confronting contraband

Confronting cigarette contraband

Confronting cigarette contraband Philip Morris International Inc. October 2003

©2003 Philip Morris International 1


Contents

Summary .................................................................................................................3

Part 1: A model for progress ...................................................................................4 1 Creating a secure distribution network ..................................................................... 5

Manufacturers, importers and exporters .................................................................. 5 Wholesalers, distributors, retailers .......................................................................... 6 Sales to consumers over the internet ...................................................................... 6 Logistics ............................................................................................................... 6 Recordkeeping ...................................................................................................... 7

2 Protecting the legitimate channel............................................................................. 8 Infiltration ............................................................................................................ 8 Diversion .............................................................................................................. 8 Circumvention....................................................................................................... 8

3 Harmonizing policies..............................................................................................10 Free movement of goods ......................................................................................10 Taxation..............................................................................................................10 Integrity ..............................................................................................................11

4 Stopping the counterfeit trade ................................................................................12 A growing problem...............................................................................................12 What needs to be done.........................................................................................13

Part 2: Overview of PMI sales practices................................................................14 Description of PMI................................................................................................14 Production locations .............................................................................................14 Volumes, sourcing, and sales ................................................................................14 Sales practices .....................................................................................................15 Monitoring and verification....................................................................................15

Bibliography ..........................................................................................................17



Summary Article 15, section 1 of the World Health Organization’s Framework Convention on Tobacco Control states, “the elimination of all forms of illicit trade in tobacco products, including smuggling, illicit manufacturing and counterfeiting, and the development and implementation of related national law, in addition to sub-regional, regional and global agreements, are essential components of tobacco control”. Philip Morris International and its affiliates support the goals of Article 15 of the FCTC. We encourage all governments to enact and enforce legislation to achieve these goals. Illicit trade in cigarettes, whether genuine or counterfeit, harms legitimate tobacco manufacturers by disrupting the market and unfairly competing with legitimate products. Sellers of illegitimate product benefit from significant “competitive advantages” – the most significant of which is that their products are able to be sold more cheaply, because they do not pay either import duties or excise or other relevant taxes. Moreover, counterfeit products are cheap to acquire because their manufacturers use inferior materials and are completely unconcerned by quality controls in terms of production, shipment, storage or distribution. In addition, counterfeiters avoid research and development expenses to improve product quality and develop new products, as well as marketing costs of establishing consumer brand awareness. This means that, whether the illegitimate cigarettes are counterfeit goods, genuine smuggled brands of international manufacturers, or extremely low cost local brands that flow into neighbouring markets and gain significant shares of the adult consumer market, they have an unfair competitive advantage. Put simply, legitimate manufacturers and importers cannot compete with smuggled products on a price basis. This paper presents the views of Philip Morris International (PMI) on how to address and ideally eliminate the problem of cigarette contraband. The paper is divided into two parts. Part 1 describes a model for combating cigarette contraband by (a) establishing regulation that will create a secure distribution network for legitimate cigarette trade; (b) enforcing the laws so as to protect that network from infiltration, diversion, and circumvention; (c) harmonizing government policies with the goal of combating contraband; and (d) expanding the fight against the growing illegal trade in counterfeit cigarettes. Part 2 describes PMI and summarizes the business systems it uses to deliver its products to their intended destination for sale to consumers in accordance with fiscal and other requirements. The paper concludes with a bibliography of relevant sources.



Part 1: A model for progress Combating cigarette smuggling on a global scale is an enormous task that requires integrated action by government, industry and consumers. Key to achieving success is the development of effective regulation and meaningful government enforcement of that regulation. The discussion below draws on suggestions and proposals from many leading sources (see bibliography) and seeks to synthesize the best thinking into a model for comprehensive, sustained, and enforceable action. As discussed in more detail below, the fight against cigarette contraband can be broken down into different categories of action:

Creating a secure distribution network (“legitimate channel”) A critical requirement for the effort to defeat contraband, as many authors have suggested, is a secure distribution network through which cigarettes are manufactured, transported, and sold to consumers in accordance with all applicable fiscal and other requirements. This legitimate channel, and all participants in it, should be subject to regulation that includes measures, such as licensing, designed to combat the manufacture, distribution and sale of illicit tobacco products. There should be appropriate penalties for non-compliance.

Protecting the legitimate channel The effectiveness of a secure distribution network in combating contraband requires that customs, police, and other authorities enforce the laws to prevent infiltration, diversion, and circumvention. Only with meaningful government action is it possible to block the pathways by which contraband cigarettes otherwise would reach consumers in contravention of fiscal requirements.

Harmonizing policies Creating and maintaining a secure distribution network and taking other anti-contraband measures will often require governments to harmonize different policies. Policymakers are often confronted by the need to strike the right balance between competing policies. For example, efforts by a manufacturer to control or limit subsequent sales of its products may be at odds with general principles of free competition. Similarly, efforts to limit cross-border shopping can conflict with the objective of promoting free movement of goods. In these and other respects, decision makers may need to reconcile different and at times conflicting interests and policies.

Confronting counterfeit cigarettes Finally, the fight against contraband needs to devote significant attention to the growing problem of counterfeit cigarettes. Current levels of counterfeit cigarette production are alarmingly high. For example, based on available data, the vast majority – almost 90% – of smuggled cigarettes bearing Philip Morris brand names seized by governments in 2002 were actually counterfeit. Cigarette counterfeiting hurts not only consumers (who are deceived) and manufacturers (whose trademarks are damaged) but also governments, since counterfeits are invariably smuggled and sold without payment of excise and other taxes. Accordingly, it is critical for industry and government to work together to stop the manufacture, smuggling and sale of counterfeit products. Each element of this proposed model is described in more detail in the following sections.



1 Creating a secure distribution network [Countries should implement] measures including licensing, where appropriate, to control or regulate the production and distribution of tobacco products in order to prevent illicit trade.

(World Health Organization 2003, article 15, section 7)

Many authors have suggested that a critical requirement for the effort to defeat contraband is a secure distribution network. Such a network should ensure the delivery of cigarettes to retailers in the market of intended destination for purchase by consumers in accordance with fiscal and other legal requirements (see Figure 1).

Figure 1: Secure distribution network

Regulation that applies to all layers of distribution, from manufacturers, their customers and subsequent purchasers, to retailers, logistics operators (e.g. warehouses and transporters) and other participants in the legitimate channel is essential to creating such a network. Ideally, regulation would be consistent both in substance and enforcement from country to country, especially among countries that are members of regional trade unions such as the European Union, the Andean Pact, Mercosur, ASEAN and NAFTA, to avoid a single country becoming a point of entry or production for illegal products. Most importantly, a secure distribution network is not possible without strict, even-handed and honest enforcement of regulatory requirements. Unless government authorities consistently enforce the laws, the network will be too porous to be effective in the fight against contraband. The substantive elements of the regulations governing the legitimate channel should strive to eliminate contraband while promoting efficiency and competitiveness among market participants. Examples of core regulatory requirements include the following:

Manufacturers, importers and exporters Along with the other participants in the legitimate channel (such as wholesalers and retailers), cigarette manufacturers, importers and exporters should be subject to a licensing regime and other forms of regulation that mandate business practices that make it difficult to participate in the smuggling of cigarettes and carry penalties that act as a strong deterrent. While manufacturers are not able to police the supply chain to the point of sale to the consumer, they are the first link in the chain and a secure distribution network will therefore depend on responsible selling practices by the companies that manufacture cigarettes. Exporters and importers serve as the access points in many cross-border transactions, making regulation of their conduct with appropriate mandatory business



practices and penalties critical to a secure network. (The problem of illegal production by cigarette counterfeiters is discussed below in part 1, section 4.) Regulation should require manufacturers to apply for a license to manufacture cigarettes. Licenses should be granted only to those manufacturers who can fulfill specific criteria. Regulations should set out standard business practices that all licensed manufacturers must follow. Key elements would include: 1. Careful selection of customers and other business partners; 2. Compliance with recordkeeping and reporting requirements; 3. Labelling of packaging with, for example, country-specific tax stamps, special markings

for duty-free products, and country-specific health warnings/country of intended retail sale markings;

4. Security markings on packaging that would provide a means for government officials to more readily determine that the product is genuine rather than counterfeit; and

5. Coding and recordkeeping requirements to facilitate product tracking by providing the name of the manufacturer, and the place and date of production.

Regulation should also impose strict penalties on licensed manufacturers who fail to comply with these requirements, including where warranted suspension or permanent revocation of the right to manufacture tobacco products. Unlicensed manufacturers should face additional penalties.

Wholesalers, distributors, retailers Regulation should also apply to each element in the chain of sale and resale following the first sale by the manufacturer. Accordingly, wholesalers and retailers should be subject to licensing, recordkeeping, and other regulatory requirements. As with manufacturers, only wholesalers, distributors, retailers and others who apply for and are granted a license would be permitted to operate in the tobacco trade. All licensed operators would have to comply with specific requirements set forth in the regulation. For example, regulation should prohibit any alteration by subsequent commercial purchasers of the coding that manufacturers place on wholesale or consumer packaging. It should further prohibit resale of any products that do not have proper fiscal markings or otherwise fail to satisfy local product labelling requirements.

Sales to consumers over the internet The internet is clearly a popular mechanism for consumer purchasing. But, as one recent article states, internet sales are “a relatively new phenomenon that, at least in some jurisdictions, may become a significant form of circumvention of… taxes” (Joossens et al. 2000, p. 396). Moreover, the sale of tobacco products over the internet presents a greater risk of sale to minors than conventional retail channels. Accordingly, regulation should prohibit the sale of tobacco products over the internet to consumers without payment of applicable taxes and appropriate restrictions so that the product is sold and delivered only to adult consumers. Specifically, delivery by mail should be permitted only when accompanied by reliable mechanisms for age verification and tax collection. Retailers who sell over the internet should be required to be licensed and should comply with labelling requirements, recordkeeping obligations, age verification standards, and all laws applicable in the country of destination including import duties, excise taxes, product regulation and health warning requirements.

Logistics The legitimate channel includes the infrastructure that physically moves product from the place of manufacture to the point of sale to consumers. This infrastructure includes numerous parties that do not take ownership of the cigarettes but nonetheless are critical participants in the legitimate network. The proper functioning of the legitimate channel



therefore requires that land, sea, and air transportation companies, warehouses, banks, and other entities also adhere to appropriate regulation. For example, as suggested by a number of authorities, including the European Parliament, excise warehouses should be subject to licensing (European Commission 1998b, pp. 3–4). Regulation should also provide for the monitoring of duty-suspended movements, including by requiring manufacturers to notify customs authorities when they have arranged for goods to be shipped on a duty-suspended basis. Transport documentation accompanying movements of duty-suspended product should also be provided to customs authorities. The exporter should include a statement of the market of intended destination for the products. In this way, the authorities would be able to monitor the flow of goods more effectively.

Recordkeeping As is the case in other highly regulated industries, regulation should require an “open book” recordkeeping regime to permit government audits of sales transactions. These records are an important element of monitoring activity in the legitimate channel, investigating any suspected diversion, and enforcing the regulations governing the channel. For example, manufacturers should be required to maintain detailed information about their significant volume customers (as well as other key business partners) by name, location, ownership structure; sales, pricing, shipping, and payment information; customer coding; and market of intended destination. Subsequent purchasers should be subject to similar requirements so that authorities can trace product sales from manufacturer to retailer. Logistics providers, banks, and other entities should also be subject to recordkeeping requirements in light of their activities.



2 Protecting the legitimate channel Large-scale smuggling also requires a willing market and a local distribution network to supply it. Unregulated distribution networks provide more opportunities to sell contraband cigarettes.

(Joossens 2003)

Full compliance by manufacturers, importers, exporters, retailers, warehouses and others with the regulations governing the legitimate channel is an essential element in combating smuggling. However, governments play the most important role in protecting the integrity of the channel. Governments need to protect and police the legitimate channel so that it is the only channel by which consumers can purchase cigarettes. Put simply, if consumers can only buy cigarettes through the legitimate channel, then there will be no real incentive and no practical mechanism for illegal sales. As shown in Figure 2, there are at least three threats to the legitimate channel: infiltration, diversion, and circumvention.

Figure 2: Threats to the legitimate channel

Infiltration First, the legitimate channel needs to be protected from infiltration. In other words, enforcement authorities need to ensure that illicit cigarettes such as counterfeits and cigarettes that have been diverted from other channels are not introduced into the legitimate channel and sold to consumers. Doing so is critical to assuring that the product for sale at retail is genuine product and complies with all fiscal and other requirements.

Diversion Second, a secure distribution network should not only be protected from infiltration into the system but should also be regulated to prevent diversion of product out of the network. Doing so entails, for example, compliance by participants in the legitimate channel with all regulatory requirements as well as enforcement of borders to block entry of product diverted from another market.

Circumvention Third, a closed distribution network will not have its intended effect of reducing contraband if it is possible to circumvent the system. When cigarettes are available for purchase through unlicensed or unregulated outlets, such as on the street corner, or in an unregulated manner



over the internet, then there will remain a market for contraband and both the government and the participants in the legitimate channel will suffer. As one study has reported, “large-scale smuggling requires a good local distribution network, most often involving extensive street-selling through which the smuggled cigarettes can be easily and quickly sold” (Joossens et al. 2000, p. 399). Police and other enforcement action against illegal sellers are therefore key components in the anti-contraband effort.



3 Harmonizing policies The key issue for policymakers is to decide how to control tobacco without jeopardizing the otherwise beneficial consequences of free trade.

(World Bank 1999)

With a secure distribution network for the legitimate channel at the core of an anti-contraband programme, it is critical that government policies support the proper functioning of the network. Three of many possible examples of such policies concern free movement of goods, taxation, and integrity:

Free movement of goods

All EU citizens have a right to buy tobacco and alcohol in other Member States, duty paid, for non-commercial use.

(EU Commissioner F. Bolkestein, cited in BBC News 2001)

In many instances, there is a conflict between anti-contraband efforts and general trade policies. This conflict has been particularly acute in the European Union, a bedrock principle of which is free movement of goods within and among the member states. For example, the European Commission at one point stated that “the controls currently being applied at UK ports and airports, and the sanctions being applied when UK excise duty law is breached, may breach the EU rules which give travellers the right to buy abroad” (European Commission 2001). In response, “to protect the rights of honest cross-Channel shoppers to bring back as much tobacco as they want, for their own use”, UK Customs and Excise recently raised “the indicative levels for tobacco” (HM Customs and Excise 2002). When conflicts of this nature arise, they do not require an “either/or” choice. In the situation above, for example, it is not necessary for governments to choose between free movement of goods, with or without indicative limits, and control of contraband and counterfeit. It simply has to be recognized that each of these has a potential cost to the other, and that maintaining both competing interests may require additional efforts and resources in related areas, such as enforcement. It is our view – we believe supported by what has happened at the UK borders – that it is possible to have free movement of goods and control of contraband; but this clearly requires a greater application of enforcement resources than a situation in which either free movement of goods is not encouraged or tax rates and structures are aligned to a greater degree.

Taxation Tax policy in relation to tobacco products is guided by multiple objectives. The policy is clearly motivated by a goal to generate revenue for government expenditure. In addition to seeking revenue, many public health officials, including the World Health Organization, have encouraged the use of taxes to reduce consumption, particularly by young people. A number of governments also view cigarette taxation as a means to cover health care costs attributed to smoking, such as the treatment of diseases caused by smoking. Whatever the goal, governments should take into account the potential impact of a tax increase on illicit trade in tobacco products. Tax is an incentive and therefore an important factor in regard to illicit trade. As excise taxes and other costs increase, smokers may seek lower-priced cigarettes from a variety of alternative venues and channels, including products sold on the black market. The World Bank has stated: “Differences in price between countries or states will clearly increase the incentives to smuggle cigarettes. However, the determinants of smuggling appear to be more than price alone” (World Bank 1999, ch. 5). As a number of recent studies state, it is possible to maintain high tax rates without a



correspondingly high level of smuggling. While it must be recognized that changes in tax rates will occur at various times, we believe any changes that result in greater tax differentials between nearby countries can and should be managed so as to minimize their effect on illicit cigarette trade. Effective management of such changes would include increased law enforcement efforts as well as legislative action to ensure that the additional taxes are also imposed on other tobacco products so that there is no shift in demand to alternative or illicit products (such as “roll your own” tobacco, cigarillos, trade brands, or the like).

Integrity In the specific context of cigarette contraband, studies report a correlation between the level of smuggling and the degree of corruption in a given country (Merriman et al. 2000, p. 385). Accordingly, anti-contraband programmes need to be supported and reinforced by concerted efforts to promote a high degree of integrity within customs and other enforcement authorities. As the World Customs Organization has stated, “Integrity is a prerequisite for the proper functioning of a Customs administration. Reforms will only have lasting effects if they are accompanied by effective strategies on integrity and by a commitment to their application” (World Customs Organization 2002).



4 Stopping the counterfeit trade From the days when Gallo-Roman potters placed their best-known competitors' seals on the necks of their own amphoras… counterfeiting and piracy have evolved constantly with emerging trends and technology.

(European Commission Taxation and Customs Union 2001)

A growing problem Counterfeiting is a long-standing but growing problem around the world. According to the United States government, “what was once a localized industry concentrated on the copying of high-end designer goods has now become a massive, sophisticated global business involving the manufacture and sale of counterfeit versions of everything from soaps, shampoos, razors and batteries to cigarettes, alcoholic beverages and automobile parts, as well as medicines and health care products” (US Trade Representative 2003). Contraband distribution channels are rife with counterfeit cigarette products. In fact, data from several sources show that contraband cigarettes bearing Philip Morris trademarks are overwhelmingly counterfeit. Some governments, as well as the World Customs Organization, estimate that approximately 150 to 200 billion counterfeit cigarettes are produced annually in East Asia alone, making the total number of counterfeit cigarettes produced annually larger than the genuine production of all but the very largest tobacco companies. Clearly, counterfeit cigarettes cause a host of problems. First, as described above in the summary to this paper, counterfeit products compete unfairly with legitimate trade and deprive trademark holders (and their shareholders) of revenue. Second, counterfeit goods cause governments to lose substantial tax revenues. According to the European Commission’s Taxation and Customs Union Directorate General, “counterfeiting and piracy… almost always escape taxation, because goods are either smuggled into Europe or come in with forged or invalid documents” (European Commission Taxation and Customs Union 2001). Aside from lost tax revenues, the WCO has observed that “for national economies, in the long term, counterfeiting causes serious economic damage, especially in terms of attracting inward investment” (World Customs Organization 1999). The European Commission estimates that counterfeit products amount to 5 to 7 per cent of world trade and are responsible for the loss of 100,000 jobs in Europe (European Commission 1998a). Third, counterfeit cigarettes usually have serious quality problems, but the consumer is fooled into thinking that he or she can rely on the reputation of the international manufacturer whose brand name has been stolen. The counterfeit product often does not taste or smell the same as authentic product because different materials are used and production often appears to be without any quality control. Moreover, the consumer who smokes counterfeit Philip Morris product will associate poor quality with the brand. This is harmful to the image and reputation of our brands. All cigarettes cause disease and there is no such thing as a safe cigarette. Counterfeit cigarettes, however, do not comply with government regulations governing the manufacture and sale of tobacco products. A recent BBC broadcast reported that, compared with genuine cigarettes on the UK market, counterfeit cigarettes “had 75% more tar, 28% more nicotine and about 63% more carbon monoxide”. Moreover, according to the BBC, tests showed that counterfeit cigarettes “were contaminated with sand and other packing material such as bits of plastic” (BBC News 2003). Finally, according to the European Commission, international criminal organizations participate in counterfeit production; and counterfeiters produce “at any cost” and “exploit



their workforce, often largely consisting of children who are locked up in cramped conditions, without any concern for personal safety or human rights” (European Commission Taxation and Customs Union 2001).

What needs to be done Efforts to eradicate the manufacture, importation and sale of counterfeit cigarettes require the support and cooperation of many sectors. As noted above, government leadership is the most important factor in this effort. Governments can and should take strong action against the production, importation and sale of counterfeit cigarettes. In addition to the regulatory measures discussed, such as licensing, specific steps should be taken to enhance the ability of right-holders, law enforcement and other government officials to combat counterfeiting. These steps should include: • Making counterfeit a serious crime and enforcing the laws: Counterfeiting must

be treated as a serious criminal offense, equivalent to fraud, with serious consequences. Strong penalties should be imposed for the manufacture and trade in counterfeit cigarettes, and effective remedies should be available to ensure punishment and to act as a deterrent. Laws must be supported by effective law enforcement and the dedication of appropriate judicial resources.

• Seizure and destruction of goods and machinery: Governments and trademark holders should collaborate promptly following the seizure of contraband product to determine whether the product is counterfeit or genuine. Counterfeit tobacco products and the machinery used to manufacture them should be seized and destroyed. Auction or resale of counterfeit cigarettes by the government should be prohibited. Such actions are just as damaging to the trademark holder as the smuggling of counterfeit products and also violate fundamental intellectual property protections; they also tend to create an enlarged supply of product available for smuggling.

• Strengthening the authority of customs: As the WCO has said, customs must play a crucial role in stopping trade in counterfeit products. Governments should enact measures to increase the ability of customs officials to stop the trafficking of counterfeit products, including permitting customs authorities to act on goods “in transit” and in free trade zones or free warehouses. Other measures include simplifying the procedures and requirements for right-holders to request action by customs and increasing the sharing of information between customs and right-holders.

The preceding section has set forth a summary of the many good ideas that have been offered for dealing with the issue of illicit trade in cigarettes. As a private manufacturing company, PMI stands ready to work with governments to support the passage of legislation and regulation that effectively deals with the issue of cigarette contraband, in both counterfeit and genuine products. In Part 2, there follows a discussion of PMI’s business systems, designed to deliver PMI’s products to their intended destination for sale to the ultimate consumer, as well as a discussion of the effectiveness of those systems.



Part 2: Overview of PMI sales practices

Description of PMI Philip Morris International, with headquarters in Lausanne, Switzerland, is engaged in the manufacture and sale of tobacco products for consumption outside the United States. PMI is a subsidiary of Altria Group, Inc., and a sister company of Philip Morris USA Inc.; the latter mainly supplies the domestic market in the United States. PMI’s principal international brands are Marlboro, L&M, Philip Morris, Chesterfield, Bond Street, Lark, Parliament, Merit, and Virginia Slims. Examples of PMI’s local brands include Optima (Russia), Vatra (Ukraine), Diana (Italy), Fajrant (Poland), Medeo (Kazakhstan), Lider (Ecuador), and Astor (Venezuela). PMI’s leading international brands are “American blended” cigarettes, which are a distinct type of cigarette made from different tobacco types (primarily Burley, Virginia or flue-cured, and oriental tobacco). Another major style of cigarette is called a “Virginia” cigarette. This cigarette, favoured in the United Kingdom and other Commonwealth countries, has just one type of tobacco: Virginia or flue-cured. Consumers in a specific market tend to favour either American-blended or Virginia cigarettes. Financial and other information about PMI is available on the company’s web site, www.philipmorrisinternational.com.

Production locations At present, over sixty production centres manufacture PMI brands, of which: • roughly half are PMI facilities, which combined employ more than 21,000 people in 26

countries; • roughly half are owned by third parties who manufacture PMI brands under contract; and • two are owned and operated by PMI’s sister company, Philip Morris USA Inc., in the

United States. PMI’s largest production centre is in Bergen op Zoom, Holland.

Volumes, sourcing, and sales PMI produces over 700 billion units per year. Nearly all of this production is intended for ultimate sale to consumers at retail outlets in domestic (tax-paid) markets and carries country-specific labelling. PMI also manufactures product for sale at authorized duty-free outlets, such as in airports, on ferries, in border shops, and on military bases. The volume of this production is somewhat less than 4% of the total production. Most (approximately two-thirds) of our cigarettes are manufactured in the country for which they are intended for sale at retail (as opposed to cigarettes for import by other countries). For example, PMI factories in Argentina, the Czech Republic, Germany, Holland, Poland, and Russia supply product for sale to consumers in those countries, as well as, in some cases, for export. PMI does not have production facilities in every country in which its brands are sold. Some markets, including Japan, France, Italy, and Spain, are supplied, in whole or in part, with imports from production centres in other countries, most notably from Germany, Holland, Switzerland, and the United States (manufactured through a contract with Philip Morris USA Inc.).


http://www.pmintl.com/


PMI products are available for sale in well over 100 countries around the world. PMI products are distributed in different ways depending on the applicable regulatory environment, including through wholesalers and, in some markets, directly to retailers. In some markets, particularly current or former monopoly countries, PMI has only one direct customer, which is then responsible for distribution and other logistics involved in moving the product to retail sale. The number of entities involved in the ultimate sale of PMI products to consumers at retail worldwide is enormous, encompassing hundreds of thousands of retail outlets, as well as thousands of wholesalers.

Sales practices PMI has taken significant, and we believe successful, steps internally to reduce as far as possible diversion of genuine cigarettes into illicit trade channels. For example, we deliver our products in a manner designed to minimize the risk that they will end up in illicit trade channels, and to that end have implemented sales practices that include such elements as: • Screening and monitoring of customers and other business partners designed to ensure

their reliability in adhering to PMI policies; • Working with business partners to promote responsible practices; • Limiting sales volumes to estimated consumer demand for our products in the markets of

intended destination; • Using delivery terms intended to reduce the risk of diversion; • Marking products with local language health warnings or other indications of country of

destination; • Using case coding and other means to assist in product tracking and tracing; and • Spot checks of transportation, delivery, and retail sale. We require our customers to be vigilant in their actions to prevent diversion of Philip Morris product into illegal trade channels. We also make clear that we will suspend or terminate our business with customers who directly or indirectly, and knowingly or recklessly, contribute to the diversion of our products into illegal trade channels. We also inform our customers that we will not supply, either directly or indirectly, customers or subsequent purchasers of our products who do not have sufficient controls in place designed to ensure that our products are sold and resold only in accordance with our policies. These and other business systems are part of a general compliance programme that includes employee training, auditing, recordkeeping and other measures designed to ensure compliance with applicable laws and company policies.

Monitoring and verification In addition to market analyses, systems reviews, on-site inspections, and other techniques, PMI uses various indicators to verify delivery of its products in accordance with the procedures described above. For example: • Monitoring consumer demand: Like any company in a highly competitive industry,

PMI seeks to increase its share of the markets in which it competes (especially in its leading markets), build volume, and increase profitability. In pursuing these goals, the company seeks to supply the market with volumes that are consistent with estimated consumer demand for PMI’s products. This means maintaining stock levels so that the company is neither undersupplying nor oversupplying the market. Examples of data used to estimate market demand include the adult smoker population, purchasing power, tourism, and market shares of competing brands.

• Monitoring import/export volumes: A number of authors have pointed to a suspected gap in total cigarette exports and imports worldwide as sustaining a significant portion of large-scale (wholesale) smuggling. As noted above, approximately two-thirds of PMI’s products are produced in the country of intended consumer sale; in other words,



they are not exported but are intended for local consumption. Other markets are supplied through imports. The systems described above are designed to ensure that this PMI product is sold at retail in the intended market of destination, thereby avoiding the risk of diversion into illegitimate channels prior to retail sale.

• Tracking product seizures: Finally, PMI monitors information it receives regarding seizures by fiscal authorities of products bearing PMI trademarks. These seizure data support our view that PMI’s procedures are working and PMI products are reaching their intended destinations of retail sale.

We believe that the results of our efforts are recognized by governments and have thus far yielded tangible results. In fact, data from different sources show that the overwhelming percentage of contraband cigarettes bearing Philip Morris trademarks seized by governments are primarily counterfeit. As a result of enhanced anti-contraband efforts by governments, law enforcement agencies and Philip Morris International, the amount of genuine Philip Morris product in contraband channels today is insubstantial. Unfortunately, the same cannot be said about counterfeit products bearing Philip Morris trademarks, the presence of which has dramatically escalated over the past several years. On the matter of counterfeit cigarettes bearing our trademarks, we are implementing technologies that will make it more difficult to counterfeit our brands. We are also working with governments, providing technical training to customs officials, fiscal agents and the police to enable them to detect counterfeit goods. And we are advocating stronger legislation and enforcement of that legislation to stop the manufacture and trade in counterfeit cigarettes. Our efforts alone, however, cannot stop illicit trade in cigarettes. Government obviously has a critical role to play. The effectiveness of any action by manufacturers depends on the ability of customs, police, and other enforcement authorities to enforce the laws to prevent infiltration, diversion, and circumvention of the legitimate distribution system.




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confronting contraband

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