The litigation environment surrounding tobacco has improved, and the Master Settlement Agreement (MSA) between tobacco manufacturers and states is firmly in place, although there are disagreements over how well states have enforced the pact.
Those are some of the conclusions drawn from discussions with industry insiders during our recent attendance at the Tobacco Merchants Association annual meetings in New Jersey. The conference provided the opportunity to talk with industry participants regarding some of the hot topics facing the tobacco settlement bond segment. Our observations included the following:
- Annual shipment declines appear to be consistent within the expected ranges of 2% to 4% per year as envisioned in the structuring assumptions of the $18.5 billion of tobacco settlement bonds issued since the MSA was created.
- Both parties to the MSA generally agree that the states have stepped up their efforts over the last two years to better enforce the MSA, although more work needs to be done. As a result of new legislation targeting the closing of loopholes in the MSA, it is estimated that the market share of tobacco companies that do not participate in the MSA has flattened and will likely decline over time.
- Tobacco manufacturers who are part of the MSA are seeking credit against future payments, through the NPM Adjustment (based on market share lost to Non-Participating Manufacturers) for alleged overpayments (plus treble penalties) for the years 2003-2004. The companies say they lost market share due to the MSA agreement itself, and the lack of adequate state enforcement during those years.
The resolution process to determine over/under payments has taken place only once so far, in 2002, and meetings are already scheduled to work out differences for subsequent years. A neutral party has been selected by both sides to determine market share loss of participating manufacturers for 2003-2004 and to what extent that loss was caused by the MSA itself. The time it will take to reach a resolution by the parties is unknown, with estimates ranging from a few months up to two years. Insiders tell us that MSA implementation “ground rules” are still evolving, with two questions having paramount importance:First, both the states and manufacturers need to agree on the size of the overall domestic cigarette market as a prelude to determining each company’s market share and gain/loss. This has been the most hotly disputed issue by both sides of the MSA. The states, which are responsible for reporting data each year on shipments, have underestimated the non-participating manufacturers market share, according to the companies who belong to the MSA. If the companies are right, their market shares would appear larger than if all non-participators, counterfeiters and Internet sales were included. The problem is that in the earlier years of the MSA, enforcement was more lax, and detection of illegal shipments was less successful than it is today.Second, once the parties reach agreement on market size, there will need to be a determination that the MSA itself was the cause of a participating manufacturer’s market share loss. Further, agreement will need to be reached whether such loss must be determined on a state-by-state or national basis, in order for the NPM Adjustment to be applied. As expected, the states support a state-by-state approach, while the manufacturers find that unwieldy and believe financial relief should be granted based upon an overall nationally determined figure.
Although the NPM Adjustment issue has raised concern by holders of tobacco settlement bonds, we believe that a concerted effort by passionate advocates on both sides will result in a compromise. Further, while there is some risk through 2007 that an NPM Adjustment could affect cash flow to the states negatively, bond payments are still expected to be made on time.
The longer term holds greater optimism. Stepped up enforcement over the last two years has stopped the market share growth of non-participating manufacturers, and many have sought to join the MSA rather than compete from outside. If that trend continues, the market share of companies outside the MSA will decline making future “Volume Adjustments” and “NPM Adjustments” a smaller factor, while the annual required “Inflation Adjustment” (minimum of 3% or actual rate of inflation) should have an upward effect on MSA payments.
Conclusion
With little success to date of class action suits against tobacco companies, and the failure of the Department of Justice to gain reinstatement of substantial financial penalties in its lawsuit against the companies, litigation appears to have lessened as a threat to tobacco bonds.
Additionally, the MSA is still in its early years. The agreement, reached in 1998, is designed to last in perpetuity. The agreement itself is highly complex and couldn’t possibly account for every “real world” twist and turn that would occur in the years following its signing. At this point, the most contentious issue within the industry surrounds the measurement of the actual size of the cigarette market and each manufacturer’s share of the market. While resolution of this issue may provide a bumpy ride for bond investors in the near term, market forces would seem to hold a promising future in subsequent years.