Controlling Key Inputs to Starve Illicit Trade

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1 THE LAW ENFORCEMENT ALLIANCE OF AMERICA Presents Controlling Key Inputs to Starve Illicit Trade January 2014

2 Criminal enterprises have long existed where the money is. Today it is not just criminal enterprises that are tied to money; modern terrorism is in large measure driven by ill-gotten dollars. This report provides the brave men and women of law enforcement with an unprecedented insight into just one part of this threat: illicit tobacco production. Illicit tobacco is a major threat to global security, and it is huge. Worldwide, over 1.1 billion people smoke some 5.7 trillion cigarettes. Illicit trade in tobacco products (ITTP, as it is known in both the tobacco and security industries) is estimated to approach 10% of this market. This study, which examines the shipments of a key input to tobacco manufacturing, suggests that ITTP could in fact be larger than that percentage. It also suggests that suppliers of key inputs need to be part of the solution to ITTP. The illicit trade in tobacco products (ITTP) is an economic de-stabilizer that threatens global security. A significant portion of the $81 billion in illicit annual revenues from ITTP 1 funds criminal networks and violent extremist organizations. It also destroys communities by robbing governments of needed tax revenues, challenges legitimate business and suppresses the minimum wage, and threatens public health with unregulated product. According to the Congressional Research Institute's study of terrorism and transnational crime: The production, smuggling, and sale of tobacco products, including genuine and counterfeit cigarettes, is a lucrative form of financing for organized crime as well as terrorist groups, such as Hezbollah, Hamas, the Kurdistan Worker's Party (PKK), and the Real Irish Republican Army (RIRA). 2 Prof. Louise Shelley has studied recent criminal and civil cases filed in US courts and found they demonstrate that the illicit trade in cigarettes (even those legitimately produced), whether by a corporation or by terrorists, can generate significant financial resources for organized crime and terrorism. The first case study in her publication The Nexus Of Organized Crime And Terrorism: Two Case Studies In Cigarette Smuggling is that of the R.J. Reynolds Tobacco Company and its alleged delivery of its products in Iraq using criminal actors as suppliers. 3 The cross-border movement of the cigarettes from Turkey into Iraq, in violation of the UN embargo, was facilitated by members of the Kurdistan Workers Party (PKK), an organization identified by the US government is a terrorist organization (European Community v. RJ Reynolds et al., 2002). The second case study focuses on a Hezbollah cell operating out of Charlotte, North Carolina. The cell trafficked cigarettes from North Carolina to Michigan, reaping significant profits for Hezbollah by exploiting the differential tax structures on cigarettes in these two states (Kaplan, 2003; MIPT Terrorism Knowledge Base, 2006). These are but two of the myriad cases of criminal traffic in cigarettes funding organized crime and terrorism, a trend that is growing as the convergence of transnational organized criminals (TOCs) and foreign terrorist organizations (FTOs) grows. 1 Calderoni, Francesco and Ernesto Ugo Savona and Serena Solmi, Crime Proofing the Policy Options for the Revision of the Tobacco Products Directive, Trento: Transcrime Università degli Studi de Trento, January 2012, p Louise Shelley and Sharon Melzer, The Nexus of Organized Crime and Terrorism, International Journal of Comparative and Applied Criminal Justice, Spring

3 The fight against transnational organized criminals (TOCs) is global. Disrupting, denying and degrading TOCs is now a Tier-One national security priority for the United States, and combating TOCs is now a cornerstone of counterterrorist strategy. According to 2011 s White House Strategy to Combat Transnational Organized Crime, Criminal networks are not only expanding their operations, but they are also diversifying their activities, resulting in a convergence of transnational threats that has evolved to become more complex, volatile and destabilizing. 4 The global threat from TOCs has also prompted the United Nations to establish the Convention Against Transnational Organized Crime (commonly referred to as UNTOC) 5. TOCs are complex, adaptive systems that grow fast and respond to threats even faster. A multi-pronged strategy against the ITTP that funds transnational organized crime 6 and terrorism has to encompass both demand-side and supply-side disruption. ITTP could not exist without the supply of key inputs such as cigarette paper and cellulose acetate tow, which is used for cigarette filters. Recent research has revealed that the biggest suppliers of cellulose acetate tow (used to make cigarette filters and supplied by only five companies in the world) are oversupplying the legal market, indicating that a significant portion of their product is going to producers whose products are fed into illicit channels for distribution. Since these illicit producers are in business with criminal networks, key input suppliers need to be part of the solution to diminish the financing of criminality and terrorism. Governments, the legitimate trade, the tobacco industry and consumers are affected by three types of illicit traffic, whose terms we clearly define here as follow: Contraband: also known as cigarette smuggling, it is the illegal diversion and smuggling of genuine cigarettes; Counterfeit: the covert manufacture and trafficking of cigarettes that falsely pretend to be from reputable manufacture (e.g., fake Marlboros); the bulk of these originate China, according to Europol; 7 Illicit Whites (also known as Cheap Whites): the smuggling, distribution and sale of cigarette brands in markets where the brands have no legitimate presence. The distribution networks for cheap whites are comprised of transnational organized criminals, referred to in security circles as TOCs Strategy to Combat Transnational Organized Crime: Letter from the President, July 19, United Nations Convention against Transnational Organized Crime. See, amongst many others: Stephen Wright, IRA s cigarette smuggling millionaires, The Daily Mail, June 6, terrorists?flooding?uk?potentially?lethal?fakes?cheating?taxpayers?billions.html#ixzz2eb4uo0nl 14 Jaime Doward, How Cigarette Smuggling Fuels Africa s Islamist Violence, The Guardian, January 26, belmokhtar?terrorism; Te?Ping Chen, The Counterfeit Cops, The Center for Public Integrity, January 27, Latif and Kate Wilson, Tobacco and the Taliban, The Center for Public Integrity, June 29, Kate Wilson, Terrorism and Tobacco, The International Consortium of Investigative Journalists, June 29, Europol, OCTA 2011: EU Organized Crime Threat Assessment, European Police Office, 2011.

4 The illicit producers of tobacco, whether counterfeiters or producers of illicit whites, have at least one critical upstream vulnerability: the supply of their key inputs is highly concentrated. All filtered cigarettes require cellulose acetate tow, which is a highly concentrated industry, with only five producers and dominated by two big companies: Eastman and Celanese. In an anticipated era of diminishing fiscal resources, countering threat finance may become the preemptive first strike option against trans-national or non-state actors, as it is far less costly to disrupt access to funding sources which will have an immediate and taming effect by obstructing or eliminating the ability of terrorist organizations to fund personnel, training and equipment. One very effective tool in reducing the illicit funding flowing through crime-terror pipelines is the invocation either of a RICO (Racketeer Influenced and Corrupt Organizations) statute or other counter-threat finance law (known in security circles as CTF). The sale of cellulose acetate tow (from which cigarette filters are made) or cigarette paper to cigarette counterfeiters or manufacturers of illicit whites should be explored under international law enforcement, as well as the US government s numerous counter-threat finance initiatives across the Departments of Defense, Treasury and Justice. Because the cigarette paper and cellulose acetate tow industries are highly-concentrated, wherein a handful of companies supply the majority of tobacco manufacturer in the world, whether licit or illicit, these companies are both: a) natural chokepoints in the illicit supply chain, and b) legitimate targets for policy. At the very least, the suppliers of these key inputs should be asked to explain how they ensure their product is not going to transnational criminal organizations. The standard of know-your-customer should be applied uniformly throughout the tobacco supply and distribution chain. Such standards are now commonplace in many other industries, including banking. The following three case studies are hot spots for illicit trafficking that show a clear oversupply of cellulose acetate tow to the stated legitimate market. It is clearly surmisable that a significant portion of the excess is fueling the ITTP. Below are countries where we can document the recorded levels of cigarette production, including cigarettes manufactured for export. The stated number of cigarettes produced is then converted to the number of metric tons of acetate tow required to produce this amount of cigarettes. Finally, the amount of legitimately required tow is then compared with the amount of acetate tow imported to each country using the PIERS database, an open source trade database. The amount of tow imported minus the required amount yields the amount of illicit cigarettes each country is able to produce. Belarus Some Facts: Steep increase in cigarette production of 153.5% in Belarus from cannot be explained by tobacco use increase within the country. 8 Between 2001 and 2011, 8 Tobacco Insights, ERC, January, p.3

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7 same time period. 17 Tracking the illicit cigarette trade through Paraguay is more complicated, as there are nearby free trade zones and unknown data, but the numbers we can see are nevertheless alarming. Number of registered tobacco companies in Paraguay ballooned from 3 companies in 1993, to 17 by 1998, to 33 companies in 2004 an expansion of more than 900%. These are official figures, which exclude a number of clandestine enterprises billion cigarettes can be manufactured from the tow imported into the free trade zone between Argentina and Paraguay that is not accounted for by the sum total of the legal tobacco market of the two countries. The true size of the Paraguayan cigarette market has been difficult to determine due to the existence of a significant parallel trade with considerable volumes of cigarettes produced and sold legally in Paraguay destined for informal exportation to neighboring countries, in particular Brazil and Argentina. This trade developed after the earlier parallel trade involving the import and re-export of Brazilian-produced cigarettes back to Brazil was halted, in large part after Brazil imposed punitive taxes on exports to Paraguay. Following this, numerous cigarette factories were set up in Paraguay to meet demand. There are reported to be five to six legitimate producers, most members of the UTP, Unión de Tabacaleras del Paraguay (the Paraguayan Tobacco Producers Union). Still present, however, is a substantial element of illegal production by smaller producers, most of which is destined for consumption outside Paraguay. 19 Recent industry studies (rather than official government figures) suggest that between billion cigarettes are produced annually in Paraguay of which the true rate of consumption in Paraguay is said to be just 3-4 billion sticks with around 7-10 billion sticks exported legally. The remainder destined to be smuggled into other Mercosur countries, including Brazil. 20 Tabacelera del Este (Tabesa) is Paraguay s top cigarette factory, a modern, sprawling facility with a declared production 1.5 billion cigarettes a month. 21 The factory supplies almost half of the Paraguayan market with its two flagship brands, Kentucky and Palermo. The company also allegedly supplies large quantities of cigarettes that are smuggled to Brazil and Argentina. Tabesa leads the market with a 54% share in 2011, while PMI holds second position with 24%, and BAT, third with 19%. In 2008, Tabesa, which now accounts for some 60% of national production, produced 13.5 billion cigarettes according to trade reports, with this increasing to 16.1 billion pieces in Tabesa's planned production alone is expected to reach 23 billion pieces per annum in the near term after it completes its current investment program. Its capacity is currently declared at 19 billion pieces Alejandro Ramos, Illegal Tobacco Trade in MERCOSUR Countries, CIET Uruguay, ERC Paraguay Report, pg. 1. Elizabeth Allen, The Illicit Trade in Tobacco Products and How to Tackle It, International Tax and Investment Center. The Global Trade in Smuggled Cigarettes: The Digital Newsbook, The International Consortium of Investigative Journalists,

8 Tabacalera del Este (Tabesa) allegedly supplies large quantities of cigarettes that end up smuggled to Brazil and Argentina. Customs officials in those two countries say they seize more contraband cigarettes from Tabesa than any other Paraguayan company. 22 Tabesa is owned by Horacio Cartes, Paraguay s new President-Elect, who was sworn in on August 13, 2013, placing illicit trafficking at the very heart of the presidential palace. Tabesa s CEO José Ortiz said about the company s business, We don t know where our cigarettes are consumed, and it s not our problem, when asked about the presence of Tabesa s cigarettes in Brazil and Argentina, two markets to which the company does not legally export. We sell our products in Paraguay and pay all local taxes, he added, sitting in his office at Tabesa s manufacturing plant, which features high-end German cigarette machinery. His view is shared by other cigarette makers in Paraguay. My job is to supply the market. However, willful ignorance should not be a defense in ITTP. By looking closer at the numbers and comparing what Paraguay is producing domestically, with what it is consuming and what it legally exports, one can see how many billions of cigarettes are likely fueling illicit trade in neighboring countries. The Scale of Paraguayan ITTP Based on Tow Oversupply Paraguay s stated production is 30 billion sticks for Paraguay s stated exports for 2011 was 7.2 billion sticks. 24 That allowed for 22.8 billion sticks to be consumed domestically in However, according to ERC s Tobacco Insights (page 2), Paraguayan domestic consumption was 4.5 billion in That means that domestic consumption is overstated by 18.3 billion cigarettes in This delta alone is enough to suggest a large pool of illicit cigarettes that is alarming. However, an analysis of the data on cellulose acetate tow, a key input for all filtered cigarettes, yields a much larger number of likely illicit tobacco products, and pegs this criminal activity to specific suppliers of the requisite key input. Paraguay has stated that in 2011 its total production of cigarettes was 30 billion sticks, of which 27 billion were filtered. 27 billion filtered cigarettes require 3,375 metric tons of cellulose acetate tow. But Paraguay only imported tons, not nearly enough to supply its stated legal demand, indicating other sources of importation for its tow. The most likely source is Argentina, its free-trade partner with whom it shares a border. Argentina imported 32, metric tons of tow in 2011, according to PIERS data. Subtracting the tons of tow required by stated Paraguayan production from the total likely importation (what was imported directly into Paraguay plus what was imported into Argentina), an extra billion cigarettes could be produced. Data indicates that Argentina has a negligible cigarette export business. Argentine stated production for 2011 was 42 billion cigarettes, while it stated domestic consumption was 41.5 billion cigarettes. Subtracting the entire domestic production in Argentina from the 231 billion cigarettes not accounted for by Paraguay, allows for 189 billion cigarettes that can be manufactured from the tow imported in the free trade zone between Argentina and Paraguay that is not accounted for by the sum total of the legal market of the two countries Marina Guevera, Mabel Mehnfeldt and Marcelo Soares, Smuggling Made Easy, The Center for Public Integrity, June 29, ERC, Tobacco Hot Spots Report: Paraguay, p. 18. ERC, Tobacco Hot Spots Report: Paraguay, p. 21.

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11 regulation: all the world s tow can be directly traced to the five producers, who are members of GAMA, the Global Acetate Manufacturers Association. Thus far, the five cellulose acetate tow manufacturers have failed to self-regulate their sales by exercising proper know-your-customer due diligence. However, policy and law enforcement are moving in the direction of instating such due diligence and supply chain control. The OECD s High-Level Risk Forum Task Force on Charting Illicit Trade is drafting an OECD Due Diligence Guidance for Responsible Supply Chains of Alcohol and Tobacco that will be grounded in the OECD s document on Minerals from Conflict-Affected and High-Risk Areas. Interpol is becoming involved in ascertaining the due diligence of key input suppliers to the tobacco industry. However, for any of these initiatives to be effective, a credible authority would have to verify supply chain control and customer due diligence by tracking key input shipments and then provide reports on any discrepancies to Interpol. Such a process would truly herald a new era of public-private partnership in global security.