Philip Morris International, Inc.'s Worst Move in 2016

By Dan Caplinger Markets Fool.com

Tobacco companies have had to deal with threats of litigation for decades, and to a large extent, they've managed to hold back the tide of lawsuits with minimal financial damage. Yet for Philip Morris International (NYSE: PM), 2016 brought a new potential risk related to legal action, when the company failed to persuade the European Union to renew an anti-smuggling agreement with the tobacco giant. As a result, it's possible that relations between Philip Morris and regulators in Europe could become colder, posing long-term issues that could threaten other initiatives like reduced-risk products.

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Image source: Philip Morris International.

How Philip Morris got a 12-year reprieve from smuggling-related lawsuits

More than a decade ago, European officials were highly concerned about the level of counterfeiting and contraband-smuggling that was happening on the continent. Even though Philip Morris International made efforts to try to reduce the incidence of illegal trading and shipment of cigarettes, the EU was concerned about the hundreds of millions of euros in unpaid taxes that were lost because of smuggling activities.

In order to spur a unified regulatory effort, the EU entered into an agreement with Philip Morris in 2004. The 12-year deal provided a mechanism to help assist in the long-term prevention of large-scale smuggling of genuine Philip Morris cigarettesin the European market. That wouldn't stop the flow of counterfeit cigarettes, but it at least assured that genuine Philip Morris products wouldn't be as likely to show up in illicit trade.

Specifically, the deal required Philip Morris to take greater measures in identifying who its final customers were, along with more extensive tracking and tracing of cigarette movements throughout the shipping process. Under the agreement, Philip Morris agreed to make payments that could have amounted to about $1.25 billion. In addition, further payments would be required if the EU seized Philip Morris products above a certain defined amount. In exchange, the agreement resolved any past disputes related to contraband cigarettes.

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Why the deal didn't get renewed

2016 brought the expiration of the 12-year term of the agreement, and the EU decided in July not to renew the pact. The decision was somewhat contentious, because some member countries in the EU would have preferred to keep agreements in place even when the members of the European Parliament as a whole had voted to recommend not renewing them.

In the end, several factors led to the EU's decision not to renew. On one hand, anti-smoking advocates argued that insulating Philip Morris and other tobacco companies could potentially allow them to hide illegal activities. Others pointed to innovations that the agreement wasn't tailored to deal with, including tobacco used for rolling one's own cigarettes or black-market-produced cigarettes.

Arguably more compelling was the idea that agreements were no longer needed because of advances in the methods that Philip Morris and customs officials use to prevent smuggling activity. Philip Morris has repeatedly noted its role in such efforts, pointing to its cooperation in helping to fight counterfeiting and ensure that only genuine products get sold in full compliance with tax and customs rules.

What happens now?

The expiration of the agreements also brings to an end the protection against litigation that the agreements provided. As a result, some fear that a wave of lawsuits will emerge from those arguing that Philip Morris was complicit in permitting or enabling smuggling activity to take place.

Yet the bigger issue from a long-term perspective is whether Philip Morris failed to do everything it could to maintain good relations with the EU's regulators and leaders. Illicit trade isn't in Philip Morris International's interest either, but the company will have to do go before EU regulators many times in the future. It will be critical for Philip Morris to count on fair assessments of requests on matters like the increased adoption of reduced-risk products, plain packaging laws, and other important issues that will have equally large impacts on its business.

It's too early to tell whether Philip Morris International's failure to earn an extension of its EU agreement will have dramatic long-term consequences. As a measure of how well received the company is among European regulators, however, it's a big warning sign that could mark Philip Morris' largest failure in 2016.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.