage points (that is, the market share loss minus 2 percentage points) times a factor of 3.

As an example to demonstrate the provision, assume that the market share for participating manufacturers was 99.6% in 1997 and dropped to 91.9% in 2004 (these are the data cited in a recent Business Week article). The market share loss that exceeds 2% is 99.6-91.9-2.0, or 5.7%. The adjustment factor is then 5.7% times 3, or 17.1%. This means that total industry payments to the states would be reduced by 17.1% in 2005. Based on the $6.2 billion paid to the states in 2004, this would represent a loss of about $1.1 billion in state revenue.

Now, the kicker: this loss of $1.1 billion in revenue to the states does not apply to all the MSA states; it only applies to those states which have failed to enact a statute that imposes escrow payments on non-participating manufacturers (companies that are not parties to the agreement).

Here it is - section IX(d)(2)(B): "A Settling State's Allocated Payment shall not be subject to an NPM Adjustment: (i) if such Settling State continuously had a Qualifying Statute (as defined in subsection (2)(E) below) in full force and effect during the entire calendar year immediately preceding the year in which the payment in question is due, and diligently enforced the provisions of such statute during such entire calendar year; or (ii) if such Settling State enacted the Model Statute (as defined in subsection (2)(E) below) for the first time during the calendar year immediately preceding the year in which the payment in question is due, continuously had the Model Statute in full force and effect during the last six months of such calendar year, and diligently enforced the provisions of such statute during the period in which it was in full force and effect."

Well - what is a "Qualifying Statute?"

For that, you have to go to Exhibit T (Model Statute), where, under section (2)(b)(1), you learn that a Qualifying Statute is a state law requiring any non-participating manufacturer (a company that is not a party to the MSA) to "place into a qualified escrow fund by April 15 of the year following the year in question the following amounts (as such amounts are adjusted for inflation) --
1999: $.0094241 per unit sold after the date of enactment of this Act;
2000: $.0104712 per unit sold after the date of enactment of this Act;
for each of 2001 and 2002: $.0136125 per unit sold after the date of enactment of this Act;
for each of 2003 through 2006: $.0167539 per unit sold after the date of enactment of this Act;
for each of 2007 and each year thereafter: $.0188482 per unit sold after the date of enactment of this Act."

In other words, the MSA has pulled a fast one - a trick of a sort. It cannot serve as a vehicle upon which to enact state legislation. Nor can it impose a requirement on non-participating manufacturers to make them pay the states in order that they not have a competitive advantage over the participating manufacturers who are subject to the burdensome MSA payments. After all, the non-participating manufacturers are not party to the agreement. It cannot possibly impose payments on them!

So instead, the MSA goes around it the back way. It first creates an incentive for the states to protect the economic interests (i.e., market share) of the participating manufacturers: that's what the NPM adjustment does.

Then, it imposes a requirement that unless a state enacts the model statute which imposes payments on non-participating manufacturers, they must share the full burden of the reduced payments attributable to the NPM adjustment. This is, of course, a strong incentive for the states to enact such a statute to preserve their MSA payments.

The simple, and it seems logical, contention of the CEI's lawsuit is that this arrangement is unconstitutional because it represents the formation of a cartel between the states and the participating manufacturers that unduly interferes with the ability of smaller (non-participating) manufacturers to compete in the marketplace, AND it does so by essentially enforcing a pact between states by which these states represent the interests of participating manufacturers' market shares and impose payments on non-participating companies which are not subject to the agreement, AND all of this is done without Congressional approval as required under the Constitution's Compact Clause.

Furthermore, the MSA actually requires that the Model Statute be enacted by a state in precisely the form specified in order for it to count. It essentially sets up the National Association of Attorneys General (NAAG) as an enforcement body to keep the states in line with the compact - any deviation from the exact wording of the Model Statute is at least potentially grounds for making a state bear the burden of the loss of revenue via the NPM adjustment.

Although not cited in the CEI's complaint, I think there is further evidence of the role of NAAG in coordinating and enforcing the behavior of the compact among the states relating to the treatment of participating and non-participating manufacturers. As I mentioned in my March 16 post: "According to a recent Fortune article (Roger Parloff, Is the $200 billion tobacco deal going up in smoke? March 7, 2005), Attorney General William Sorrell of Vermont wrote a letter to all state attorneys general in September 2003 warning them that the success of non-participating tobacco companies was threatening the market share of Big Tobacco and urging them to take action to protect Big Tobacco from this competition: "Increasing sales by [nonparticipating manufacturers] will sharply reduce the next scheduled payments. These results underscore the urgency of all states taking steps to deal with the proliferation of [nonparticipant] sales."

What is my take on all of this?

I think that the lawsuit makes perfect sense, and that the claim appears to be quite valid. I do not see how the states can constitutionally enter into a compact that governs how they must treat non-participating manufacturers -- non-parties to the settlement contract -- without Congressional approval.

I also think there are strong grounds to claim that the MSA violates the 10th Amendment (as asserted in the lawsuit) by forcing states to adopt the Model Statute without revision; this appears to take powers away from the state government and to bestow such power upon a body that is not subject to control by any level of government: namely, the compact itself, as administered by NAAG.

There is also a reasonable claim, I believe, (also as asserted in the lawsuit) that the MSA violates both the Commerce Clause and Due Process Clause of the Constitution by basing MSA tobacco company payments on sales occurring in the four non-settling states, which appears to represent a regulation of interstate commerce that occurs outside of the settling states, and without their consent.

All of this goes to reinforce what I stated back in March and in May, when I concluded that:

"The MSA has in fact set up a partnership between the states and the tobacco companies, and the attorneys general have gone to great lengths to come to the financial rescue of Big Tobacco in order to protect both of their financial interests. The financial interests of the states and Big Tobacco are irretrievably intertwined because of the MSA."


"The MSA represents the greatest public health blunder of my lifetime. Now, more than ever, the financial well-being of the states is inextricably tied to the economic health of the major tobacco companies, creating an overwhelmingly compelling incentive for the states not to enact any policies or take any actions that may endanger the sales and/or profits of the major tobacco companies. The states are now economic partners with the tobacco companies and as such, deserve a share of the blame for the most important epidemic of the 21st century."


Mrs. Non-Gorilla said...

mike -- thanks for discussing this. a few observations:

i'm not sure how well the 10th amendment claim will hold up (para. 85) -- i don't see how the states, in allowing NAAG to monitor the enforcement of specific state legislation is a violation of the federal constitution. it may be a violation of state constitutions, however. state's traditional prerogative to delegate authority to their constituent parts has been consistently recognized by SCOTUS; this could conceivably be extended to include non-political entities subject to state oversight (i'm not familiar enough with NAAG to know if there's a rational argument to be made that sufficient control is exerted by the states via their AGs, but the possibility is there).

also, because the settlement was offered to the non-negotiating states, i'm don't think the argument that states were forced to adopt the model statute without revision holds much water -- states were free to decline the invitation to join the settlement and continue to pursue their individual lawsuits. furthermore, states are free to withdraw from the agreement; their penalty being forfeiture of MSA funds. theoretically this would free them up to renew their suits against the industry.

there are similar arguments against the claim set out in para. 65 regarding the MSA's affect on protected speech. the tobacco companies voluntarily agreed to the provision; there is no state law which impinges on the companies' speech.

finally, i'm particularly disturbed by the langauge in para. 68 describing the MSA as offering a hobson's choice. a true hobson's choice would allow the state to choose between enacting a qualifying statute or maintaining the status quo, not require a choice between the statute or a penalty.

that said, the antitrust allegations do seem to me to be on firm ground (although they are based on federal legislation, not art. 1§10 of the constitution, as the suit implies). and i never saw the logic in giving states a vested interest in the financial health of the tobacco industry in the first place.

Michael Siegel said...

Thanks for your thoughtful and insightful comments on this post.

I agree with you that the 10th amendment claims are probably the weakest of the whole complaint. And that it is really the anti-trust claims that have the strongest foundation.

I also think you are exactly on target in terms of what the states and tobacco companies will likely use as a defense: namely, that there is no direct compulsion of states to take a certain action. It will be interesting to see how the court treats the difference between direct compulsion and incentivization. The case may in fact come down to the court's interpretation of this issue.

trigg said...

I've been studying the MSA for quite some time, but still don't consider myself an expert by any means. For what its worth, I agree that the antitrust arguments appear to be the most viable.

I would appreciate your thoughts on another aspect of the MSA that intrigues me, but apparently has not drawn any attention to date. It relates to the definitions of "tobacco product manufacturer" and "affiliate". The definitions appear to "exempt" a foreign manufacturer who imports solely through an OPM, when the OPM agrees to make the payments on those imported cigarettes. The definition of "affiliate" is mutual ownership of 10% or more of two entities.

However, when you look at the amendments to the MSA, the definition of "affiliate" is changed to mutual ownership of 50%. These amendments also appear to grant SPM's the same ability to "insulate" foreign manufacturers of cigarettes imported by the SPM.

This appears to exclude NPM's from agreeing to be the "manufacturer" and "escrow obligor" for cigarettes assembled by a foreign concern, and imported by an NPM.

I'm sure I haven't stated this concern with alot of clarity, but if you take a look at those definitions and the MSA amendments, I believe you will notice the aspects that have aroused my curiosity. It certainly has the "appearance" of another hidden competitive advantage in the MSA for OPM's, to the exclusion of all others.