On Dec. 21st, 1999, the Canadian federal government announced that it had filed a civil suit, under the United States Racketeer Influenced Corrupt Organizations (RICO) statute, against Canada’s No. 3 cigarette company, RJR-Macdonald (now JTI-Macdonald), the Canadian Tobacco Manufacturers’ Council (CTMC), 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. 18th, 1999.)
Several other media outlets, including La Presse and the Ottawa Citizen, have reported specifically on tobacco industry documents relating to Imperial Tobacco’s exports of cigarettes to the United States. (For information on the source of these documents, read our "Background on the Philip Morris paper trail," as well as Health Canada's backgrounder on the Guildford depository.) However, details of the paper trail on exports of du Maurier and Player’s brand cigarettes have yet to be discussed extensively. This analysis pulls together smuggling-relevant documents from two primary sources:
The Competitive Environment
Throughout the early 1990s, as cigarette smuggling increasingly became a major political issue, Imperial Tobacco consistently portrayed itself as an innocent victim of excessive tobacco taxes and the resulting smuggling trade between the United States and Canada. The company acknowledged that a large part of its rapidly expanding ‘exports’ to the United States was destined to return to Canada as contraband, but claimed it could not be held responsible for this illegal trade, since it sold only to licensed, legitimate distributors. Imperial also claimed smuggling was against its own business interests.
It is interesting to compare these public statements with the private reports to British American Tobacco (BAT) headquarters in England. Imasco, the holding company that owned Imperial Tobacco (ITL), Canada Trust, and several other companies, regularly met with BAT executives to get approval of its business and financial plans.
An early mention of the smuggling issue comes from the minutes of one such meeting, in November 1991. Imasco Chairman and CEO Purdy Crawford briefed top BAT executives Patrick Sheehy and Martin Broughton about the issue:
...following the sharp increase in excise [taxes, in early 1991], direct sales to the domestic market had dropped sharply. However, consumption had reduced by only 3% with the difference being accounted for by exports to the USA, which were then re-imported. Imprial estimate that 16% of Canadian cigarette production is now sold in the USA.
Exports are as profitable as domestic sales within Canada itself. However, Imperial are restricted to exporting du Maurier since Philip Morris owns the Players trade-mark in the USA. As a result, Imperial’s share of the export business is rather lower than their share of the domestic market... Unfortunately, the general view is that the Government is unlikely to reduce the levels of excise. The best that can be hoped for is to persuade the authorities that to introduce an export tax as a way of discouraging reimports will only result in accelerating imports of US manufactured cigarettes.
In February 1992, over the industry’s objections, the federal government did introduce an export tax, in an attempt to cut off smuggling at its Canadian source, i.e. the factories of the three big Canadian manufacturers, Imperial Tobacco, Rothmans, Benson & Hedges, and RJR-Macdonald. Imperial Tobacco’s "1992 Competitive Report” to BAT indicate that the export tax achieved its purpose:
...[T]he market was further complicated in 1992 by the growth of the black market cigarette trade. While 1991 did see activity in this area, it exploded in 1992 after the export tax was rescinded.
The industry lobbied heavily, and successfully, to have the export tax repealed. (See "Imperial Tobacco and the Canadian Government,"below.)
Here is how Imperial Tobacco presented the issue in its October 1992 “Comments on 1992-1997 Forecast”:
The export tax was replaced by new labelling requirements and other controls, including agreement by the canadian manufacturers to reduce shipments. one producer did not respect the agreement and began manufacturing Canadian type cigarettes in Puerto Rico to avoid the Canadian regulations.
The shift in production to Puerto Rico was, of course, a reference to RJR-Macdonald. RJR’s Puerto Rico operation is a central element in the federal lawsuit against that corporate group. What is interesting in the case of Imperial Tobacco is how rapidly the company decided to follow the RJR lead. An excerpt from another meeting with top BAT management, just five months after the export tax was repealed, demonstrates this nicely:
ITL’s profits are about 8% higher than 1991. Smuggling is a major issue in the Canadian market. ITL has not followed its competitors in exporting cigarettes that might come back to Canada. Imperial has restrained its exports and instead it is trying to convince the Department of Finance that it should roll back tobacco taxes to resolve the issue... [F]uture growth will be more difficult if it is limited to selling to Canadians. ITL’s role outside Canada is still under discussion.
In other words, Imperial Tobacco’s profits were still rising, despite major tax increases in 1991 and what the company saw as unfair black-market competition from RJR-Macdonald and Rothmans, Benson & Hedges. Yet already Imperial Tobacco was “discussing” its role outside Canada — and taking concrete steps, as early as May 1992, to make its flagship brand Player’s available to distributors in the United States. (See “Player’s: Dividing up the Spoils with Philip Morris,"below.)
In February or March 1993, according to several Guildford documents, Imperial Tobacco abandoned any restraint with respect to supplying the black market. Here’s how the decision was presented in May 1992, in a “Summary of Competitive Environment” report to top BAT management:
Smuggling of exported Canadian cigarette back into the country continues in 1993... ITL’s CTMC member competitors have been and continue to fully participate in this alternative distribution network. Due to the federal government’s unwillingness to lower tobacco taxes as a means to discourage smuggling, ITL products, in February of 1993, were made available for full distribution... For the industry as a whole, ITL’s 12 month share of the total tobacco industry is 55.0%, down 1.5 share points from the previous year. This is mainly due to our previous commitment not to supply smuggling channels...
To this day, Imperial Tobacco presents its 1993 move as a defensive decision to lift voluntary limits on the quantities of cigarettes it was exporting to the United States. Yet the document trail indicates that Imperial Tobacco had never stopped exporting to the legitimate U.S. market.
- DFX = duty-free/export
- CTMC = Canadian Tobacco Manufacturers' Council
- tailor-made cigarettes = manufactured cigarettes, as opposed to roll-your-own
- general trading = a euphemism for smuggling, used throughout the British American Tobacco group, from Argentina to Singapore.
Two “Reviews of the Competitive Environment,” from September and November 1993, make this very clear.
DFX CTMC tailor-made volume in 1992 totalled 8.1 billion cigarettes of which we estimate 6.1 billion entered Canada illegally. Through the first ten months of 1993, DFX CTMC tailor-made volume stands at 10.9 billion cigarettes (compared to 6.2 billion in October ‘92). By year end, we anticipate this volume to reach 13.0 billion cigarettes, of which approximately 10.8 billion can be attributed to “general trading”.
[...] I.T.L.'s share of the total market has been hampered by our lack of full availability in these alternative channels. However, agreements that have been put in place to ensure wider distribution of our products, particularly Player's products, should serve to ensure our continued share growth in the DFX portion of the market.
In response to the weak domestic performance of the Export trademark, RJR has attempted to capitalize on the tremendous growth in smuggling by making their products fully available in general trading at highly competitive prices... ITL’s performance has been hindered by the March 1992 decision to restrain shipments to the general trading portion of the DFX market. However, since ITL’s decision to reenter this market in March of 1993, ITL’s three month share of the DFX market has increased by over 10 share points...
In April 1994, shortly after the major tobacco tax rollback of early 1994, Imperial Tobacco provided more detailed information on market shares in the Canadian legal and illegal cigarette trade. This “Market Update,” sent to top BAT management, includes the following bit of self-congratulation:
In share terms, ITL finished 1993 back where it left off in 1991. Following a loss of share in 1992, ITL rebounded by making its major trademarks available in smuggled channels in the second half of 1993.
All of this raises an obvious question: how was Imperial Tobacco able to distinguish so clearly between the legal and “general trading” portions of its export shipments? Did the company have a list of which U.S. distributors supplied product to smugglers? Did the company direct its U.S. customers on whether or not a particular shipment should return to Canada?
At least at BAT corporate headquarters in England, there was no doubt that Imperial Tobacco knew very precisely, month-by-month, how many cigarettes it was shipping into the contraband market. This is confirmed in November 1993 by an amusing little fax message from a “statistics assistant” in England, Terri Harwood, to a clerk in Montreal, Diane Renaud. Renaud and Harwood had been exchanging messages for several months about the format of monthly sales reports to BAT headquarters. She had a small request for her colleague:
Many Thanks for your Hand Written Spreadsheets... I am also looking for your Duty Free sales. Legitimate DF to be reported as Duty Free and any Transit DF to be reported as Duty Free Unspecified.
As it happens, “transit” was a euphemism used throught the BAT Group to refer to smuggling. This even gave rise to the term “transited,” as in shipments of cigarettes that were being “transited into Malaysia.” (ASH UK provides numerous examples of the use of term “transit” on its web site.)
Harwood’s request flowed from an ongoing process of “end market allocation,” which was being worked out at the very top levels of BAT group management during this period. In March 1994, for example, BAT’s Tobacco Strategy Group discussed the responsibility for international duty free, including a paper assigning responsibility for sales in various countries. According to the minutes, senior BAT manager Ulrich Herter felt the need to clarify one point:
Mr. Herter emphasised that this paper covered genuine duty free only and not border trade.
The du Maurier brand: competing in the smuggling market
Du Maurier and Player’s are Canada’s top two cigarette brands, and both trademarks belong to Imperial Tobacco — but only in Canada. In the early 1990s, American rights to the Player’s trademark belonged to Philip Morris. U.S. rights to the du Maurier trademark belonged to Peter Jackson (Overseas), which is part of the British American Tobacco family to which Imperial Tobacco of Canada also belongs.
In the case of du Maurier, Imperial Tobacco signed a licensing agreement back in 1982 that gave it the right to sell into the U.S. market, upon payment of a 5% royalty fee. [* See "du Maurier — USA: History," in Adobe PDF format.]In 1989, this royalty fee was reduced to 2% for a limited period of 2-3 years, while Imperial Tobacco built up the brand. This agreement appears to have been extended to various other markets.
In February 1992, Imperial Tobacco and Imasco approached their parent company, British American Tobacco, with a curious proposal to sell 10 million du Maurier-brand cigarettes per month to a Romanian company, Global Manufacturing, Construction & Trade SRL, via an agent in Montreal, Crown Holdings. This required agreement from BAT to extend Imperial Tobacco’s royalty arrangement for du Maurier to Romania.
Ten million cigarettes per month, or 120 million cigarettes per year, is a very small fraction of the roughly 43 billion cigarettes sold in Canada in 1992. However, demand for Canadian cigarettes is tiny outside Canada. In 1989, for example, before smuggling became a significant issue, total exports were 1.1 billion cigarettes. [* See Appendix A in Surveying the Damage: Cut-rate tobacco products and public health in the 1990s.]In short, Imperial Tobacco was proposing a deal for a single, impoverished country, Romania, that amounted to more than 10% of the legitimate export market for all brands of Canadian cigarettes.
It is also worth noting that the December 1998 criminal conviction of Northern Brands International in the United States (relating to the smuggling of Export "A" cigarettes over the Canada-U.S. border) involved a shipment of Canadian-made cigarettes theoretically bound for Eastern Europe via a Free-Trade Zone in the United States, but in fact diverted into the North American black market.
Be that as it may, the Romanian deal fell through because another BAT subsidiary, BATUKE, insisted on keeping Imperial Tobacco out of Eastern Europe. Moreover, BAT Chairman Barry Bramley informed Imperial Tobacco of Canada that headquarters was increasing the royalty rate on du Maurier exports back up to 5%. Various correspondence indicates that discussions on exports to Eastern Europe continued, to little avail, through 1992. There was also discussion of the possibility of giving Imperial Tobacco responsibility for producing du Maurier cigarettes for the entire world.
In 1993, with the Canadian black market for cigarettes expanding rapidly, the issue of the level of royalty payments came up again. On June 3, 1993, Imperial Tobacco President Don Brown wrote to Ulrich Herter of BAT in London with the following frank arguments as to why Imperial Tobacco should be granted a reduced royalty rate on exports of du Maurier to the United States.
...Federal tax increases here have created a difficult situation for us, and we ask your consideration of the following. As you are aware, smuggled cigarettes (due to exorbitant tax levels) represent nearly 30% of total sales in Canada, and the level is growing. Although we agreed to support the Federal government’s effort to reduce smuggling by limiting our exports to the U.S.A., our competitors did not. Subsequently, we have decided to remove the limits on exports to regain our share of Canadian smokers. To do otherwise would place the long-term welfare of our trademarks in the home market at great risk. Until the smuggling issue is resolved, an increasing volume of our domestic sales in Canada will be exported, then smuggled back for sale here. In the process, that (domestic) volume attracts Royalty.
The intent of our agreement is to pay Royalty to P.J. (Overseas) on du Maurier cigarettes sold outside of Canada. You can appreciate that being in a situation of paying Royalty on volume actually sold in Canada, where I.T.L. is the trademark owner, not only impacts on earnings, but also renders us less competitive.
We can fairly accurately estimate those volumes sold outside of Canada and those returning from the total. We would ask you to consider an agreement whereby we would not pay Royalty on the volume actually sold in Canada or at worst at a considerably reduced Royalty rate.
In short, Imperial Tobacco was asking for a break from its parent company to make du Maurier cigarettes more competitive in the smuggling market. A few days later, BAT wrote back, agreeing to separate royalty rates for what the company referred to as "genuine" exports to the U.S. and for "products smuggled back into Canada." Moreover, BAT’s Ulrich Herter noted, "No doubt you will let me know if you feel that the accuracy around the estimation of the ‘genuine’ exports to the US is such that a lower royalty even than 2% would be appropriate."
Player’s: dividing up the spoils with Philip Morris
In January 1992, lawyers for Philip Morris USA (the largest American tobacco firm, manufacturers of Marlboro cigarettes) obtained an injunction against distributors in the State of Washington, preventing them from selling Canadian-made Player’s cigarettes, on the grounds that Philip Morris had U.S. rights to the Player’s trademark.
Two months later, an internal Philip Morris memo speculates about the role of a U.S. company, IMASCO Holdings, Inc. (Imasco of Canada is the holding company that owns Imperial Tobacco of Canada). "The first opinion that comes to mind is a potential business decision by IMASCO to import cigarettes into the U.S., probably because of the current climate in Canada."
The issue pops up again in May 1992, at which stage Philip Morris and Imperial Tobacco are already negotiating a licensing agreement, under which Philip Morris will receive a royalty for sales of Canadian-made Player’s cigarettes in the United States.
The structure of the Philip Morris group played an important role in the discussions that followed, with two separate Philip Morris companies getting involved. Philip Morris USA (PM-USA), the domestic arm of the group, has an extensive distribution network across the United States, as well as trademark rights to Player’s in the United States. on the other hand, Philip Morris International (PMI) handled exports of Philip Morris products to other countries, and also had control of duty-free operations within the United States. Thus, in discussions with Imperial Tobacco about selling Canadian-made Player’s cigarettes, PM-USA’s interest was in duty-paid sales in the United States (to Canadian tourists and cross-border shoppers), whereas PMI’s interest was in developing the duty-free trade.
By an interesting coincidence, virtually all the Philip Morris documents about Player’s negotiations that have been located in discovery documents come from PM-USA’s files. PMI’s files on the topic, if they existed, were either destroyed or somehow escaped court orders on document disclosure.
The differing interests between PM-USA and PMI are reflected in May 1992 memos from PM-USA executive Tim Beane. [Memos dated May 5th and May 14th, respectively.]Beane apparently believes his company should be providing substantial advertising support for Canadian-style Player’s, which he wishes to see sold through duty-paid outlets. He is very enthusiastic: "...Canadian style Player’s could generate over 2.0 billion units of annual volume given Player’s share of the Canadian domestic market and the size of export (to U.S.) business..." He therefore suggests that, rather than simply receiving a royalty on Imperial Tobacco sales of Canadian-made Player’s into the U.S., Philip Morris should instead purchase the cigarettes outright and sell them itself.
"PM-USA could realize significant incremental volume while largely preserving the additional profits we would have received under the license agreement," Beane argues. "If we can keep Imperial whole from a profit standpoint while providing the services of a much larger sales force, the potential for greater Players volume could be attractive to Imperial."
On September 29th, 1992, PM-USA and Imperial Tobacco finally reached an agreement with respect to sales of Canadian-style Player’s cigarettes into the United States. This contract was signed by PM-USA President William Campbell, and by Imperial Tobacco’s CEO (Jean-Louis Mercier) and President (Don Brown). [* See Primary Agreement and Cross-Licensing Agreement.]Under the terms of the agreement, PM-USA would buy shipments of Canadian-made Player’s "for ultimate sale to consumers in the Territory"; the Territory was defined as "domestic and duty-free markets of the United States."
PM-USA’s first order under the agreement, dated Nov. 5, 1992, was for more than 150 million Player’s cigarettes — roughly equivalent to 1% of total annual production of Player’s cigarettes in 1992. [Assuming a Canadian market share of under 25% for Player’s in 1992. The most recent estimate for Player’s market share, from November 1999, is 28.3%. — See Newcrest Capital Inc.’s Imasco Limited Valuation and Fairness Option, p. F16.]
In January 1993, two Philip Morris executives, Barbara Reuter and Susan Reich, headed up to Montreal to discuss a joint marketing plan for Player’s brand cigarettes. A document attached to the agenda for this Jan. 11th meeting includes an interesting table entitled "Imperial Business Development."In particular, the document foresees what is apparently a joint Imperial Tobacco/Philip Morris "Canadian Border Market Visit" from Jan. 18th through 22nd, 1993, to places such as Syracuse, Buffalo, Plattsburgh, Detroit and Minneapolis.
By June 1993, PM-USA enthusiasm about the Player’s deal with Imperial Tobacco had cooled markedly. PM-USA sales executive Barbara Reuter complained bitterly to company CEO William Campbell about competition from Philip Morris International, which was booking duty-free sales:
We have just completed a series of marketing meetings with selected sales units along the Canadian border to prepare for the Summer Distribution Drive for both Imperial and Rothmans products. The meetings went well, with considerable enthusiasm expressed for the opportunity to market full margin units to Canadian visitors.
However, in Region 1, where more than 60% of our projected volume resides, we discovered a disturbing deterioration of the business. The problem is centered in Unit 1202, the Buffalo, New York market where an Indian reservation [Akwesasne] straddles the border... This change was primarily due to the availability of duty free product from Philip Morris International at a lower price point in March...
As long as the two operating companies remain rivals in the Canadian export business, where Duty Free has a price advantage, there is little incentive for PM USA Sales to take this business opportunity seriously.
I, therefore, recommend that the business be consolidated within PM USA under one management, enabling the PM USA Sales organization to support and receive credit for total USA regional sales gains — both duty paid and duty free.
Indeed, in the Buffalo area, duty-paid sales of Canadian-made Player’s plummeted from 13.9 million in January 1993 to just 96,000 by April 1993, according to Reuter. In short, smuggling and duty-free shops were wiping out cross-border shopping in normal retail outlets.
Reuter also made the following interesting note with respect to the behaviour of Canadian tobacco companies:
...both Imperial and Rothmans are pressuring [Philip Morris] Duty Free to increase sales. Imperial, in particular is urging PMI to push sales along the Western border.
This is particularly interesting given Imperial Tobacco’s central role, just months earlier, in setting up the "Quebec Coalition for Fair Tobacco Taxation," an attempt to pressure governments into slashing tobacco taxes in order to combat smuggling.
In September 1993 — with smuggling at a historic high — Reuter made another pitch to give all Player’s business to PM-USA, or at least to compensate PM-USA for doing lots of legwork to cater to Canadians. Again, her arguments are frank and unequivocal:
In 1993, year-to-date sales volume of all Canadian cigarettes sold by PM have nearly reached 2 billion units in sales, with another billion in sales projected through the end of the year... [By way of comparison, the forensic accountants hired by the tobacco industry to evaluate the size of total Canadian contraband market estimated total black-market sales of 14.5 billion cigarettes in 1993.]Almost all of the unit volume is sold through U.S.A. Duty Free sales (which became part of PMI in 1978 when it was given to International to help see that operating company’s growth).
The duty free special market business has taken off because the Canadian consumer is turning to imported product which is readily available in alternative Canadian outlets at a lower price point, $3.50 versus $6.50/pack or $22 versus $48/cartons for regular domestic products sold through traditional tobacco outlets. Thus, the special market product available in Canada is priced almost as low as the Canadian duty paid produc