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9 comply with the We Card program after their first fine/conviction). • There is room for PMUSA to improve its implementation of the withholding of merchandising benefits. Territory Sales Managers ("TSMs") are uncertain about the extent of their responsibility for implementing the enforcement/penalty aspects of the program, and retailers are generally unfamiliar with the program. In our view, these fmdings are largely attributable to the fact that PMUSA has not been able to obtain the enforcement data from state and local officials needed to implement the sanctions program nationwide. • Our survey and interview data indicate clearly ihat a broadly implemented PMUSA program of withholding merchandising benefits from noncompliant retailers would be a significant deterrent to the illegal sale of cigarettes to minors -- and, in some states, would be more effective than the penalties available under anti-youth access laws. Recommendations: • Given the significant potential deterrent effect of this incentive program, PMUSA should continue to make every effort to obtain retailer fine/conviction data from each state. ® Because PMUSA's good-faith efforts to obtain fine/conviction data through direct contacts with state and local governments have yielded disappointing results to date, the company should devote additional resources to this program and take additional steps to obtain the data, including: • significantly expanding its use of its network of government affairs representatives and consultants to encourage state agencies to collect and provide this data, and, in appropriate cases, to obtain information directly from local governments; seeking the amendment of state law, in the context of supporting_ AAA legislation, to require state collection of this data; and • taking more aggressive action to expedite the data collection and distribution process in those states (including Florida, Kentucky, and Vermont) that have indicated an ability to provide this data, Dock: D C 1:50152.1 1317A

10 and in those states (including New Jersey and Rhode Island) that have indicated they are worlcing on a process to provide this data. • We propose to continue our review of this element of the AAA program and provide an update one year from now. 6. Placement of Minimum Age Signs and Related Materials in Retail Outlets That Participate in PMUSA's Incentive Progralns. Findings: • Our field survey found =.hat over 85 % of retail outlets display some form of signage relating to tobacco sales restrictions, and that stores with which PMUSA has a merchandising agreement are more likely than -PMUSA's other accounts to display such signage. In addition, managers and clerks in such stores are more likely to have received training relating to the sale of tobacco products. • Convenience stores and gas stations, which are widely viewed as prime targets of minors seeking to purchase cigarettes, are among the categories of retail stores that displayed the highest percentage of PMUSA-sponsored minimum-age signage. • The level of familiarity with and commitment exhibited by TSM's to the We Card program -- although not as high as their dedication to the "Ask First/It's The Law" initiative -- is nonetheless high, both in absolute terms and when compared with other recent promotional campaigns for PMUSA products that the TSMs have implemented. • TSMs believe that there exists a genuine institutional commitment to the AAA program at all levels within PMUSA. However, while over 84 % of TSMs believe that corporate headquarters has either a "fairly strong" or a "very strong" commitment to the program, less than half believe that their Unit Manager displays these levels of commitment. TSMs also place greater emphasis on communications received from Unit Managers than on those received from headquarters. These findings suggest that it would be beneficial for PMUSA to reinforce Unit Managers' awareness of and commitment to the AAA and We Card programs. • Retail store managers and clerks are generally familiar with laws governing tobacco sales. In those instances in which they are mistaken Doctl: DC 1:50152.1 1317A

11 Findings: =a regarding applicable laws, they tend to err on the side of caution. PMUSA's accounts with merchandising agreements are more knowledgeable about applicable state and local laws than its other accounts. This indicates that TSM training and commitment may have a beneficial impact on retailer, knowledge and behavior. • TSMs clearly want to participate successfully in the We Card and Responsible Retailer programs. We believe that they (and their Unit Managers) would benefit from renewed training, a clearer statement of mission, and the development of qualitative benchmarks of the success of these programs. * With respect to retailers, PMUSA has substantially achieved its objectives of placing minimum-age materials in stores and educating retailers about underage tobacco sales laws. Retailers would clearly benefit, however, from renewed education about the non-signage aspects of the We Card program and aaout the compliance/enforcement elements of the Responsible Retailer Program. 7. Implementation of Program to Reward Members of the Public Who Identify Unauthorized Uses of Philip Morris Trademarks. Findings: • We are satisfied that the AAA trademark program has been implemented in a manner consistent with its original design. • The program does not represent a radical departure from PMUSA's traditional practices with regard to trademark enforcement. In view of the fact that tradernark protection is an essential element of PMUSA's business, it is not surprising that the trademark program has not revealed any instances of widespread infringement of which the company was not already aware. 8. Efforts to Support the Enactment of State Legislation Relating to the Use of Tobacco Products by Nilihors. • PMUSA has, to date, fulfilled its promise to attempt to enact reasonable state legislation embodying the AAA agenda. PMUSA's initial AAA Doc.# : D C 1: 50152.1 1317 A

12 'I legislative proposals were comprehensive, and the company sought legislative action in the states where it had a reasonable opportunity to pass legislation. • When confronted with political opposition to a major AAA element (usually line-of-sight or licensing provisions), PMUSA usually took reasonable, pragmatic approaches to attain those elements of the AAA bill for which adequate political support existed. PMUSA was usually pragmatic about the local preemption issue, with the debatable (but minor) exceptions of South Carolina and Kentucky. • Eight states have enacted new anti-youth access laws, due in part to PMUSA's efforts. Six of these laws clearly improve prior law. Fourteen states considered legislation that contained major portions of the AAA agenda, 10 of which contained full licensing regimes-, and- this bodes well for future positive legislative action. • PMUSA should continue the legislative efforts it initiated for the 1996 legislative session. In particular, it should focus on enactment of the comprehensive legislation that was considered in ten states in 1996 but did not receive final approval. • PMUSA should pay additional attention to: (1) improving weak laws that are coupled with local preemption in states such as Indiana, Kentucky, and South Carolina, and (2) supporting adequate funding for the agencies charged with enforcing the anti-youth access regimes in each state. • We propose to continue our review of PMUSA's state legislative efforts in 1997 and to update our findings after the completion of the 1997 legislative sessions. Doc#: DC 1:50152.1 1317A

13 III. FIlVDINGS AND RECOMMENDATIONS REGARI)ING EACH ELEMENT OF THE AAA PROGRAM In the following sections, we set forth our findings and recommendations regarding each element of the AAA program, and, in appropriate cases, identify areas that may warrant further ex min tion. A. Printing of "Underage Sale Prohibited" Notices On All Packs and Cartons of Philip Morris Brand CiearettQs PMUSA's objective with regard to this program element was to introduce by the end of 1995 a new "Underage Sale Prohibited" notice on all packs and cartons of Philip Morris brand cigarettes sold--within the United States. Based on our meetings with company representatives who were involved in the implementation of this program element, and our review of relevant company records, we have determined that PIVIUSA introduced the new legend well within its established deadline through a process that involved a high degree of interdepartmental coordination and noteworthy commitment on the part of responsible personnel. Our review included several meetings at PMUSA's New York headquarters, and at the company's Richmond, Virginia manufacturing facility, with company personnel who were responsible for the day-to-day implementation of this program element. The departments and functions represented by these individuals included Packaging Technical Services (both New York and Richmond), production planning, packaging materials purchasing and inventory management, and implementation of printing activities. We reviewed background documents relating to, among other things, the process underlying the design of the new notice, the formal policies and procedures that governed the transition to the new packs and cartons (i.e., those that bear the AAA legend), and Pack Conversion Status Reports, which summarize, for each of Philip Morris' 400+ product codes,11 the date on which the_change to the new packs and cartons occurred. 1/ A single "product code" represents a specific combination of brand family (e.g., Marlboro or Basic), product features (e.g., king-size, lights, menthol) and packaging option (e.g., soft pack or flip-top box). Daa'+`: DC1:50152.1 1317A

14 We found that PMUSA achieved its objective with respect to the introduction of the new package notice under very challenging circumstances. For example, while PMUSA had established a formal deadline of December 31, 1995 for completing the transition to the notice-bearing packs and cartons, the teams responsible for implementing this transition established a more aggressive deadline -- of October 1, 1995 -- for attaining a "significant market presence" of products bearing the new legend. With this objective in mind, the company assigned a priority to its highest volume brands -- Marlboro and Basic -- and, according to the records that we reviewed, had by October 1, 1995 introduced the new notice-bearing packs and cartons on product codes representing approximately 85 % of the company's total domestic cigarette sales. In addition, we were advised that the typical turn-around time for implementing a graphics change for a single Philip Morris cigarette brand is 4-6 weeks, in a process that includes the design of the new graphics and the engraving of new printing cylinders to incorporate the graphics and color changes. The implementation of the AAA notice required the company and its printing contractors to change graphics and engrave new cylinders for all pack and carton types of each cigarette brand on a much more aggressive timetable. We noted that there were a few product codes for which the transition to the new packs and cartons did not occur until early 1996. Based on the documents that we reviewed and the explanations provided by company representatives, we are satisfied that the majority of these relatively few product types represented either low-volume brand types for which packs and cartons are printed infrequently, or generic brands (which PMUSA manufactures under contract for unrelated parties who own the brand names) that were assigned a lower priority than Philip Morris brands. The product codes for which a year- end transition was not achieved represented less than two percent of the company's projected annual domestic cigarette sales for 1995. As the final step in our review of this program element, during the nationwide field audit of PMUSA retail accounts conducted by Hoffmann Research Associates ("HRA") in connection with our audit of the We Card program, HRA interviewers randomly inspected retailers' cigarette inventories to determine the proportiori of Philip Morris. brand. cigarettes currently offered for sale that bear the AAA notice. (The HRA report is included at Exhibit A, and is discussed in detail in Section III.E. below.) PIl2A found that over 90% of packs and cartons of PMUSA's higher-volume brands currently offered for sale nationwide (including Marlboro, Marlboro Lights, Basic, Virginia Slims and Merit) include the "Underage Sale Prohibited" notice. HRA found also, D0c#:DC 1:50152.1 1317A

15 however, that a smaller percentage of PMUSA's lower-volume brands currently held in retail accounts' inventories bear the AAA legend. These include Benson & Hedges Lights (83.6 % of packs, 87.8 % of cartons), Cambridge (77.5 % of packs, 80.8 % of cartons), Players (66.1 % of packs, 74.4 % of cartons) and Bristol Lights (55.1 % of packs, 70.4% of cartons). These findings likely reflect slow turnover of these brands. We recommend that PMUSA instruct its TSMs to examine their accounts' stocks of these brands to ensure that aging packs and cartons that do not bear the AAA notice are replaced expeditiously. B. Discontinuation of Free Samples Of Philip Morris Brand CiLyarettes In this element of the AAA program, PMUSA pledged to discontinue immediately the provision of free cigarette samples to consumers. To examine the company's activities, we met in New York with PMUSA's Vice President of Marketing Services, who described the steps taken by the company to discontinue free cigarette samples. We also reviewed relevant background documents relating to this initiative. We were informed that, prior to the introduction of the AAA program, PMUSA generally provided free cigarette samples to consumers in only two situations: (1) the distribution of free packs of cigarettes in connection with special promotional events, such as "bar nights" (at which PM requires that the attendance be limited to persons 21 or older), and (2) the mailing of samples of new cigarette brands to consumers, who have certified they are smokers 21 or older, in specified test marketsY We are satisfied that PMUSA promptly suspended the first category of activities upon the announcement of the AAA program. In addition, none of the information that we reviewed contradicts the company's representation to us that it discontinued the second type of activity approximately one year prior to the commencement of the AAA program. We reviewed copies of memoranda through which the President and CEO of PMUSA notified the compan}'s sales force of the termination of sampling activities ~ We reviewed- also- copies of internal- correspondence 21 The AAA policy does not apply to the provision of complimentary packs of cigarettes at dinners and other social functions that Philip Morris hosts, and for which the company controls the guest list. In our view, this minor exception to the policy is unremarkable. D0Ci1:DC 1:50152.1 1317A

16 relating to two marketing events that took place during July 1995, immediately following the announcement of the AAA program: the "Cheyenne Frontier Days" event in Cheyenne, Wyoming, and the "Black Expo USA" in Oakland, California. In each case, the list of Philip Morris event-related activities referred specifically to on-site "sales" of tobacco products "to smokers 21 years of age or older. " The memoranda stipulate that the cigarette sales (as well as distributions of branded incentive items) will occur at sites to be agreed upon by Philip Morris and the event sponsor. We reviewed also copies of intercompany correspondence relating to the company's sponsorship of Marlboro Team Penske and Indy Car Racing events. Each of the documents we reviewed indicated that (1) promotional materials that were provided without charge to event attendees consisted only of merchandise such as coffee cups, ashtrays and banners, and did not include cigarette products; (2) such items were provided only to smokers who were 21 years of age or older; and (3) Marlboro operated a Pack Sales Trailer at each event, at which smokers who were 21 years of age or older received "incentive items" in exchange-for a purchase of a specified pack of cigarettes. With respect to the mailing of new or "test" brands of cigarettes, we were informed that the last such promotion occurred approximately three years ago, when PMUSA mailed packs of the "Dave" brand of cigarettes to adult smokers in test markets in Colorado and Washington state. We were further advised that PMUSA had begun to phase out promotional product mailings long before :.he AAA program was developed, due primarily to increasing state. restrictions on direct mailings of tobacco products. In summary, it appears that upon the announcement of the AAA program PMUSA discontinued all promotional activities that involved the provision of free cigarette samples, and that this policy remains in effect. C. Discontinuation of Mailing of Philip Morris Brand Cigarettes This program element entailed an immediate discontinuation of the mailing of packs or cartons of cigarettes to consumers. We understand that these so-called "live product" mailings previously occurred primarily in three situations: (1) for reimbursement of consumers who were dissatisfied with Philip Morris-brand cigarettes that they had purchased; (2) as a gesture of goodwill to consumers who contacted the company to complain about a problem, not relating to product quality, that they encountered in connection Doc#:DC 1:50152.1 1317A

17 with the purchase or use of Philip Morris brand cigarettes; and (3) in response to catalogue promotions, in which consumers typically could redeem a specified quantity of Universal Product Code symbols from a brand of Philip Morris cigarettes, and receive a free carton of cigarettes in return. As a substitute for direct mailings of cigarette products, PMUSA has instituted a coupon redemption system pursuant to which, upon providing written verification to PMUSA that s/he is a smoker 21 years of age or older, a qualifying consumer will receive coupons for a stated quantity of packs or cartons of Philip Morris brand cigarettes. These coupons may be redeemed at any retail outlet, where the retailers can verify the customer's age. Our objective was to verify that PMUSA terminated cigarette mailings immediately upon the announcement of the AAA program, and that the coupon program was promptly instituted. Our review consisted, among other things, of the following: • Meetings in PMUSA's New York headquarters with senior company executives who were responsible for the implementation of this element of the AAA program. • Interviews in the New York headquarters with the individuals responsible for maintaining the company's database of adult smokers who have expressed a willingness to receive promotional materials from Philip Morris. • Interviews in New York with the managers of fulfillment for PMUSA's Marlboro brand and other premium brands, who oversee product fulfillment for all promotions relating to their respective brands (e.g., the recent "Marlboro Unlimited" campaign, and catalogue promotions involving other premium brands, such as "Club Cambridge"). • Visits to PMUSA's Consumer Affairs department in New York and Quality Assurance department in Richmond, during which we interviewed personnel responsible for handling consumer complaints and inquiries, reviewed the master logs and other systems that PMUSA introduced to control the dissemination of cigarette product poupons, and examined relevant background documents. Doc# : D C 1:50152.1 1317 A

18 1. Database Manag_ement. We have confumed to our satisfaction that it was PMUSA's policy prior to the commencement of the AAA program to obtain written verification of a consumer's age (on an Age Verification Form; or "AVF")31 before adding the consumer's name and other descriptive information into the company's direct marketing database. We were informed that the institution of the AAA program necessitated only one change to the procedures employed by the database development group: namely, that the language in the AVF that formerly expressed the consumer's willingness to receive cigarette rop ducts in the mail was revised to refer to product coupons. The information provided to us indicates that this change was instituted promptly upon the announcement of the AAA program. Our findings with respect to this program element are as follows: 3/ • A visit to the PreCon facility in Richmond, which functions primarily as a contract assembler of special package types of Philip Morris brand cigarette packs and cartons (e.g., two-for-one packages) that cannot be produced efficiently at PMUSA's highly automated manufacturing plant. Prior to the institution of the AAA program, PreCon was involved also in the packing, labeling and mailing of cigarette packs and cartons to consumers who were participating in catalogue redemptions or other PMUSA marketing promotions. • A review of several categories of background documents, including internal correspondence relating to the coupon fulfillment program, formal policies and procedures relating to coupon control and dissemination, order fulfillment guidelines and procedures, random samples of records obtained from the Consumer Affairs and Quality Assurance departments (as described below), and correspondence between PMUSA and Catalogue Resources, Inc. ("CRI"), a company that provides order fulfillment services to PMUSA in connection with catalogue promotions. I The operative language of a typical AVF is as follows: "By signing this form, you certify that you are a smoker 21 years of age or older, and that you are willing to receive cigarette coupons and branded incentive items in the mail, subject to applicable state and federal laws." D0cff: DC1:5Q152.1 1317A