Rogue Missives April 28, 1997

Pushing for a Settlement?
by Jim Surowiecki (Surowiecki)

NEW YORK, N.Y. (Apr. 30, 1997) -- As last week began, much of the talk on Wall Street had to do with negotiations between American tobacco companies and a group of state attorneys general about the possibility of a deal that would limit the companies' liability for cigarette-related deaths in exchange for an enormous financial settlement. Reports from the negotiations suggested that the tobacco companies -- most notably PHILIP MORRIS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MO)") else Response.Write("(NYSE: MO)") end if %> and RJR TOBACCO <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: RJR)") else Response.Write("(NYSE: RJR)") end if %> -- were willing to create a fund worth as much as $300 billion over 25 years out of which compensation would be paid to smokers dying of lung cancer or other ailments. Both sides, it seemed, preferred a one-time settlement to years of protracted and potentially endless litigation.

Today, though, the picture for the tobacco companies looks somewhat more complicated, and not necessarily for the better. Two court decisions -- the first handed down on Friday and the second on Monday -- have expanded both the reach and the power of state regulation of tobacco, and in doing so have strengthened the hand of the anti-tobacco forces in their talks with the companies, talks that resumed on Monday. Investors, who had driven up shares of both Philip Morris and R.J. Reynolds on the news of a possible settlement, have responded predictably, with both stocks suffering sharp drops over the last four trading sessions.

The two decisions deal with substantively different issues, and in one interesting respect might be seen to conflict with each other. But taken together, they represent a serious challenge to the tobacco companies' insistence that cigarettes should not be government-regulated and that the First Amendment protects cigarette advertising of any sort.

Friday's decision was, in some respects, the more surprising of the two. Federal Judge William Osteen, a North Carolina judge and former tobacco lobbyist whom many had believed would be sympathetic to the tobacco companies, ruled that cigarettes were "drug-delivery devices" and that the Food and Drug Administration could therefore regulate them. In doing so, Osteen essentially gave the imprimatur to departing FDA chairman David Kessler's five-year quest to bring cigarettes under his agency's jurisdiction. Surprising as it may seem, knowing all that we do about the addictiveness of nicotine, cigarettes have always occupied a curious place in the law, almost drugs and yet not regulated as even something like aspirin is. Osteen's decision opens the door to major changes in that area.

On the other hand, Osteen actually struck down some of the seemingly more important aspects of the FDA regulations that the tobacco companies were challenging in the case. The FDA had formulated restrictions on a wide array of outside advertising and tobacco promotion -- all designed, at least rhetorically, to limit children's exposure to toabcco ads -- that were scheduled to go into effect on August 28. But Osteen ruled that the agency did not have the legal authority to implement these restrictions, which means that for the foreseeable future tobacco ads in magazines will still be in color, that there will still be cigarette billboards near schools, and that you'll still get to wear that Joe Camel hat.

Still, while both sides will be appealing the decision to a higher court, Osteen's ruling is clearly landmark in its acceptance of the concept of FDA regulation of tobacco. In practical terms, it takes away one of the tobacco industry's key bargaining chips, since the industry had been expressing a willingness to accept FDA regulation in exchange for protection from liability. More importantly, it's possible that an aggressive FDA could promulgate a series of regulations that would essentially destroy tobacco as a consumer product.

When FDA chairman Kessler started this fight, after all, he said that he would bring nicotine levels in cigarettes down to zero in a decade by regulating it as a medical device. And a forthcoming article in the trade journal Medical Device Approval Letter argues that the agency has a wide range of weapons at its disposal, including requiring tobacco companies to pay "user fees" to the FDA and, more strikingly, forcing cigarettes to be dispensed by prescription only.

Opinions on the impact of the ruling differ widely, though. Kenneth Reid, editor of MDAL, said in a statement released with the article that Osteen's decision could cause "legal Armageddon." And Mississippi Attorney General Michael Moore, who has been one of the industry's most implacable opponents, said: "We're going to shoot for it all ... and then tightly regulate the industry." President Clinton, meanwhile, called it "a historic and landmark day for the nation's health and children." But tobacco analysts downplayed the long-term ramifications of the decision, while an attorney for the American Advertising Federation told Reuters, "Joe Camel lives. Winston Cup is alive. Billboards are alive." And in context the market's reaction, while definite, was relatively mild, with MO's shares off 2 1/2 and RJR's down 2 3/4.

Monday's decision by the Supreme Court, though, calls into question just how alive Joe Camel really is. The Court refused to hear an appeal of a case in which in a Baltimore law restricting outdoor tobacco and liquor ads was upheld. In refusing to hear the case, the justices let the lower court's decision stand. That means that the Baltimore ordinance, which imposes strict zoning regulations on billboards and other outside advertising, is constitutional and does not violate the First Amendment. (Osteen's decision that the FDA couldn't regulate such ads had to do with the agency's authority, not with the First Amendment.) And it also means that other cities could adopt similar ordinances.

On the other hand, the Baltimore law did permit cigarette and liquor billboards in industrial areas and along freeways. And one might read the decision as having more to do with zoning than with an explicit judgment on tobacco or liquor advertising more generally. Still, it's important to see that the decision that the Supreme Court allowed to stand was handed down by a Richmond court, just as Friday's decision was handed down by a North Carolina judge. The regional divisions that had once seemed to be crucial to the protection of tobacco interests no longer seem to have the weight they once did.

Nonetheless, all indications are that a settlement may very well still be in the offing, and in that sense what these decisions may have done is make Philip Morris and RJR even more willing to settle. Ironically, in any such settlement advertising -- at least of the sort that has come to pervade magazines and billboards -- will likely be the first thing to go. Given the importance attached to ads by anti-smoking forces, the tobacco companies' willingness to give up Joe Camel and the Marlboro Man may seem surprising. But there's been very little real work done on the effectiveness of advertising. In particular, if no company in an industry is advertising, it's not clear that all companies necessarily suffer.

The real stumbling block in any settlement will be the precise nature of the companies' immunity from further lawsuits. While a deal is conceivable that would protect companies from state or federal suits, it will be impossible to prevent suits by individual smokers unless a law is passed by Congress. And that, in turn, means that the parties to any deal will have to convince legislators that it makes sense. On the other hand, it's possible that an end to the ceaseless litigation and a recognition that adults who smoke do so in full knowledge of the eventual consequences may be appealing to a country that oscillates permanently between the desire for security and the desire for independence.

The most curious thing about the settlement talks, at least from the perspective of investors, is that any settlement will be, at worst, valuation-neutral for the tobacco companies. A strong argument can be made, in fact, that a real settlement -- even if it comes at the cost of $300 billion and a 25-50-cent hike in the price of a pack of cigarettes -- will boost the P/Es of Philip Morris, in particular, to such an extent that the stock will trade significantly higher, even with reduced earnings. Philip Morris may never trade at the elevated P/E of a consumer staple like Coke, for instance. But Philip Morris' growth in earnings over the last five years has been faster than Coke. The only reason it trades at such a discount is because investors wonder if tomorrow they'll wake up to find out that cigarettes are now being treated as prescription drugs. If a settlement takes away that worry, the market caps of tobacco companies may very well rise significantly. All of which seems like a rather ironic consequence of the quest to put tobacco on trial.