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Foreign cigarette makers won a partial victory Tuesday when a federal appeals court reinstated their claim that New York laws passed to enforce a nationwide 1998 tobacco settlement created a state-authorized cartel among domestic cigarette companies. The 2nd U.S. Circuit Court of Appeals in Freedom Holdings, Inc. v. Spitzer revived a Sherman Act claim alleging that provisions for reducing payments to the state under the settlement amount to a state-sanctioned monopoly that prevents price competition. New York was one of 46 states that sued in 1997 seeking damages from the tobacco industry for the cost of treating smoking-related illnesses. The four major tobacco makers signed a Master Settlement Agreement in 1998 that included restrictions on sales, marketing, lobbying and other practices. The agreement was later joined by 33 smaller tobacco companies. The settlement called for annual payments to the settling states to be made based on the market share of the participating companies, with the payments to be adjusted based on changes in the overall volume of cigarette sales and in market share. It also allowed for a reduction of payments by participating manufacturers who lose market share to non-participating cigarette makers because of “disadvantages” in the settlement agreement. Freedom Holdings Inc., a cigarette importer, and other plaintiffs claimed that the market share provisions deter price competition between the original and subsequent participants in the settlement, because any increase in market share would lead to increased payments to the state and offset additional profits. “More than this,” Judge Ralph K. Winter said, “appellants allege that this disincentive induces cigarette manufacturers to follow price increases by a major manufacturer because there is little to be gained — increased market share will be offset or exceeded by increased payment obligations — by maintaining a lower price.” New York followed the settlement by enacting an escrow statute aimed at preventing competition from non-participating manufacturers that would reduce the state’s tobacco revenue over time. Under the escrow law, cigarette makers must either join the settlement or make payments into an escrow account. The plaintiffs alleged the law relieves participating manufacturers from competition because they have lower operating profit margins, and payments to the escrow account, unlike payments under the settlement, are not tax-deductible. Problems enforcing the escrow statute led New York to pass laws that label as contraband any cigarettes made by manufacturers who do not comply with the escrow statute. Before Judge Alvin K. Hellerstein, Freedom Holdings challenged the Contraband statutes : �� 480-b, 481(c) and 1846 of the New York State Tax Law. Hellerstein dismissed the case, finding no violations of the Commerce Clause of the U.S. Constitution or the Sherman Act. He also dismissed a selective enforcement claim brought by Freedom Holdings, which alleged that New York state was refusing to enforce the provisions against wholesalers and importers on American Indian reservations. PRE-EMPTION ISSUE The 2nd Circuit upheld the dismissal of the Commerce Clause claim and remanded the selective enforcement claim for further proceedings. But the court reversed Hellerstein on the Sherman Act claim because of the issue of federal pre-emption. To determine whether a state law restraining competition among private firms is pre-empted by the Sherman Act, Judge Winter said, the first question is whether the “scheme of market control created by the statute would constitute a per se violation of the Sherman Act if brought about by an agreement among private parties.” The answer here, Winter said, was yes. “Had the executive of the major tobacco companies entered into such an arrangement without the involvement of the States and their attorneys general, those executives would long ago have had depressing conversations with their attorneys about the United States Sentencing Guidelines,” he said. Nonetheless, Winter said, the alleged anticompetitive scheme might still be protected by the state action immunity doctrine, which protects the state when it “regulates commerce in furtherance of legitimate state policy goals and limits unnecessary anticompetitive effects.” Under U.S. Supreme Court case law, Winter said, a state law that mandates a per se violation of the Sherman Act is saved from pre-emption if the restraint is “clearly articulated and affirmatively expressed as state policy,” and the policy is “actively supervised.” But Judge Winter said, “Until now the State has relied in a conclusory fashion on the claimed benefits to public health as a showstopper rendering further analysis or discussion irrelevant.” He added: “It suffices to say here that … the relationship of such benefits to the restraint on competition is not obvious and may even be counterproductive.” The court then turned to New York’s obligation under the state immunity doctrine to supervise the alleged scheme. “New York has failed to provide for any state supervision, much less active supervision, of the pricing conduct of cigarette manufacturers under the anticompetitive market structure created by the [settlement] and the Contraband Statutes,” he said, leading the court to conclude that state action immunity would not apply if Freedom Holdings’ complaint is proven. Judge Robert Sack issued a concurring opinion in which he expressed “some doubt about the majority’s conclusions” on the Sherman Act claims. Judge Sonia Sotomayor joined in Judge Winter’s opinion. David F. Dobbins of Patterson, Belknap, Webb & Tyler represented the plaintiffs. Avi Schick, deputy counsel to the New York attorney general, Deputy Solicitor General Michael S. Belohlavek and Assistant Attorney General Daniel Schulze represented the state.

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