We recently attended the annual Tobacco Merchants Association conference and interviewed Standard & Poor’s to better gauge the impact that the Master Settlement Agreement (MSA) is having on the tobacco industry and tobacco settlement bonds.
Our research indicates that industry analysts and bondholders are primarily focused on litigation, shipment volumes and enforcement of the master settlement agreement. However, due to a variety of factors, bondholders can expect to see their principal and interest payments continue as they have in the past.
Background
The 1998 agreement between the four largest tobacco companies and 50 states and territories requires the original tobacco companies, plus 36 companies that signed on afterward, to pay approximately $206 billion over 25 years to the states as repayment for health costs borne by the states from smoking-related illness.
In return, the states agreed not to sue the tobacco companies who are part of the agreement. Non-participating cigarette producers that wish to ship their products must post escrow payments in the states where they seek to do business as collateral against any future state suits against them.
Litigation
Although numerous individual and class-action suits remain outstanding, it appeared to most of the conference participants and tobacco industry analysts that the litigation landscape for tobacco companies is improving. For example, plaintiff attorneys have apparently concluded that higher courts are not sustaining suits based on health claims. Instead, plaintiff attorneys are asserting fraud, arguing that cigarette producers misled the public into believing that "light" cigarettes are healthier than regular smokes. In the Price case, in Madison County, Illinois, the trial judge agreed with the plaintiffs in their suit against Altria (parent of Philip Morris USA), but his decision is expected to be overturned on appeal.
Most industry observers we have talked with believe suits of this kind will not meet with success. Federal law prescribes the health warning contained on cigarette packaging, and both cigarette makers and the states are prohibited from overriding these disclosures.
Furthermore, limitations on punitive awards under the recent U.S. Supreme Court State Farm decision may well reduce the size of potential liability cigarette producers are faced with.
Shipment Volumes
An area of greater concern is the inordinately high excise taxes that have been, and are likely to be, placed on the sale of cigarettes by the states. Because of state budget shortfalls, eight states have already passed tax hikes and 21 more are considering it. If all such tax increases are passed, the tax bite would increase by 36% per pack. In addition to tax increases already enacted since the MSA was signed, the increasing price gap between premium brand and deep discount cigarettes has grown more stark.
As can be expected, consumers have moved from higher price brands to generics as prices have risen. Market share has then shifted to smaller producers, many of whom are MSA participants, and some who are not. Market share is significant since it determines the percentage each cigarette manufacturer is responsible for paying under the MSA.
To the extent that the four original participating manufacturers lose market share, it has weakened their bond ratings and, in turn, the bond ratings of the tobacco settlement bonds. Also of concern is the market share that could be slipping to non-participating manufacturers who do not share in the obligation to make MSA payments.
Market share data are often conflicting and reliability is suspect, making tracking industry trends difficult. Despite this, MSA participants are still thought to control 85% – 90% of total industry shipments, ensuring that sufficient MSA payments flow to the states and secure outstanding bonds.
MSA Enforcement
Increased enforcement actions are underway against non-participating manufacturers seeking to evade required escrow payments, counterfeit cigarette makers and other illegal imports, and unregulated Internet sales operations seeking unfair price advantages over MSA participants.
Legislation has been introduced to strengthen enforcement in approximately half the states so far this year that would tighten compliance with MSA requirements and reduce incentives for non-participating manufacturers to remain outside of the MSA. Increased enforcement by the Federal Bureau of Alcohol, Tobacco and Firearms (BATF) along with greater vigilance by state attorneys general should work to reduce unaccounted for shipments and decrease opportunities to undercut cigarette prices charged by legitimate sales channels.
Conclusion
Current uncertainty surrounding the direction of the tobacco industry is partially ameliorated by an improving litigation environment, increased enforcement activities and efforts to better quantify market share data. Tobacco settlement bonds have suffered downgrades and remain on CreditWatch, but they are viewed by rating agencies as stronger than tobacco company direct debt due to the strength of the MSA payment mechanism and the likelihood it would be viewed as an executory contract in a bankruptcy scenario. All this means that with increased efforts to insure that the MSA continues to work, bondholders can expect to see their principal and interest payments continue as they have in the past.