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REPORT TO THE MANAGEMENT OF PffiLIP MORRIS U. S. A. REGARDING- ENAPLEMENT-ATION OF- - THE ACTION AGAINST ACCESS PROGRAM Warren B. Rudman Paul, Weiss, Ri#ldnd, Wharton & Garrison March 31, 1997

TABLE OF CONTENTS I. 11. BACKGROUND AND INTRODUCTION ................. I EXECUTIVE SUMMARY .......................... 6 M. FINDINGS AND 12ECONNIENDATIONS REGARDING EACH FLEMENT OF THE AAA PItOGRAM ................. 13 A. B. C. D. E. . . Printing of "Underage Sale Prohibited" Notices On All Packs and Cartons of Philip Morris Brand Cigarettes .................. 13 Discontinuation of Free Samples Of Philip Morris Brand Cigarettes .................. 15 Discontinuation of Maidng of Philip Morris- Brand Cigarettes ........... . ........... 16 Denial of Merchandising Benefits to Retailers Who Are Fined or Convicted of Selling Tobacco Products to Minors ........... 23 Placement of Minimum Age Signs and Related Materials In Retail Outlets That Farticipate in PMUSA's Incentive Programs ............................ 32 Implementation of Program to Reward Members of the Public Who Identify Unauthorized Uses of Philip Morris Trademarks ........................... 49 Efforts to Support the Enactment of State Legislation Relating to the Use of Tobacco Products by Minors ...................... 54 IV. SUMMARY CONCLUSIONS AND I2ECOMMENDA'pIONS .. 102 Doc#: DC 1:50152.1 1317A

L BACKGROUND AND INTRODUCTION On June 27, 1995, Philip Morris U.S.A. ("PMUSA") announced the Action Against Access program ("the AAA program"), a voluntary undertaking that the company described as "a new initiative to attack the problem of youth smoking. " The AAA program consisted of several elements, each of which, according to the company, was intended to deny minors access to tobacco products at retail. PMUSA announced that it would implement many elements of the AAA program unilaterally, and would seek to implement the remaining steps in cooperation with other parties (e.g., wholesale and retail trade associations, and other tobacco manufacturers) interested in issues relating to the marketing and sale of tobacco products. As announced, the AAA program consisted of the following elements: 1. The printing of a notice reading "Underage Sale Prohibited" on all packs and cartons of Philip Morris brand cigarettes. 2. The immediate discontinuation of free cigarette sampling to consumers. 3'. The immediate discontinuation of cigarette distribution through the mail: 4. The denial of merchandising benefits 3 o participants in PMUSA's retail incentive programs who are fined or convicted for selling tobacco products to minors. In addition, PMUSA established an incentive program that requires retailers to display point-of-sale signage regarding minimum age laws, train employees on these laws, and obey them, as a condition of participation. 5. The placement by PMUSA's- retail- sales- force of minimum age signs and related materials, prepared in conjunction with the company's "Ask First/It's the Law" progam, at the more than 200,000 retail outlets that participate in the company's retail incentive programs. The company announced also that it would seek the cooperation of trade associations to ensure that these materials would be made available to retail outlets that the Doc#:DC 1:50152.1 1317A

PMUSA sales force does not visit. In January 1996, PMUSA discontinued the "Ask First/It's the Law" program and supported the "We Card" program sponsored by the multi-industry Coalition for Responsible Tobacco Retailing. PMUSA's support of the We Card program is examined in Section III.E. below. 6. The implementation of a program to reward members of the public who notify PMUSA of an unauthorized use of the company's trademarks, as part of an overall effort to prevent the use of Philip Morris brand names or logos on any items (including, for example, video games or toys) that are marketed to minors. 7. Working with other interested parties to seek enactment of state legislation that would: (a) require the licensing of retail establishments that sell cigarettes, coupled with enforcement measures to identify and sanction retailers who sell cigarettes to minors; (b) prevent the purchase by minors of cigarettes from vending machines; (c) require that all cigarettes sold in retail establishments to which minors have access be within the line of sight of, or within the control of, a store clerk; and (d) require the posting of minimum age signs in all retail outlets that sell cigarettes. The implementation of the AAA program has occurred during a period of substantial controversy surrounding the U.S. tobacco industry, some eIements of which relate directly to the use of tobacco products by minors. One aspect of j.he ongoing controversy relates to the August 28, 1996 publication by the U.S. Food and Drug Administration ("FDA") of a set of regulations that, for the first time, vests authority in the FDA to regulate the marketing, sale 'and distribution of cigarettes. T he regulations are based on the FDA's position that cigarettes constitute a "nicotine delivery device" over which the FDA has jurisdiction under existing law. Certain of the FDA regulations became effective on February 28, 199-7. The FDA regulations impose a variety of new restrictions upon the manufacture, packaging, marketing, distribution and sale of cigarettes and smokeless tobacco products. The rules prohibit the sale of cigarettes to persons under the age of 18, and require retailers to verify the age of purchasers of cigarettes through visual inspection and, if necessary, a photographic identification card. In addition, the regulations prohibit the use of electronic or mechanical devices for providing cigarettes to a retail purchaser, establish a minimum mandatory package size of 20 cigarettes, and prohibit all impersonal modes of cigarette sales, including vending machines, self-service displays, Doc#: DC 1:50152.1 1317A

mail-order sales and mail-order redemption of coupons. The FDA has also imposed a prohibition on free samples of cigarette products, as well as numerous restrictions on the format and content of print advertising of cigarettes. The more stringent of these rules apply to advertising in publications having a youth readership (defined as persons under 18 years of age) of more than 15 percent or at least 2 million. In the Summer of 1995, Philip Morris and other plaintiffs , (including other cigarette manufacturers) filed suit in the United States District Court for the Middle District of North Carolina, seeking to enjoin implementation of the FDA regulations. The plaintiffs argue that FDA lacks statutory authority to regulate the marketing and sale of tobacco products. This litigation is ongoing as of the date of this report. In May 1996, PMUSA and the United States Tobacco Company proposed comprehensive federal legislation to address most of the issues to which the FDA regulations relate. The company stated that it would support enactment of the legislation only if the FDA were precluded from exercising jurisdiction over tobacco products. The principal elements of the PMUSA proposal include the foliowing: • Establishing a federal minimum age of 18 for sales of tobacco products, and requiring photo identification for purchases by anyone who appears to be under 21 years of age; • Prohibiting vending machine and mail-order sales of cigarettes, as well as the distribution of individual cigarettes or packages containing fewer than 20 cigarettes; • Banning all outdoor advertising of tobacco products within 1,000 feet of any public playground or elementary or secondary school; • Banning all tobacco billboards of less than 225 square feet, regardless of location, and prohibiting tobacco advertising in or on trains, subways, buses and taxis; • Prohibiting tobacco product advertising in or on video games, or at video arcades or family amusement centers (other than those to which minors are'denied access); Doc#:DC1:50152.1 1317A

4 • Banning payments for the use or placement of tobacco products or advertisements in movies or television programs; • Limiting magazine advertising of tobacco products to publications for which adults represent at least 85% of the subscribers; • Banning sales and gifts to consumers of non-tobacco-related products that display tobacco product names or logos (e.g., t-shirts, hats, jackets and bags); • Limiting permanent tobacco product advertising to facilities dedicated primarily to motor sports or rodeo productions; and • Limiting tobacco brand-name sponsorship to events for which at least 75% of those in attendance are. expected to be 18 years of age or older. Corporate sponsorship would be permitted by tobacco companies whose company name was in existence prior to January 1, 1995. • Vesting enforcement authority in the Federal Trade Commission, the Department of Health and Human Services and the Justice Department, and requiring tobacco manufacturers to pay a total of $250 million over a five-year period to pay for administration and enforcement of the program, and for materials to support retailer compliance. No legislation alorig these lines. was introduced in the U. S. Congress in 1996, although press reports indicated that certain Members of Congress were considering sponsorship of the proposed legislation. At the time it announced the AAA program, PMUSA disclosed that it had retained our nrm to conduct an independent audit of the company's implementation of the program, and to report our findings and recommendations to senior management. We 'W"ish to emphasize that our mandate is limited to an examination and evaluation of the actions taken by PMUSA to implement the measures that it announced in June 1995. We have_ been not asked to provide, and we have not undertaken to provide, any advice on the broader policy issues or~'ousiness judgments that arise from the current political and regulatory environment -- including, for example, whether voluntary initiatives such as the AAA program constitute a reasonable alternative to FDA regulation of cigarette sales and marketing, or whether there Doc#: DC 1:50152.1 1317A

5 are additional steps that PMUSA should take in attempting to make it more difficult for minors to purchase tobacco products. We have, at all stages of our review, held the company to a high standard of commitment and performance with respect to the AAA program. We informed PMUSA at the commencement of our audit that we expected that the company would make a determined effort to implement each element of the AAA program thoroughly and effectively -- and this is the test that we have applied in conducting our examination and preparing this report. As described above, certain elements of the AAA program constitute immediate, unilateral steps taken by PMUSA (e.g., the discontinuation of mailing of cigarette products), while others involve longer- term initiatives (e, g. , the effort to enact state legislation relating to cigarette sales to minors). In July 1996, we provided an interim report to 1'MUSA management that focused primarily on the unilateral, shorter-term program elements that were immediately implemented, including the printing of "Underage Sale Prohibited" notices on cigarette packs and cartons, and the discontinuation of mailings and ffee distributions of cigarettes. We provided also our preliminary findings and recommendations regarding all other elements of the AAA program. In this report, we review and update our initial findings and recommendations regarding the unilateral elements of the AAA program, and provide many new findings and recommendations regarding the more detailed elements of the program. As discussed below, we believe that continued oversight may be warranted with respect to two program elements: the effort to enact state legislation to restrict youth access to tobacco products, and the implementation of the Responsible Retailer Program. The next section will provide an Executive Summary of the report, and the following sections will provide our detailed lindings and recommendations with respect to each element of the AAA program. Doc'{:DC 1:50152.1 1317A

6 11. EXECUTIVE SUNIlI4ARY The following is a summary of our principal findings and recommendations regarding each element of the AAA program: 1. Overall Conclusions. • PMUSA has made a good-faith effort to implement each element of the AAA program. As of January 31, 1997, some aspects of the AAA program have been more successfully implemented than others. The AAA program elements over which PMUSA had complete control -- underage sale notice, the discontinuation of free samples and of mailing cigarettes, and rewarding the identification of infringements of PMUSA trademarks -- have been fully and effectively implemented. ~ The element of the AAA program over which PMUSA exercised significant influence -- the placement of minimum age signage and related materials in retail stores with PMUSA merchandising agreements -- has been implemented with substantial, if not complete, success. ~ In the area of state legislation, PMUSA has achieved important initial successes in a number of states, with the clear possibility of additional successes in the coming legislative session. PMTJSA should continue its efforts in this area. ~ One aspect of the AAA program cannot be deemed a success as of the date of this report: the denial of merchandising benefits to retailers who violate underage sale laws. This lack of success is not due to PMUSA's lack of sincerity or effort (indeed, PMtJSA did take appropriate actions in the limited number of cases where it obtained information on retailers that had violated the law), but instead is due to the general unavailability of state or local government dar.a on fined or convicted retailers. PMUSA should take substantial additional steps to convince states to collect and share this data. Doc#:DC 1:50152.1 1317A

7 2. Printing of "Underage Sale Prohibited" Notice On All Packs and Cartons of Philip Morris Brand,Cigarettes. Findings: • PMUSA accomplished in all material respects its objective of introducing a new "Underage Sale Prohibited" notice on all packs and cartons of Philip Morris brand cigarettes by the end of 1995 -- and, in fact, achieved this goal with respect to the vast majority of its product offerings (including its most popular brand names) well in advance of the year-end deadline. • Our field survey found that over 90 % of packs and cartons of PMUSA's highest-volume cigarette brands offered for sale in late 1996 contained the "Underage Sale Prohibited" notice. We found also, however, that a significant percentage of packs and cartons of lower-volume brands (including Cambridge, Players and Bristol Lights) being offered for sale nationwide still do not carry the AAA notice. Discontinuation of Free Samples of Philip Morris Brand Cigarettes. Findings: • The company fulfilled its commitment to discontinue providing free cigarette samples to consumers upon the announcement of the AAA program. 4. Termination of Mailing of Philip Morris Brand Cigarettes. Findings: • PMUSA fulfilled its commitment to terminate the mailing of cigarette products to consumers upon the announcement of the AAA program. Doc#:DC 1:50152.1 1317A

8 5. Denial of Merchandising Benefits to Retailers Who Are Fined or Convicted of Selling Tobacco Products to Minors. Findings: • PMUSA has encountered unexpected obstacles in implementing its pledge to withhold benefits from retail accounts with whom it has a merchandising agreement who are fined or convicted of selling cigarettes to minors. Because of unanticipated changes in proposed federal regulations, the company's initial (and reasonable) assumption that reliable data would be available from the states to track enforcement actions against retailers is no longer valid. • When PMUSA discovered that most state governments do not collect data on retailers that_are fined or convicted for selling cigarettes to minors, the company made a determined effort to obtain this information from various local government entities. However, the company's efforts have not produced a significant amount of data on fined/convicted retailers. Fine/conviction data was only received from six states, and it appears reasonable to expect that such data will be available from only an additional five states in the near future. • As of January 31, 1997 PMUSA had obtained fine/conviction data on 64.1 stores from state and local governments, of which data on ~62 stores were "valid" (i.e., the records were complete and the offense occurred after the-effective date of the program). 286 of these 462 stores had a merchandising agreement with PMUSA (and thus received benefits that PMUSA could withhold). PIVIUSA took the following actions with regard to these 286 stores: • It issued 286 "warning letters" to advise the retailers that PMUSA would waive the suspension of merchandising benefits for the referenced violation only if the store pledged to comply with the We Card program; and • It issued 16 one-month benefits suspensions ((1) 13 stores had two convictions, and the second offense thus triggered the benefits suspension, (2) one store was convicted twice and declined to comply with the We Card program, and thus received two suspensions, and (3) one store was convicted once and declined to Doc#: DC 1:50152.1 1317A