The 2011 Master Settlement Agreement (MSA) payments from participating tobacco companies were made in April, as usual. Altria, the nation’s largest cigarette manufacturer and parent of Philip Morris, paid $3.5 billion, roughly half of the total annual payment due to the states. However, unlike past years, $267 million of that total was deposited into the “Disputed Payments Account,” established under the MSA, causing a shortfall in the amount the states expected to receive.
The Disputed Payments Account, created as part of the MSA, enables tobacco companies to challenge the amount of their annual assessments. Under the agreement, if the tobacco companies can prove they lost market share due to the existence of the MSA itself, and that the member states have failed to rigorously enforce the MSA, a portion of the payments due each year may be rebated to the cigarette producers.
In arbitration, the tobacco companies made the case that market share diminished as a direct result of the MSA. However, the second test – adequate state enforcement against non-participating manufacturers – remains unresolved for each year going back to 2003. As a result, there are more than $3 billion in tobacco settlement payments now sitting in the Disputed Payments Account awaiting a final arbitration ruling. This has been a slow and tedious process.
Arbitration for 2003 is currently underway. Decisions on the following years, 2004 to the present, are not expected anytime soon and have yet to be scheduled. No resolution of those years is expected until sometime after 2012. To date, we have seen no evidence that state enforcement has been lax.
Impact on tobacco bonds
Due to the swelling Disputed Payments Account, states are feeling the pinch in the receipt of expected tobacco settlement revenues.
At the same time, increased excise taxes on tobacco by both the federal and state governments has caused the rate of decline of tobacco shipments to be higher than expected. Nevertheless, Altria, representing half the cigarette manufacturers, has always paid out its disputed amount with the provision that it reserves the right to reclaim those amounts, if the tobacco companies are successful in arbitration. This year, Altria followed other tobacco companies in placing its disputed amount in escrow in the Disputed Payments Account.
Consequently, although all states are still expected to make timely principal and interest payments on their tobacco bonds, some are likely to require the use of reserves to do so.
Earnings on reserves have also fallen short of estimates, increasing the payment amount needed this year. None of the reserve draws will result in a payment default in 2011, and bondholders can expect to be paid in full this year. The states that are affected will see modest decreases in their liquidity reserves that exist for use in cases such as this. The three states are:
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Golden State Tobacco Securitization Corporation, Series 2005 – $5.3 million may be drawn for the December 1, 2011, payment out of a total $68.3 million. These bonds however, are also backed by an appropriation pledge of the state of California.
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Golden State Tobacco Securitization Corporation, Series 2007 – $7.7million may be drawn for the December 1, 2011 payment out of a total $87.9 million.
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Buckeye Tobacco Settlement Financing Authority, Series 2007 – A total of $6-8 million may be drawn from a reserve totaling over $389 million.
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Virginia Tobacco Settlement Financing Corporation – $3.6 million is anticipated to be utilized from a total liquidity reserve of $87.5 million.
All of these liquidity reserves are ample to make up the shortfalls. And if the states are successful in documenting their diligent enforcement of the MSA over past years, a substantial back payment from the Disputed Payments Account will then flow to the states. In that event, any prior draws made will easily be covered. Meanwhile, this large escrow keeps building. Nevertheless, reserves are adequate to fill in the gaps for the foreseeable future, as the payment dispute is being ironed out.
An agreement as complex as the MSA was structured to recognize that disputes, such as the one unfolding, are likely to occur. Unfortunately, the methodology for timely resolution was not well detailed and has resulted in the long delays we are witnessing. It is unfortunate that a payment dispute such as this one is taking so long to resolve, as it hamstrings the substantial tobacco payment amounts that fund the MSA and also increases uncertainty throughout the tobacco bond market.