Testimony of David Adelman before the US Senate Committee on the Judiciary
US Tobacco Industry Analyst
Morgan Stanley
September 5, 2001

Chairman Leahy, Senator Hatch, and members of the Committee, it is my pleasure to provide you with my assessment of the Department of Justice's (DOJ) lawsuit currently pending against the leading US cigarette manufacturers. I am an Executive Director at Morgan Stanley, where I have been the Firm's senior US tobacco industry equity analyst for more than ten years. I am neither an advocate nor an opponent of the tobacco industry; rather, I endeavor to provide our Firm's retail and institutional clients with an accurate and objective assessment of the various issues facing the industry. It is in that spirit and context that I am providing to you my assessment of the DOJ's tobacco lawsuit this afternoon. My key conclusion is that while the US tobacco industry faces many legal challenges, I do not believe that the DOJ's tobacco claim represents a significant legal threat to the industry. I believe that the lawsuit will ultimately be dismissed or otherwise resolved at little financial cost to the Defendants. My assessment is primarily based on five factors:

First, on two separate occasions lower court Judge Gladys Kessler has dismissed all of the DOJ's claims for tobacco-related health care cost reimbursement. Recall that the primary original rationale for the DOJ's tobacco lawsuit was to seek the recovery of tobacco-related health care costs. Following the rejection of all claims based on the Medical Care Recovery Act (MCRA) and the Medicare Secondary Payers (MSP) provisions, only the RICO components of the Government's tobacco claim remain. As a result, the potential financial threat of the lawsuit has already been significantly reduced.

Second, I believe that the remaining RICO counts represent novel legal claims and face significant legal and factual challenges. In particular, the DOJ will be required to establish that prior industry profits were "ill gotten;" that future industry wrongdoing is likely despite the extensive restrictions placed on industry conduct as a result of the Master Settlement Agreement (MSA); and that disgorgement is an allowable and appropriate remedy under the equitable provisions of RICO.

Third, since the DOJ's tobacco lawsuit was originally filed, the US Court of Appeals for the DC Circuit has unanimously dismissed two separate groups of tobacco health care cost recovery claims. Importantly, Judge Kessler had initially allowed the RICO claims in one of these groups of lawsuits to proceed to trial. The US Court of Appeals for the DC Circuit's ruling in those cases, in my opinion, indicates an unwillingness to alter existing precedent to punish a currently unpopular defendant. As long as existing law is applied fairly to the remaining RICO claims, we believe that the DOJ's tobacco lawsuit will ultimately be dismissed or otherwise resolved at little financial cost to the Defendants.

Fourth, Judge Kessler's earlier rulings, in our opinion, provide little ground for DOJ-optimism regarding the ultimate outcome of the lawsuit. As outlined above, Judge Kessler has twice rejected much of the lawsuit. Equally important, given the fact-based nature of the RICO claims, while it is not surprising and we anticipated that Judge Kessler did not dismiss the DOJ's RICO claims in response to the industry's Motion to Dismiss, in our opinion, she left little ground for DOJ-optimism regarding her ultimate evaluation of the RICO counts. In particular, she indicated that "The Government has stated a claim for injunctive relief; whether the Government can prove it remains to be seen." For example, the government will probably have to prove that the industry is currently in violation of the MSA and that it is currently engaged in an ongoing criminal Enterprise.

Finally, we believe that it is important to recognize that many of the advocates of the DOJ's remaining tobacco RICO claims were earlier optimistic regarding the prospects for other ultimately unsuccessful legal attacks against the US tobacco industry. These included the FDA's effort to claim tobacco regulatory authority, the initial health care cost recovery claims in the DOJ's tobacco lawsuit, and the RICO counts in private third-party payer tobacco health care cost reimbursement actions.

Below, I review some of these points in greater detail.

First, lower court Judge Gladys Kessler has TWICE dismissed ALL of the DOJ's claims for tobacco-related health care cost recovery. In reaching these decisions, Judge Kessler indicated that the Federal Government lacks any common law right to seek health care cost reimbursement, lacks any statutory right to seek cost recovery on a direct or independent basis, and cannot seek recovery of any Medicare or Federal Employee Health Benefits Act ("FEHBA") costs. It is important to note that these claims were originally lauded by the DOJ as having a sound basis in law. As a result of Judge Kessler's rulings, the potential financial threat of the DOJ's tobacco claim has been significantly reduced, and the Government's remaining claims have been limited to potential RICO recovery.

Second, the remaining RICO counts are novel claims and face significant legal and factual challenges. Under the infrequently utilized equitable provisions of RICO (Section A), the DOJ is pursuing "disgorgement" of allegedly "ill gotten" gains that resulted from the industry's alleged wrongful conduct, and other equitable injunctive relief that it considers necessary to reform industry practices. The Government alleges that equitable relief is necessary to prevent and restrain the Defendants from continuing their unlawful conduct in the future. As an initial threshold matter, we know of no instance in which an equitable RICO claim has been allowed to proceed to trial without a prior criminal conviction based on the same underlying activity. The DOJ has indicated, however, that it has dropped all of its criminal investigations of the US tobacco industry. More significant legal and factual hurdles facing the DOJ's RICO claims include:

A) Can the DOJ establish that prior industry wrongful conduct generated "ill gotten" gains? The core of the government's RICO claim for disgorgement of "ill gotten" gains is that the tobacco industry deceived the public and the government regarding the health risks associated with smoking. In our opinion, there has been decades-long widespread awareness of these risks, and in particular, the federal government has required a health warning on all cigarettes sold in the US since 1966, has published ongoing Surgeon General reports on the health risks associated with smoking since 1964, and concluded in 1988 that cigarette smoking is "addictive." As a result, we believe that it may prove difficult for the Government to establish that a causal nexus exists between the industry's alleged wrongful conduct and its "ill gotten" gains. Note that the industry has often prevailed against allegations of prior wrongful conduct (e.g., the unanimous defense verdict in Ohio Iron Workers, and the rejection of all RICO claims in Empire Blue Cross).

B) Can the DOJ distinguish the industry's prior "ill gotten" gains? Even if the DOJ can prevail in establishing prior industry wrongful conduct, we believe that it may face a significant challenge in quantifying the extent to which prior industry gains were "ill gotten." In particular, we believe that the DOJ would likely have to establish which consumers, at which specific times, and at which specific transactions, were deceived by the industry regarding the risks associated with cigarette smoking (and would not have purchased cigarettes absent the deception). Although the DOJ would presumably intend to rely on statistics and extrapolations to determine the magnitude of the industry's allegedly "ill gotten" gains (e.g., it will likely argue that people would have smoked some percentage less if they were aware of the true risks associated with cigarette smoking), courts have typically rejected the use of statistics and/or aggregation to determine damages.

C) Can the DOJ establish a reasonable likelihood of future industry wrongdoing in light of the Master Settlement Agreement (MSA)? Irrespective of prior alleged wrongful conduct, equitable relief under RICO must be closely tied to a threatened future occurrence of wrongful conduct so as to "prevent and restrain" future RICO violations. Importantly, the DOJ's complaint alleges essentially no post-1995 wrongful industry conduct, and the MSA arguably addresses essentially all of the equitable relief that the DOJ is seeking. As a result, we believe that it may prove difficult for the DOJ to argue that additional equitable relief is necessary.

For example, while the DOJ seeks an injunction against making misrepresentations, the companies are barred from making any material misrepresentations regarding the health consequences of smoking under the MSA. While the DOJ seeks the disclosure of smoking and health research, the manufacturers are already required to do so under the MSA. While the DOJ seeks an injunction against future advertising campaigns targeting minors, the manufacturers are explicitly barred from doing so under the MSA (and are subject to a variety of extensive marketing restrictions). Finally, while the DOJ seeks the funding of a "corrective public education campaign," under the MSA the Defendants are required to contribute $1.7 billion to an independent foundation to take such action.

Although at this early stage of the litigation Judge Kessler was understandably not willing to assume that the Defendants have complied with the MSA, or that the MSA has adequate enforcement mechanisms in the event of non-compliance (e.g., consent decrees with each settling State and Territory), as the case proceeds we expect the Court to fully consider these issues in the context of the need to "prevent and restrain" future wrongful conduct.

D) Is disgorgement an available remedy under the equitable provisions of RICO? Traditionally, equitable relief has been provided through an injunction or specific performance, in contrast to monetary damages. While disgorgement of allegedly "ill gotten" gains is the primary financial threat remaining in the DOJ's tobacco claim, several factors, in our opinion, limit the potential financial threat associated with disgorgement. First, disgorgement is not even listed as a remedy under the equitable RICO statute. While the statute lists divestiture, injunctions, and reorganization as possible relief, it does not mention disgorgement (which is arguably not "forward looking"). Second, disgorgement has never been authorized under the equitable provisions of RICO within the DC Circuit. Third, while among Federal Courts of Appeal only the Second Circuit in United States v. Carson has authorized disgorgement under the equitable provisions of RICO (to our knowledge, only in Carson has the Government been awarded monetary relief under the specific RICO cause of action being pursued in this case), that Court: i) required evidence that disgorgement of particular "ill gotten" gains was necessary to "prevent and restrain" future RICO violations "rather than to punish past conduct;" ii) determined that "RICO does not authorize disgorgement of gains ill-gotten long in the past;" and iii) ruled that whether disgorgement is appropriate in a particular circumstance depends on whether there is a "finding that the gains are being used to fund or promote illegal conduct." Each of these rulings, in our opinion, limits the potential financial threat of disgorgement under the equitable provisions of RICO in the DOJ's tobacco claim, if such relief is allowed.

With respect to the legal challenges confronting the pursuit of disgorgement under RICO, also note that a DC District Court in FTC v. Mylan Labs, a 1999 decision, ruled that disgorgement was not a permissible remedy under the Clayton Act -- whose remedial provisions are similar to RICO's -- because it considered disgorgement a retrospective, rather than prospective, remedy. In Mylan Labs, the DC Court ruled that disgorgement is only available under statutes that explicitly provide for that remedy.

Third, since the DOJ's tobacco lawsuit was originally filed, the US Court of Appeals for the DC Circuit has unanimously dismissed two separate groups of tobacco health care cost recovery claims. Its rulings were consistent with the unanimous decisions of seven other Federal Courts of Appeal, and in our opinion, indicate an unwillingness to alter existing law to punish a currently unpopular defendant. Given existing law and the issues outlined above, we believe that DOJ's tobacco lawsuit will ultimately be dismissed or otherwise resolved at little financial cost to the Defendants.

Let me conclude with an observation based on my training and experience as a financial analyst. The public policy purpose of this lawsuit is presumably to stop any unethical behavior by the tobacco companies; for example, marketing to children. While the federal government could strongly support the MSA to promote that worthwhile goal, further monetary transfers from the tobacco industry, in my opinon, will not. Rather, monetary payments will only increase the economic partnership between the industry and the federal government, resulting in further taxes on people who in many cases can least afford to pay them.