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A Manhattan Supreme Court judge has dealt a setback to cigarette makers in the opening round of a legal battle to lower by $1 billion a year the tobacco industry payments reached under a historic settlement in 1998. Justice Charles Ramos last week rejected the industry’s position that its claims to a lower payment could be litigated in a single arbitration proceeding. Instead, he said, the cigarette makers must proceed in a more cost-intensive, state-by-state litigation. As some cigarette makers press to lower their annual payments — claiming an explosive growth in illegal Internet cigarette sales makes their participation in the pact unfair — New York becomes a particularly inviting target. Under the settlement, annual payments to the state are roughly $800 million, according to the Attorney General’s Office. Should the industry prevail, the cigarette makers “would likely target the deep-pocket states that receive the largest payments” under the $206 billion settlement reached between 46 states and six territories, said Marc Violette, a spokesman for Attorney General Eliot Spitzer. New York and California together receive about 25 percent of the $6.2 billion distributed annually under the settlement, which was crafted to resolve the states’ claims for funds spent on treating smoking-related illnesses either through programs for the poor or for state employees. Three small cigarette makers opened the battle in June to lower the annual payments for 2003 by taking legal action in five states, including New York. In motions seeking arbitration, they sought to invoke a provision in the settlement that requires the payments to be lowered if the states do not take required actions to create parity between the manufacturers that joined the agreement and those that did not. Led by Commonwealth Brands, the three cigarette makers, all of whom joined the settlement after it was forged, claim they are entitled to a $33 million refund on payments made in 2003 under the agreement. King Maker Manufacturing and Sherman are the other two companies. The trio are among 40 cigarette makers who joined the pact after it was signed by the nation’s four largest manufacturers: Philip Morris, Lorillard Tobacco, R.J. Reynolds Tobacco, and Brown & Williamson, which last summer merged with R.J. Reynolds. Philip Morris, Lorillard and R.J. Reynolds, which make about 85 percent of the nation’s cigarettes, are not seeking a reduction in their 2003 payments, but agree with the three smaller makers that the industry is entitled to the estimated $1 billion reduction. In addition to the annual payments, the companies bound by the settlement are obligated to abide by provisions restricting their advertising and marketing practices. NON-PARTICIPANTS Some 80 cigarette makers have not joined the pact. To insure they do not gain an advantage, the 1998 accord required each state to enact a “model statute,” requiring the non-participants to pay into an escrow account an amount equivalent to what the participating makers must pay. So, all manufacturers ultimately are required to pay the states the same amount, two cents for every cigarette sold. The settlement requires an estimated $1 billion adjustment in the amount the participating companies must contribute if two conditions are met: there is a finding that participation in the pact was a significant factor in market share loss for those that signed on, and the states failed to “diligently enforce” their statutes designed to put participating and non-participating companies on equal footing. All the states and territories that signed on to the pact have adopted the model statute, but the participating manufacturers contend that the states’ efforts to collect the two cents per cigarette from the burgeoning — and often illegal — Internet trade have been lacking. The agreement further holds any state found not to have “diligently enforced” its model statute liable for the full amount of its payment for the year in question. That leaves New York with a maximum exposure of $800 million for any year in which that claim can be proven. Last year, Commonwealth, King Maker and Sherman asked PriceWaterhouseCoopers, which both sides selected to carry out the complex calculations required by the agreement, to impose the penalty. PriceWaterhouse found that since the accord was signed, the participating manufacturers had lost more than 6 percent of the market share in “significant” part because of their participation in the pact, the trio of small manufacturers claimed. Though that finding was a legal predicate for the penalty, according to the three, PriceWaterhouse declined to impose it citing a presumption that all the states were diligently enforcing the other half of the bargain — the laws requiring the two cent per cigarette assessment. The three manufacturers then filed motions in New York, Connecticut, Virginia, New Mexico and Arkansas asking that the dispute be taken to arbitration, claiming that is the path required by the pact. THE FIRST RULING Litigation so far has only advanced in New York and Connecticut, with the first ruling coming when Justice Ramos denied the arbitration request from the bench on March 1 after hearing 30 minutes of oral argument. He agreed with New York state that the determination regarding diligent enforcement remains within the court’s jurisdiction under the accord, and it was not the type of accounting decision that had been delegated to PriceWaterhouse, and thus subject to arbitration. “This is not an arbitrable dispute under the [settlement agreement], not even close,” Justice Ramos said from the bench. Robert Brookhiser of Howry Simon Arnold & White in Washington, D.C., who represents the three small cigarette makers, said he was “disappointed” in the ruling and plans to appeal. Stephen Patton, who took the lead role for the largest cigarette makers before Justice Ramos, said the big three backed the arbitration request because the “pact creates a complex calculation to create a single nationwide payment obligation.” He added, “It is important to have a single forum to resolve disputes” and not 52 separate court systems with authority to rule on the issue. But Violette, Spitzer’s spokesman, said that Justice Ramos had correctly recognized the arbitration request “as a thinly veiled effort to circumvent his jurisdiction to determine whether New York state is diligently enforcing” its statute. New York and the three small companies took fundamentally opposing views over how any fact-finder — an arbitrator or a judge — should decide whether the $1 billion reduction should be imposed. Brookhiser said his clients and the other participating manufacturers take the position that the settlement language requires PriceWaterhouse to impose the $1 billion payment adjustment once the accounting firm finds that participation in the settlement has been a “significant factor” in the companies’ loss of market share. The accord then allows individual states to demonstrate that they should not be held responsible for payment of the penalty because they had diligently enforced their statutes, he said. Violette asserted that Brookhiser had it backwards. “Over 100 years of case law provides that states are presumed to be diligently enforcing their laws until it is demonstrated otherwise,” he said. Patton, who represents R.J. Reynolds, said the three large companies have not joined the three smaller companies in seeking the 2003 adjustment because they disagree that PriceWaterhouse could have made “a significant factor” analysis for that year. A “significant factor” finding can only be made by an economic firm selected by the parties to carry out analysis separate from that of PriceWaterhouse’s role, said Patton, of the Chicago office of Kirkland & Ellis. While the parties have selected a firm, a contract has not been completed, he said. Once the firm analyzes market developments, Patton said, the industry is confident the economists will issue “a significant factor” finding. He declined to identify the economic firm until the contract is finalized. CLASH ON MERITS Even though the first round has gone against the participating manufacturers on the arbitration question, they could still prevail in one of the other four states, or on appeal in New York. And Brookhiser declined to rule out suing individual states in their own courts should the effort to take the matter before the arbitration panel fail. The evidence is “clear” that the states are not diligently enforcing the collection requirement, Brookhiser said. When the pact was signed in 1998, there were hardly any non-participating manufacturers. Since then, the number of new cigarette makers operating outside the pact has grown to 80, he said. PriceWaterhouse’s finding that the participating manufacturers have lost 6 percent of the market share since 1997 is actually 2 percent less than the total decline under the formula the pact requires, Brookhiser said. When unreported sales over the Internet are added in, he said, the actual decline in market share “has to be at least 10 percent.” Violette countered that the agreement only requires a state to collect the two-cent assessment on cigarettes that are reported to the state and taxed. To require states to collect the fee on cigarettes sold over the Internet without proper disclosure to the state is “an impossible task,” he said. Besides, he added, “the vast majority of cigarettes sold on the Internet are premium brands made by tobacco companies participating in the settlement.” Daniel Wise is a reporter with the New York Law Journal, a Recorder affiliate.

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