Sunday, 8 December 2013

Can Japan Tobacco stay judgment-proof??

In the public relations business, the bombshell news is often delivered on a Friday afternoon. It seems this practice may also apply to court rulings.

It was on Friday that Justice Robert Mongeon of the Quebec Superior Court made public his ruling against the plaintiffs in the Montreal Tobacco Trials. In it, he turned down their request for an order to stop JTI-Macdonald from using an artificial debt to shelter its earnings from the tax-man or from other creditors.

In this case, it was more than the ruling which was revealed on a sleepy weekend. The dispute behind it had also been cloaked in secrecy up until Justice Mongeon's ruling was uploaded to the court's web-site. The issue had been managed in isolation from the main trial and kept away from Justice Riordan. Even the hearing before Justice Mongeon on November 11 and 12 had been subject to a publication ban. (The ban has not been removed, but the ruling seems to disclose pretty much all that was discussed.)

It was only by his recapitulation of the issues that Justice Mongeon finally shed light on a problem that may exist elsewhere within Japan Tobacco's global empire. Japan Tobacco had created paper companies and artificial debts between them in order to make it look like it was losing money in Canada, even though it was operating profitably.

Justice Mongeon's ruling is a sobering lesson to me in how misleading a judge's body language and interventions during the hearing process can can be. During the hearing he seemed a little shocked by the corporate actions that were under discussion, and sympathetic to the situation of the plaintiffs.

But his ruling was an unequivocal thumbs down for the plaintiffs. If they want to block JTI-Macdonald's corporate shenanigans, they will have to find a different mechanism to do so than the one they provided him with. He said he would not hang the solution they wanted (a Safeguard Order) on the hook they provided (Article 46 of the Code of Civil Procedure).

The corporate ruse

A surprising ruling? Maybe, maybe not. But the situation it exposed -- one that remains in place -- is a shocking one.

Japan Tobacco seems to have found a way to extract profits from Canada while externalizing the costs with impunity - and avoiding income taxes to boot.

This mechanism was put in place in the fall of 1999, a few months after Japan Tobacco purchased the international assets of RJ Reynolds. Among those assets was Canada's third-largest tobacco company, RJR-Macdonald, which is now known as JTI-Macdonald, or JTIM.

The structural adjustments made by Japan Tobacco are referred to as "the transactions" in Justice Mongeon's ruling. These involved removing the value of the newly-acquired company, and then borrowing $1.2 billion against it. In effect, JTI-Macdonald became fully-mortgaged, with the mortgage held by another Japan Tobacco company.

Japan Tobacco also divided the Canadian business into a company which made and sold cigarettes (JTIM) and a company which owned the trademarks (JTI-Trade Mark, or JTI-TM). The process is more fully described in Paragraph 14 of Justice Mongeon's ruling.

For the past 14 years, Japan Tobacco has been busy making and selling cigarettes - but has, technically speaking, usually made no profits on those sales. That's because most of its income (about $110 to $130 million each year) is used to service its debt to other Japan Tobacco companies ($92 million per year), or to pay royalties to its trade-mark company ($20 million a year).

That is to say, without the inter-company payments, JTI-Macdonald would be showing a profit of $130 million on its 2011 sale of 3 billion cigarettes/cigarette equivalents - or just over 4 cents per cigarette. But with these payments to sister-companies, the company reports a loss of about 3 cents on each cigarette it sells.

On the assets side, the picture is even more dramatic. In 1999, before the purchase by Japan Tobacco, RJR-Macdonald was valued at $2.24 billion. In December 2011 (the most recent evaluation made public as a result of this dispute), JTI-Macdonald had lost $4 billion in value. It's balance sheet showed a net deficit of $334.3 million and liabilities of $2.046 billion.

(This ruling, and the release of previously confidential information, also reveals some discrepancies with the public filings of Japan Tobacco. Its 2013 Annual report says that JTI-Macdonald is valued at $535 million.)

The benefit to Japan Tobacco's shareholders

The lawyers for JTI-M told Justice Mongeon that this restructuring was done in order to save on corporate income taxes.

It is easy to see how this might benefit JTI's shareholders. Japan Tobacco is the only tobacco multinational that is effectively controlled by a government. (At the time this structure was put in place, one-half of the shares were owned by Japan's Ministry of Finance, which remains the largest shareholder).

By receiving income from Canada in the form of loan payments and not repatriated revenues, the company can reduce its corporate income taxes in Canada, and shift the tax benefit to the Japanese government. There are other tax advantages too: Canada is almost unique in the world in imposing a 50% income tax surcharge on tobacco companies - ITA section 182. This tax applies only to tobacco manufacturers, so shifting income to trade-mark owners would help escape the surtax, even if Canadian income taxes were owed.

The federal response

It's not so easy to see why Revenue Canada finds this acceptable. Justice Mongeon's ruling reveals that there was indeed a time when the federal government challenged the corporate reorganizations as "fraudulent conveyance".

This happened only a few years ago, when federal and provincial governments were suing Japan Tobacco to recover excise taxes lost as a result of RJR-Macdonald's involvement in cigarette smuggling in the 1990s. In those days, the federal government recognized that Japan Tobacco was trying to "hinder and defeat the plaintiff [federal government] and other creditors." 

But the settlement that was reached in April 2010 did nothing to make the conveyance any less fraudulent. JTI-Macdonald agreed to a criminal fine of $150 million, but, as Justice Mongeon notes "without any decision having been made on the validity of the inter-company transactions."

The plaintiff's request

The plaintiffs did not learn of the situation until a year ago, when Japan Tobacco was forced, as a result of a ruling by Justice Riordan, to share its financial situation with them. They hoped that Justice Mongeon could issue a "safeguard order" to prevent future funneling of profits away from the manufacturing company. Justice Mongeon clearly understood their position:

"The Plaintiffs allege that these transactions were structured so as to render JTIM, the Canadian tobacco company, "creditor proof" and to ensure that the revenues generated from the sale of tobacco products in Canada would be, for the most part, funnelled out of JTIM, out of its subsidiary JTI-TM and into off-shore related corporate entities." 

... "More particularly, the Plaintiffs are concerned with the question of punitive damages. They allege that if the current situation is allowed to continue, JTIM will have little or no capacity to pay any such damages. More importantly, they suggest that the eventual award of such punitive damages by the trial judge is a direct function of JTIM's capacity to pay. Consequently, the Plaintiffs now seek an order whereby all current payments of capital, interest or royalties by JTIM in favour of JTI-TM would be suspended. This would permit the accumulation of approximately $550 million in cash in favour of JTIM over the next five years, thus creating a basis for the allowance of punitive damages."

Neither the CQTS/Blais nor the Létourneau class actions included any of the other JTI-subsidiaries in their initial actions. Only the manufacturing arm, JTI-Macdonald, is involved. This is not so surprising, given that the other companies were created in 1999 - after these suits were filed.

The judge's ruling

In his 25-page ruling, Justice Mongeon gave several reasons for refusing to issue the safeguard order the plaintiffs requested.

The plaintiffs had based their request on Article 46 of the Quebec Code of Civil Procedure, which gives broad and general powers to a judge to safeguard the right of parties. But Justice Mongeon did not see that the solution of a safeguard order would justify the use of this section.

For one thing, the safeguard order would not necessarily help the plaintiffs. Even if the money were held back from the sister-companies, they would still have the right to claim the money. The debt and royalty arrangements would still be in place. In addition, as secured creditors, other JTI companies would be first in line for any pay-out, ahead of any court-ordered payments from this lawsuit.

Secondly, the "capacity to pay" of JTI-Macdonald would be the same, whether or not the money had been held back. Justice Riordan would not be able to ignore the over-due payments when assessing the company's financial situation.

Thirdly, the plaintiffs could not, unless they otherwise challenged the legitimacy of JTI's financial structures, get around the fact that only one company was before the courts and that the other JTI companies were third parties to the lawsuit. Justice Mongeon said that Article 46 could not be used to affect the rights of third-parties.

Not this time, and not this way, he seemed to conclude. As long as JTI's financial structures were not challenged, and as long as only the manufacturing arm, JTI-Macdonald, was in the lawsuit, there was nothing he could do.

Or was he just pointing out two other routes the plaintiffs could take?

The trial resumes on Monday, December 9th, with the appearance of former Agriculture Canada scientist, Brian Zilkey.