Big tobacco’s New York black market

Introduction

For New York Governor David Paterson, there was no good option.

Faced with a crushing state deficit, angry American Indians, and uncooperative tobacco companies, Paterson on December 15 signed into law a bill designed to take on one of America’s most lucrative black markets: the underground trade in cigarettes flowing through the state’s 10 Indian reservations.

New York’s 70-year-old tobacco black market exploded after 2002, as cigarette tax hikes encouraged smuggling from out of state and through reservations. The traffic is part of a nationwide boom in smuggled cigarettes, but the trade has reached a peak in New York. In 2007, one in three cigarettes sold in New York was channeled untaxed through Indian smoke shops, robbing the state and New York City of nearly $1 billion in tax revenue.

Ironically, this illicit trade has been protected in part by the state’s own reluctance to enforce cigarette tax collection on reservations, a policy known as forbearance. Indians protested violently at the state’s last attempt at collecting the tax in 1997, briefly shutting down the New York State Thruway. Since then, New York governors have vowed to end the black market, but ultimately have shied away from enforcing cigarette tax laws on reservation sales.

It remains unclear whether Paterson will be any different from his predecessors. If implemented, the new law will require manufacturers to supply only wholesalers that can certify that cigarettes won’t be re-sold tax-free to reservations.

The stakes are high. The law moves enforcement up the supply chain to the wholesale and manufacturing level, charging tobacco companies with ensuring that their products are not smuggled. “This means cutting off cigarettes at the factory door,” said Russell Sciandra, director of the Center for a Tobacco Free New York.

That may not be easy to do. Within hours of the bill’s enactment, Philip Morris USA, maker of Marlboro, criticized the legislation. “We applaud the government in trying to move forward with something . . . [but] we are not sure that is going to lead to tax collection,” said Joe Murillo, a Philip Morris counsel. Among the challenges Murillo cited: the state’s forbearance policy as well as current and possible litigation by wholesalers and Native Americans.

And then there’s the role of the big tobacco companies themselves, who in the past have shown a marked reluctance to ensure their products are not smuggled. “Cigarette manufacturers should not be expected to police the trade in untaxed cigarettes,” Lorillard, a leading tobacco firm, said in a December 9 statement.

In fact, for years, America’s three largest tobacco companies — Lorillard, Philip Morris, and R.J. Reynolds — have flooded New York Indian reservations with their untaxed cigarettes, despite ample evidence that those sales fueled a billion-dollar black market, an investigation by the International Consortium of Investigative Journalists (ICIJ) has found.

A three-month inquiry by ICIJ lays bare the role played by leading tobacco companies and their direct distributors as suppliers of the bulk of cigarettes sold untaxed on reservations. The investigation relied on internal company sales data, tax filings by cigarette wholesalers, and court documents, as well as interviews with law enforcement officials, cigarette wholesalers, and smugglers.

Consider these findings:

• As New York state struggled with a massive fiscal crisis in 2007, Lorillard, Philip Morris, and R.J. Reynolds funneled 4.3 billion tax-free cigarettes to smoke shops on New York Indian reservations — more than 25 percent of the companies’ combined total sales in the state.

• Although 43 manufacturers supplied reservations in New York last year, two-thirds of those cigarettes came from Lorillard, Philip Morris, and R.J. Reynolds, an analysis of tax data by ICIJ shows. Lorillard, maker of the popular Newport brand, sold 40 percent of its cigarettes in New York through reservations — more than any other manufacturer.

• To distribute through the reservations, tobacco companies have relied on a handful of wholesalers who ship billions of untaxed cigarettes to Indian stores. One in three cigarettes sold in New York last year was channeled, untaxed, through these wholesalers, who are being sued by New York City for complicity in cigarette smuggling.

• Bootleggers and online vendors working with the reservations have netted, conservatively, an average of $500 million annually since 2000, according to ICIJ’s analysis.

The cost of this trade is considerable: In 2007, New York state and New York City lost more than $850 million in cigarette tax revenue, according to an analysis by ICIJ. That money would have cut the state’s 2008 fiscal deficit by half.

“The cigarette black market in New York is enormous, and it’s brazen, and it’s carried out right under the nose of the government,” said Eric Proshansky, an attorney for New York City who has filed lawsuits against wholesalers and Indian vendors for their role in the illicit cigarette trade. So brazen are they, Proshansky added, that two New York smugglers are even suing each other in court over their illegal profits.

Billion-Dollar Black Market

Experts say the size of New York’s cigarette black market is exceeded only by the region’s traffic in narcotics. And within the nation’s illicit cigarette trade, New York likely ranks at the top, rivaled only by states such as California and Michigan.

Patrick Fleenor, who has studied the evolution of this underground economy as chief economist at the Tax Foundation, a nonpartisan tax research group, said New York’s black market dates back to the city’s first cigarette tax of one cent, in 1938. While in the 1960s and ’70s cigarette bootlegging in New York was controlled by a handful of organized crime groups, including the Mafia, today the trade is much more fragmented, with groups including Dominican tax-stamp counterfeiters, African-American smugglers, and Middle Eastern vendors from Jordan and Yemen competing for the profits. “The potential for volatility is much greater,” Fleenor said.

The incentive to smuggle is strong. New York has the highest cigarette taxes in the nation, cashing in at $4.90 per pack when state and city excise and sales taxes are factored in. For smugglers this means they can buy a pack of untaxed cigarettes on the reservations for $3, sell it for twice as much in a Bronx “bodega” — a mom-and-pop convenience store — and still beat the price of a 7-Eleven store in Manhattan.

“This is the new crack,” says a former smuggler. “The money is easy, the charges are less.”

The problem is not exclusive to New York. Officials across the country are wrestling with cigarette smuggling from Indian reservations, as they try to strike a balance between law enforcement and tribal sovereignty. The U.S. Supreme Court ruled in 1994 that although American Indians are allowed to sell untaxed cigarettes to members of their own tribe, states have a right to collect taxes on sales to non-Indians.

Native American legal advocates say reservations are sovereign territories, and centuries-old treaties prevent interference from the U.S. government. “Tribes never really have been a part of the legal or political system,” said G. William Rice, professor at University of Tulsa College of Law and co-director of the Native American Law Center. “We have a treaty that says this is our house; what we do here should be our business; It’s no different than Monaco being surrounded by France.” Rice said, however, that Indian nations have no choice but in the end to comply with U.S. law. “When a bigger sovereign tells a smaller sovereign, ‘We’re going to do something,’ what choice do we have?”

Some states are entering into agreements with the tribes that provide for either the collection of taxes or establish quotas for cigarette shipments. Arizona, with the highest cigarette tax rate in the Southwest, is trying to curb smuggling from the nation’s largest Indian reservation, Navajo, as well as counterfeit cigarette flows from Mexico and smuggling from lower-tax states.

Washington state estimates it has lost at least $161 million to cigarette tax evasion in 2008 even as it tries to stem the tide by signing contracts with the state’s 29 tribes. Oddly enough, officials there estimate that most cigarette tax evasion by local smokers comes not from Washington state sales, but through Internet purchases from Seneca reservations in western New York.

The sparsely populated New York reservations, in particular, have embraced the tobacco trade. With fewer than 17,000 residents, the state’s reservations cannot possibly absorb the huge numbers of Marlboros, Camels, and Newports, among other brands, shipped to smoke shops in their territories — 6.4 billion in 2007. Each resident — from newborn to nonagenarian — on New York’s 10 reservations would have had to smoke 1,060 cigarettes per day to consume what their smoke shops purchased. The bulk end up sold over the Internet or bootlegged — largely by minivan — to New York City for sale, tax free, in bodegas and on the streets. A low-level smuggler can walk away with up to $7,000 a day.

“This is the new crack,” boasted a young former New York smuggler who asked his name not be used because he is now collaborating with law enforcement. “It’s better than crack. The money is easy, the charges are less. Crack, you do years. Cigarettes, you spend the night in jail and then you go through the system.”

Big Tobacco’s Supply Chain

A group of seven cigarette wholesalers, all but one in New York state, is responsible for supplying more than 90 percent of all cigarettes sold on Indian land, according to wholesalers’ tax filings. They buy directly from the manufacturers and receive bonuses for providing the companies detailed sales information. Last spring, one longtime Philip Morris direct distributor was caught allegedly diverting Marlboros to a notorious smoke shop owner on the Long Island Poospatuck reservation. At about the same time, another distributor allegedly sold millions of cigarettes to seemingly fictitious smoke shops, also on the Poospatuck, whose listed addresses were nothing more than light posts, trees, and dumpsters.

Philip Morris terminated its relationship with both wholesalers, but critics say the big tobacco companies have shown little interest in ensuring their cigarettes are not smuggled. An April 2008 report on New York’s cigarette black market by the Republican staff of the House Committee on Homeland Security noted that the tobacco industry lacks much incentive to prevent smuggling, as the illicit trade boosts the companies’ bottom line. “That would explain why manufacturers and distributors continue to flood New York’s Native American Indian reservations,” the report said.

“Lorillard is not in a position to know where, or to whom, the product will be resold,” the company responded in a statement to ICIJ. Stopping smugglers, Lorillard said, “is the responsibility of the state and law enforcement.” The companies also claim that since the state hasn’t enforced tax collection on reservations, they risk being sued if they cut wholesalers unilaterally.

Philip Morris officials, who get higher marks from law enforcement for cracking down on the illicit trade, claim they are doing their best. “We monitor our contracts [with wholesalers], we enforce our contracts, we bring litigation when appropriate and we have ample cooperation with law enforcement particularly on this New York situation,” said Murillo, the Philip Morris counsel.

R.J. Reynolds, whose brands include Camel and Doral, plans only limited action. Starting December 28, the company will cut off discounts to retailers who sell untaxed cigarettes, according to a spokeswoman.

In the 1990s, leading American and British tobacco companies were at the core of the cigarette smuggling business. An investigation by ICIJ in 2000 revealed how Philip Morris, R.J. Reynolds, and British American Tobacco colluded with criminal networks to smuggle cigarettes worldwide in an effort to increase market share. In North America, manufacturers used the Akwesasne Indian reservation, which straddles the U.S.-Canada border, to smuggle millions of cigarettes into the high-taxed Canadian market.

Today, some companies have seemingly retreated from an active role in cigarette smuggling, but the situation remains murky in duty-free shops and other untaxed venues.

New York officials say they have been reluctant to take on the tobacco companies directly for their role in supplying the reservations because of the industry’s ability to put up an extended legal battle. Instead, they are going after the middlemen in hopes manufacturers will feel pressure to reform.

Stocking the Reservation

Every shop is a smoke shop on the Seneca Nation’s 34-square mile Cattaraugus reservation, bordered on one side by Lake Erie, and three sides by hardwood forest and farms laden in summer with concord grapes, tomatoes, and sweet corn.

Doogie’s Smoke Shop is painted bright green, boasting two lonely-looking gas pumps amid a clutter of signs announcing sales of Newports, Marlboros, and Kools. Smoke shop operators say tobacco company sales representatives visit reservation vendors like Doogie’s monthly to check supply and product placement, update signs, and discuss discounts. The reps also provide price cuts in exchange for prominent shelf space.

“R.J. Reynolds, Lorillard, and Philip Morris come in monthly and change signs, check that no product is out of date, that kind of thing,” said Doogie’s owner Sally Snow, who heads an organization comprised of the Seneca Nation’s 234 smoke shops, gas stations, and mail-order cigarette outlets.

A carton of Marlboros or Newports was selling for $32 at Doogie’s this fall — a deep discount from the $60 price at the Mighty Mart off the reservation in Binghampton, or the $80 price at 7-Eleven in Manhattan.

“Lorillard and the folks who sell Sonoma and USA Gold most want their products sold,” said Nikki Jimerson at the Seneca’s Cloud Company Smoke Shop in Salamanca. “They talk to us more. [They ask,] ‘What can we do to promote these cigarettes? What ideas do you have?’”

The marketing is not new. Over the years, manufacturers have eyed the reservations’ tax-free status as a way to increase market share, according to internal industry documents uncovered by litigation in 1998. A Philip Morris presentation noted the potential “growth” to be made from “mega volume outlets” such as reservation smoke shops. “Consumers are willing to travel to get promotions and/or tax breaks in these outlets,” the 1994 presentation said, noting that “changes to purchasing patterns may be accelerated by federal excise tax, state excise
tax. . .” Similarly, Lorillard noted in 1996 that “Indian reservations have had a significant impact on Kent’s performance.”

Although reservation smoke shops have sold untaxed tobacco products for decades, their popularity among smugglers has jumped along with the tax rates. When New York raised the state tax in 2002 to $3 per pack, cigarette shipments to reservations soared, reaching 10 billion cigarettes in 2005 — enough to supply every New York smoker with 128 packs of cigarettes.

Not surprisingly, the black market exploded. Cigarette smuggling investigations have quadrupled since 2002, one New York official estimated.

When state and New York City taxes increased again last June to $4.90 per pack, off-reservation convenience stores saw their cigarette revenues drop 25 percent.

“There has been a sharp increase in demand for black market cigarettes,” said James Calvin, executive director of the New York Association of Convenience Stores. “It’s a huge tax evasion epidemic in New York.”

Peace Pipe and the Poospatuck

The one-square mile Poospatuck reservation on Long Island — reminiscent of a 1950s trailer park with its three sand-edged streets lined with ramshackle trailers — has become a hotbed of bootleggers and is New York City’s primary source of illegal cigarettes, New York officials say. The 283-resident reservation went from purchasing less than 90 million cigarettes in 2000 to more than 2 billion last year.

Jeffrey Cohen, associate chief counsel for the Bureau of Alcohol, Tobacco and Firearms’ Northeast division, calls the illicit cigarette trade stemming from the Poospatuck “a huge problem.” The tribe, he adds, has “offered no cooperation at all” with law enforcement to stop the smuggling.

“It’s not a tobacco issue — it’s a sovereignty issue,” responded Poospatuck Chief Harry Wallace, who owns the reservation’s oldest smoke shop. In 2003, Wallace himself was implicated in a government wiretap (falsely, he says) for smuggling cigarettes, but he was never charged. “Our position is if it’s a bad thing, make it illegal,” he said. “If you’re not going to make it illegal, then we have the right to sell.”

The Poospatuck gained notoriety in 2004, after Rodney Morrison — owner of the reservation’s lucrative Peace Pipe Smoke Shop — was charged with firebombing a competitor’s car, beating and robbing another, and financing the murder of a third. A jury found the 41-year-old Costa Rica native not guilty on everything, except for a firearms charge and conspiracy to smuggle untaxed tobacco. He is appealing the conviction, which could net him up to 30 years in prison.

Morrison — built like a brick, with a shaved head, owlish coke-bottle glasses, and plenty of bling — had for years sold millions of cigarettes to smugglers, who turned big profits on New York City streets. In the process he became a multimillionaire, with $30 million tucked away in foreign bank accounts, another $8 million in real estate, and nearly $4.5 million in jewelry, coins, pens, and watches, according to court records.

The year of Morrison’s arrest, Philip Morris, Lorillard, R.J. Reynolds, and a number of smaller companies supplied him with nearly 400 million cigarettes through their distributors. But the criminal accusations didn’t run Morrison out of business. In the almost four years between his arrest and cigarette smuggling conviction, more than 1.6 billion untaxed cigarettes flowed through his smoke shop, according to wholesaler tax filings to New York state.

Morrison, reached in jail, declined to comment, and his lawyer did not return calls.

Morrison’s case and other court records, along with interviews with smugglers and officials, offer a revealing look inside this teeming black market. Among the smugglers’ favored vehicles: Chevy Astro and Dodge Caravan minivans with their back seats pulled out. At the reservation, the shippers stuff as many as 20 cases — 12,000 packs — into black trash bags and cram them into their vans. As an added precaution, they toss a blanket over the top, then drive off the reservation, often times on the phone with a smoke shop employee who acts as a lookout for nearby law enforcement. In Suffolk County, Long Island, police arrested 81 people between March 2007 and November 2008 who later pleaded guilty to illegally purchasing untaxed cigarettes from the Poospatuck reservation. The City of New York offered evidence in court that the average person was stopped carrying more than 10,000 packs of cigarettes.

Once back in New York City, the drivers unload their stash on a ring of street-level peddlers who affix counterfeit tax stamps and sell the cigarettes to established customers at bodegas and markets in New York’s poorest neighborhoods.

For each trip, smugglers easily double their investment. “We had so much money we wouldn’t know what to do with it sometimes,” said the former New York City smuggler. “It got to the point we would just open the glove box and throw it in. It went to casinos, cars — a lot of cars. . . . We blew a lot in the casinos. We would go in there and blow it on girls, drink the good stuff — Hennessy and Grey Goose.”

Going After the Middlemen

At the heart of the black market stand seven wholesale distributors who have for decades sold candy and cigarettes to New York vendors. They buy millions of cigarettes directly from the manufacturers, then ship them, untaxed, to smoke shops, according to distributors’ sales records filed with the New York Department of Taxation. State investigators have alleged in court that, at least on one occasion, a driver for Queens-based wholesaler Gutlove & Shirvint was spotted on the Poospatuck reservation transferring cigarettes directly from a Gutlove truck into a smuggler’s van.

Wholesalers flooded New York reservations with 6.4 billion cigarettes in 2007. In all, 43 manufacturers supplied the reservation smoke shops, although Philip Morris, Lorillard, and R.J. Reynolds accounted for two-thirds of the amount. Lorillard brands alone comprised 2 billion of the cigarettes — or “sticks” in industry parlance — sold on reservations in 2007.

“The cigarette black market is enormous, it’s brazen, and it’s carried out right under the nose of the government.” — Eric Proshansky, attorney for New York City.

While these wholesale distributors are licensed by the state to affix cigarette tax stamps, nearly all their business is tax-free. Untaxed reservation sales account for 90 percent of business for Long Island wholesaler Mauro Pennisi Inc., according to wholesaler tax reports filed to the state. Buffalo-based distributor Milhelm Attea & Bros. sold 135 untaxed cigarettes for every taxed stick sold in 2007. And two other licensed tax stamp agents haven’t affixed a single stamp to their millions of cigarettes shipped since at least 2004, tax data show.

Sal Pennisi, who took over the business from his father Mauro, insists that he’s following the letter of the law. “We deliver the cigarettes to the reservation,” he said. “Where they go from there, I couldn’t tell you. I don’t particularly care. Until New York state says ‘stop doing it,’ we’ll keep doing it. When New York state says ‘start taxing,’ we’ll start taxing.”

In 2006, the office of then-New York Attorney General Eliot Spitzer sent a letter to manufacturers asking them to drop the wholesalers that supplied the Indians. “We believe that many manufacturers are aware of the legal violations of these agents, and continue to supply them,” the letter read. “We are putting you on notice of this conduct and asking for your cooperation in ending it.”

Lawyers in Spitzer’s office were deflated by the response. Some companies shifted blame onto the state for not enforcing the law, while others failed to respond at all.

Only Philip Morris acted upon the attorney general’s letter. It sent a notice to all its wholesalers saying it would drop them if they sold tax-free. The company even cut one of its distributors, Day Wholesale. But the wholesaler sued the state and the attorney general, and Philip Morris resumed the sales after the courts ruled that the cigarette tax law could not be enforced until the tax department implemented regulations. Those regulations centered on a tax exemption coupon system for reservations from which New York officials, in line with their forbearance policy, backed away.

“That was the end of it,” said David Weinstein, the lawyer who signed the attorney general’s letter.

At the same time the attorney general threw up its hands, the City of New York sought to stem the smuggling by filing a lawsuit against those same wholesalers. It accused them of complicity in cigarette smuggling.

Pennisi, one the wholesalers targeted in the suit along with Gutlove and five others, wonders why officials don’t go after the manufacturers. “We’re buying all our cigarettes from the manufacturers,” he said. “And they [the manufacturers] know where it’s going.”

Cigarettes Sold to a Light Post

In December 2007, on the eve of opening statements in Rodney Morrison’s high profile trial, Philip Morris ordered its distributors to stop selling to Morrison’s by then notorious Peace Pipe smoke shop. But for Morrison’s wholesaler, Gutlove & Shirvint, Philip Morris products made up nearly half the Peace Pipe’s order, which came to more than 30 million cigarettes a month. Gutlove continued to supply the Peace Pipe, according to state and city officials. He allegedly sought out a smoke shop seven hours away on the Seneca reservation in Gowanda, New York, to unload shipments of Philip Morris cigarettes, load them up again and ship them — often in the same day — to the Peace Pipe. The suspected scheme has sparked a federal criminal investigation into Gutlove’s alleged complicity in cigarette bootlegging and money laundering, according to an October 2008 affidavit by Assistant U.S. Attorney Anthony Bruce.

Philip Morris severed its direct buyer agreement with Gutlove in April. Gutlove declined to comment on the allegations against the company.

Gutlove’s alleged supplying of Morrison was only part of Philip Morris’ mounting troubles on the Poospatuck reservation. At the same time, another one of the company’s distributors, Mauro Pennisi Inc., was apparently delivering millions of cigarettes to benches, trees, and light posts.

Beginning in January 2008, dozens of new smoke shops registered with Suffolk County and started ordering millions of cigarettes from Pennisi’s Long Island warehouse. Pennisi’s drivers made the daily deliveries but investigators haven’t discovered where those cigarettes wound up. Visits to the reservation by ICIJ reporters revealed the new shops were no more than small signs nailed to park benches and trees — in cases where the signs or addresses existed at all.

Pennisi began shipping upward of 50 million cigarettes a month to Smoke and Rolls Smoke Shop in January, according to industry cigarette sales data. No smoke shop by that name exists on the reservation and local residents say they have never heard of the place.

“In Native American land what do you classify as a store?” responded owner Sal Pennisi when asked about the deliveries. “On the reservation, some of these guys sell out of their trailers, which are their homes, because they don’t have the revenue to build a store.”

After supplying through Pennisi the seemingly fictitious shops for five months, Philip Morris sent investigators to verify the stores’ existence, according to an affidavit by Philip Morris Vice President for Customer Service and Merchandising Randy Lawrence. Three months later, in September 2008, the company severed ties with Pennisi — drastically stemming the reservation’s supply of Marlboros.

Today the Poospatuck smoke shops are pushing Native brands as a replacement for now-scarce Marlboros, while Lorillard and other manufacturers continue to supply the shops. Lorillard said it “does not profit from the allegedly illegal trade in cigarettes” because it charges wholesalers the same price whether or not taxes are paid.” But that has not stopped the company from major shipments to smoke shop suppliers. In the first seven months of 2008, Smoke and Rolls purchased nearly 300 million cigarettes — 96 percent of which were Lorillard brands.

As pressure increases, Philip Morris continues to distance itself from its longtime reservation distributors. In December, the firm cut off Milhelm Attea, the primary supplier to the Seneca Nation.

The City of New York also responded with a September lawsuit, this time targeting the Poospatuck’s biggest smoke shops. The city is seeking restitution for the loss of taxes and to have the shops shuttered. A federal judge is set to rule shortly on whether to order the shops closed while the case plays out. The tribe has requested that the suit be dismissed.

While a stream of litigation moves through New York courts, Governor Paterson’s signing of the new cigarette bill on December 15 may trigger yet a new wave of lawsuits. Several New York Indian tribes reacted angrily to Paterson’s move, saying that the law violates their sovereignty and threatens their livelihoods.

Proshansky, the attorney for New York City, said the big tobacco companies are keeping a close eye on all the legal maneuvering, watching to see if they are implicated. “It’s a delicate game,” he said. For their part, the tobacco companies insist they will be good corporate citizens and abide by New York’s new legislation. “We will comply with the law,” said Philip Morris’ Murillo, “as best we can.”