Tobacco Documents Online

mat~xial with a gold foil-like appearance. This pouch 16 then boxed Jn a conventional hinged lid box with six units in each pack. The pack is then overwrapped with polypropolene clear film and a tear tape ~s added. The packs are cartoned in groups of ten with sixty cartons comprising a master case. All processing involving raw nicotine, loading agents and flavorings can be done off-line and is being performed in a separate facility, thereby reducing the risk of a plant shutdown in the ca~e ofian aoeldental spill or other such oecurence. In addition, handllng'of the chemlcal elements in this manner will ensure a very clean environment In the actual assem- bling and packaging process. The product development and manufacturing operations currently occupy approximately 12,000 square feet. This space is adequate for both labor- atory and office areas for Manufacturing, Product Development and for two operational production lines which the Company currently has ~n place. The projected direct manufacturing cost of a pack of Favor smoke-free cigarettes is approximately $.16 when volume dictates full utilization of the machinery on a two-shift basis. The utilization of two lines running a two-shift operation will produce approximately 4,560,000 packs of smoke-free cigarettes per month. The cost of modifying, refurbishing and making operational the pro- duction line utilizing the various machines discussed above is approx- imately $500~000 per production line. PATENTS AND TRADEMARKS The Company is the owner of United States Patent No, 4,284,089, which was issued on August 18, 1981, and will expire on August i~, ]998. This patent relates to the technology underlying the smoke-free cigarette. The Company has been advised by its patent eout%sel that -]l-

the product which it intends to market, as well as The process which it intends to use in manufacturing its product, does not infringe any known existing patent rights of other parties. Three additional United States patent applications have been filed in the ordinary course of the Company's research and develop- ment activities with regard to nicotine delivery. The Company cannot predict whether any particular patent appl~ed for will be granted, i The Company is also the owner of patents issued by eleven for- eJgn countries paralleling its United States patent. The Company intends to seek additional foreign patents in selected countries paralleling currently pending United states patent applications. The Company is not able to determine at this time whether its patents or those which may eventually be issued from pending applications will secure long-term competitive advantages for the Company. None of the Company's patent rights have been liti- gated or subjected to judicial scrutiny, and the Company belleves that many courts have been unsympathetic to the holders of patents relating to relatively simple inventions such as the smoke-free cigarette in patent infringement actions seeking to assert such patents. Therefore, if the Company's patent rights are tested in litigation, there can be no assurance that patent rights affording substantial competitive protection to the Company will be upheld or that such rlghts would prevent the marketing of competing products similar in concept to the FAVOR Smoke-Free Cigarette. Therefore it is possible that if a competitor could demonstrate significant d~fference Detween the form of a competing product or the related manufacturing process and the smoke-free cigarette; -]2-

the Company would not be able to prevent the competitor from marketing such a product. The Company intends vlgorously to defend its patent rights agalnst infringement by competitors, but the Company's limited resources may make it difficult or impossible to sustai~ any such defenses, ~owever meritorious. The Company has obtained from the Unlted States Patent and Trademark Office a registration of the trademark '~FAVOR" for use in connection with its smoke-free cigarette. ~n addition, the Company holds five foreign reglstrations for the trademark "FAVOR" and has twenty-six pending foreign trademark applications. GOVERNMENTAL R~GULATION AND TAMATION General Governmental regulation and taxation of tobacco products, including cigarettes, generally oonslsts of the television advertising prohibitions and labeling requirements of the Federal Cigarette Labeling and Advertising Act and similar state statutes or regulations, and federal and state cigarette excise taxes. The Company believes that its smoke-free cigarette ks not subject to significant state or federal governmental regulation or taxatioN. The Company's belief, however, is based upon the opinion of its counsel, Matthews & Branscomb, San Antonio, Texas, and, to the extent such opinions relate to matters wlthin the jurisdiction of or relating to the FDA, its special FDA counsel Burditt & Calkins, Washington, D.C., generally to the effect sun~arized below. Such opinlons are based primarily upon s~¢h counsels' literal interpretation of several significant statutes and regulations applicable to cerbain tobacco products, but which do not specifically include or exclude the Smoke-Free -13-

Cigarette as a regulated or specially taxed product. Such opinions are not binding upon any court or governmental agency and the Company has not sought any ruling or determination, nor is it aware of a[*y controlling precedents under any such statutes or regulations. FDA Cigarette Regulation Although tobacco products are not specifically excluded from the provisions of the Federal Food, Drug and ~osme£ic Act (the "FDC Act"), the Food and Drug Administra£ion (the "FDA") has refused to assert 3urisdiction over conventional Cigarettes by maintaining th~ position that the FDC Act does not apply to cigarettes containing nicotine or nicotine separately. The FDA'S position was affirmed in 1980 by the United States Court of Appeals for the District of Columbia Circuit in Action on Smoking and Health v. Harris. It is Managements belief that the FDA's position with regard to tobacco products has been modified only when a maIlufacturer of a tobacco product claims that its product is thera- peutically or medicinally beneficial as well as pleasurable or when the users of the product intend therapeutic or medicinal effects. The Company does not claim any therapeutic or medicinal effects from the use of the smoke-free cigarette nor does it intend to market the FAVOR Smoke-Free Cigarette claimin9 any such effects. The Company does not believe that use of the smoke-free cigarette, unlike the use of conventional cigarettes, will increase the user's rlsk of lung disease or cancer because the smoke-free cigarette does not contain any of the ingredients that the Surgeon General has concluded ~ncrease such risks, but the Company does believe that use of the smoke-free cJgarette will not leduce the user's rlsk of lung disease or cancer or -14-

have a therapeutic or medicinal effect on any user suffering such a condition. Nevertheless, users of the smoke-free cigarette may believe the smoke-free cigarette has therapeutic or medicinal effects which could increase the risk that the FDA could take the position that the smoke-free cigarette is subject to the FDC Act, and, in any event, the FDA may determine, based on statements by the Company or any other relevant evidence, that the smoke-free cigarette ks subject to FDA approval and regula%iono~ The term "drug," as defined in the FDC Act, includes "articles (other than food) intended to affect the structure or any function ~f the body .... Although cigarettes and the nicotine delivere~ thereby do affect certain body functions, in 1953 the United States Court of Appeals for the Second Circuit in F.T.C.v. Llgett & Myers Tobacco Co., construed the Federal Trade Commission Act, which employs an identical definition of "drug," so as to exclude conventional cigarettes from such definition. In reaching this conclusion, the Oourt relied upon the legislative history of the FDC Act and admiN- zstrative interpretation of the Federal Trade Commission Act. The court noted that while cigarettes and the nicotine delivered thereby might be deemed to have a "soothing" effect on the body, it was doubtful that Congress intended for every substance which produces a soothing effect to be considered a ~'drug" for regulatory purposes. Because of the foregoing, the Company does not believe the smoke-free cigarette will be subject to FDA regulation. Hewever~ there is a possibility that the FDA could consider the FAVOR Smoke- Free Cigarette to be a "drug" under the FDC Act, and while the Com- -15-

pany would vigorously oppose and appeal such a determination, it is possible that the Company would be unsuccessful In its Opposition and appeal. Under the FDC ACt, a "new drug" must be the subject of an approved new drug application in order to move lawfully in interstate coJ~lerce. The Company has ~ot filed a notice of claimed investigational exemption for a new drug or a new drug application for the smoke-free cigarette. Should FDA regulation i be imposed, introductlon of the smoke-free cigarette into the United States market could be delayed for an indefinite period pending testing by the Company to demonstrate the safety and effectiveness 6f the product. In addition, should FDA regulation f be imposed, the'~ompany may fail to obtain the FDA approval that would be needed to conduct approprlate tests or the Company may otherwise fail to obtain approval of a new drug application. Any FDA approval of the smoke-free elgarette could be conditioned upon restrictions materially adverse to the Company's marketing efforts, such as a requirement that a prescription be obtained for each purchase of smoke-free cigarettes. If the smoke-free cigarette is marketed in interstate commerce under such circumstances without an approved application, the Company could be in violation of the FDC Act and such violation could result in seizure of the the product, injunctions and criminal penalties. FDA Smoking Deterrent Regulation ................................ The most recently publlshed FDA action regarding smoking rel- ated products has been its proposal in 1982 of rules on Smoking Deterrent Drug Products• The proposed rules would establish cond- itions under which over-the-counter smoking deterrent' products would -]6-

generally be recognized as safe and effective and not misbranded. These rules do not purport to regulate nlcotine, but are intended to regulate those products which claim to deter or reduce smoking. If these proposed rules become effective and if the smoke-free cigarette were advertised or marketed as a product to ~educe or or deter smoking, the Company would be required to conform to the labeling and testing requirements of these rules as finally adopted. The Company intends, however, to market the smoke-free cigarette as a pleasurable nicotine product and not as a pr6duot intended to reduce or deter smoking. Therefore, the Company does not believe that the smoke-free clgarette would be subject to the FDA'S pro- posed rules. Nevertheless, the FAVOR Smoke-Free Cigarette may be deemed to De subject to the proposed rules because of user perceptions of the effect of the product. Taxation of Cigarettes Under the Internal Revenue Code The Infernal Revenue Code of 1954, as amended (the "Code"), and the regulations promulgated thereunGer by the Bureau of AlcohOl, Tobacco and Firearms (the "SATE") generally deal with the taxation of the manufacture and sale of cigarettes and cigars. Smoking tobaceo~ chewing tobacco and snuff are exclHded from taxatlon by deflnltJons contained in the Code and by specific BATE regulatlon, The Code and BATF regulation definition of a 'Pcigarette" iDcludes a product which is a "roll of tobacco" wrapped in paper or other substances. Because the smoke-free cigarette contains a nicoti~e sol~tlon instead of a "roll of tobacco," the Company believes that it is not a "cigarette" as defined by the Code and BATF regulatlons. In a ruling (ATF Rullng 78-2) attempting to clarlfy the deflnition of t'ciqarette" under the Code and BATF Regulatlons, the BATF held -17-

that "a clgarette-style smoking product which contains no tobacco, tobacco-derived compo~ent or resin, nicotine or nicotine derivative is not a cigarette .... " Although the quoted languaqe could indi- cate that the BATF considers any cigarette-style smoking product which eoDtains nicotine to be a "cigarette" for such purposes, the BATF has not indicated by publlshed action known to the Company whether in its view a cigarette-style nlcotine product llke the smoke-free cigarette which is not smoked would'be a~clgarette as defined in the Code or HATF regulations. The Federal Cigarette Labeling and Advertising Act The labelln~ requirements and television advertising prohib- % itJons of the Federal Cigarette Labeling and Advertising Act (the "Advertising Act") apply only to cigarettes. The deflnltion of "cigarette" under the Advertlsing Act is identical to the "roll of tobacco" definitio~ of "cigarette" ~sed in the Code and the BATF regulations. The Federal Trade Commission, the fedsral agency [hlough which the Advertising Act is enforced, has not expressly ruled on the question of whether a clgarette-style product which contalns a tobacco derived component such as nicotine would be a "c~garette" as defined in the Advertlsing Act. Again, because the smoke-free cigarette contains a nicotine solution instead of a "roll of tobacco" and in the Company's opinion does not give rise to the health concerns addressed by the Advertising Act, the Company believes that the smoXe-free cigarette is not a "cigarette" as defined by the Advertlsing Act. However, because the smoke-free cigarette nicotlner has the appearance of a conventional olgarette and contains there can be no assurance that the FTC would concur with -18-

the Company~s posltlon. The Federal Hazardous Substances Act The Federal Hazardous Substances Act (the "Substanaes Act") provides the Consumer Product Safety Commission ("CPSC'~) with the authority to regulate the labeling, packaging, manufacturing and sale of products determined by the CPSC to be "hazardous substances" within the meaning of the S~hstanoes. A~t ~nd the regulations promulgated thereunder. The Substances Act specif- ically excludes "tobacco and tobacco products" from its scope. TO the Company's knowledge, the CPSC has not ruled on the question of whether nicotine or the smoke-free cigarette is a "tobacco product'' under the,Substances Act. The Company believes that because the nicotine used in the sm0ke-free cigarette is derived entirely from tobacco, the smoke-free olgarette Is a "tobacco product" not regulated under the Substances Act. State Regulation and Taxation State regulation of tobacco products generally consists of taxlng laws and regulatlons and the regulatlon of the use of tobacco products, primarily cigars and cigarettes. Although ~ost states tax all tobacco products, cigarettes and cigars are generally taxed at the highest rate. State statutes taking cigarettes and cigars arc believed by the Company to be generally inapplicable to sMoke-free cigarettes because definitions of th8 taxed product generally include "a roll of tobacco for smoking," without specifying nicotine alone as the relevant substance. However, to the Company's knowledge no state or municipal taxing authority has interpreted any such law or regulation in the -]9-

~p~clilc ~ont~xt of the smok~-freo clgarette~ The Company believes that the smoke-free cigarette will be generally subject to state and municlpal taxation as a smokeless tobacco product such as chewing tobacco and snuff. The use of tobacco smoking products is primarily regulated by state statutes and municipal ordinances prohibiting public smoking. The prohibitions in these state statutes and municipal ordinances generally proscribe "smoking tobac6o" i~ certain public places. The Company believes that the' state and municipal prohibitions are generally inapplicable to the use of its smoke-free cigarettes because such us~ does not involve "smoking." However, to the~Company's knowledge no prohibition on public smoklng has been interpreted in the specific context of the smoke-free cigarettes. Many states have enacted hazardous substance laws simllar to the federal Substances Act. TO the Company's knowledge these laws have not generally been enforced against tobacco or tobacco products, even when tobacco products are not specifically excluded as hazardous substances as is the case under the federal Substances Act. Texas, the state in which the Company intends to initially manufacture and market the FAVOR Smoke-Free Cigarette, has a hazardous substance law similar to the federal Substances Act, and which to the Company's knowledge has not been applied to tobacco or tobacco products. Unlike the Substances Act, however, there is no speclfic Texas statutory exclusion of tobacco or tobacco products. No Texas court or agency has interpre%ed Texas' hazardous substance law in the specific context of the smoke-free cigaxette. There can therefore be no assurance that -20-