A Philip Morris advertisement Flickers across a New York television screen advising viewers that the recent tobacco settlement agreement “restricts the marketing of tobacco products …bans all tobacco company billboards and transit advertising…no more tobacco logos on clothing or merchandise…no more cartoon characters selling cigarettes…strictly prohibits marketing tobacco products to kids…”. It’s a rather humble announcement, where once gloss, seduction, image, indulgence and temptation dominated. How times have changed. The new order of the late 20th century has put the tobacco industry through a punishing round of litigation that it has lost. Winners and losers
The winners are “the settling states”, 46 states of the US (excluding Florida, Minnesota, Mississippi and Texas, which had already won a handy $40 billion from the tobacco companies) and seven territories: the District of Columbia, Puerto Rico, the US Virgin Islands, the Northern Mariana Islands, American Samoa and Guam. The winners are also the law Firms that undertook the litigation on behalf of the states and territories.
The losers are the four tobacco companies, together accounting for 97% of the US domestic market, that have signed the master settlement agreement (MSA): Brown&Williamson Tobacco (owned by UK company British American Tobacco), Lorillard Tobacco, Philip Morris and R J Reynolds Tobacco (a subsidiary of RJR Nabisco). In exchange for $206 billion, these four tobacco companies are released from all past, present and future claims from the states and territories related to the use of tobacco products. However it does not include protection from personal injury claims from individuals, class actions or federal government actions.
For the winners, how to use the future cashflow streams to best advantage becomes the issue. They can choose to receive the Flows as they become available or they can raise cash now against future Flows using securitization, secured loans and revenue bonds.
To date, securitization has been a popular choice with six deals completed and several others in the pipeline.
According to Christopher Howley, director of synthetic securities at Standard&Poor’s, “securitization allows the government entities to transfer a portion of the risk, the risk being the Financial well-being of the tobacco companies, while at the same time allowing them to keep the residual upside”.
Morgan Stanley has three securitization deals in the pipeline, as lead manager for Oregon and Virginia, and co-lead for Alaska. Rob Larkins, principal at Morgan Stanley Dean Witter, says: “Essentially what the states hold is a volume asset. What we have said to the states is that you own a derivative.”
According to Larkins, the states’ treatment to date of the future cashflows falls into three categories: spend as you receive, with the funds having been earmarked for certain purposes; put the windfall into a trust fund; and securitization. The First two options do not deal with the liquidity and risk issues effectively. Larkins says: “Securitization can enhance the viability of a trust fund programme by converting a single industry receivable into cash, which can be then invested in a diversified portfolio.”
For S&P the key challenges associated with the securitization of the tobacco manufacturers’ future revenue Flows are the bankruptcy of one or more of the tobacco companies and the uncertain litigation landscape for the tobacco industry in the US.
S&P concluded that the payments would be deemed to be an administrative expense under the bankruptcy code and would therefore be allowed to continue. S&P is of the view that if one or more of the tobacco companies File for Chapter 11 bankruptcy, a bankruptcy trustee would choose to continue the MSA payments in order to maintain the litigation protection the MSA provides.
In the event of a Chapter 7 bankruptcy and liquidation of one of the tobacco manufacturers, S&P took the view that one result might be that the remaining tobacco manufacturers would absorb the market share of the liquidated company and the overall Flow would therefore not be significantly reduced. Alternatively, if a new entrant entered the Weld it would have a strong incentive to join the MSA to gain the protection it offers, and the aggregate Flow from the MSA would be maintained.
Six securitization deals of future MSA payments have been completed to date, and the Five assessed by S&P have been rated favourably.
Uncertain litigation landscape
In the wake of the states and territories’ successful litigation the federal government has its own action pending against the tobacco companies for billions of dollars, seeking repayment of smoking-related Medicare expenses. The federal case is brought against the tobacco manufacturers on the basis of fraud, racketeering and antitrust violations.
This action may have come too late. If George W Bush is elected to the White House, many believe that he will have a more lenient attitude towards the tobacco industry than incumbent president Bill Clinton. It is possible that he would drop the litigation altogether. The current tide of public opinion appears to be not as acutely hostile towards the tobacco manufacturers as it has been in the recent past. Consequently there appears to have been limited damage to the perceived credit viability of the industry. But bonds issued by tobacco companies have long traded wide of other non-tobacco issuers with comparable ratings, because of litigation fears and distaste for the sector. Worryingly for the tobacco companies, the MSA has not drawn a line under legal uncertainties and possible liabilities.
The federal government case is a more difficult one to make and not as clear cut as the action brought by the states and territories. Apart from anything else, until the mid 1970s the federal government purchased cigarettes and distributed them free to military personnel. Although all subsidies were eventually eradicated, sales of large volumes of cigarettes are still made on military bases with the blessing of the military. In addition, the federal government has required health warnings on cigarette packs for some years, which could be considered a mitigating factor.
All market players have their antennae tuned to the Engle class action in Florida. Engle is a class action brought on behalf of Florida smokers against the tobacco manufacturers. On 14 July 2000, the jury decided on punitive damages of a startling $146 billion.
Surprisingly, this massive Figure barely sent a murmur through the bond and equity markets. Martin Feldman, tobacco analyst with Salomon Smith Barney, says: “The market understands that the case is unlikely to survive on appeal. There is potential for the case to be moved from the state court to the federal court. In the federal court the tobacco manufacturers have won outright 100% of cases. The Finding in the Castano case, which dealt with a nationwide class, was that, ‘the individual issues overwhelm the common issues’ and therefore,” this, Feldman argues, implies that “you cannot have a tobacco class action”. The Castano ruling has been followed on numerous occasions in the federal court. There is a likelihood of the class being decertified and the amount of damages reduced.
In a defensive move for the tobacco industry, on 5 May 2000, the Florida legislature passed legislation capping the appeal bond at $100 million. This prevented the immediate possibility of bankruptcy for the tobacco manufacturers, which clearly would not have been able to pay out collectively in one hit the $146 billion Figure set by an angry and hostile jury. It also protected the economic viability of the MSA.
This was an unusual move by the Florida legislature and an acknowledgement that the Florida court was behaving in ways that defied precedent.
In the event that the tobacco manufacturers lose on appeal, the Final phase of the trial requires that each member of the class action has an individual trial. The exact number of has been estimated at between 50,000 and 500,000. According to Feldman, dealing with so many cases “could take 100 years to process, in which case the manufacturers could marginally increase the price of a carton of cigarettes and cover the cost of the award”.
The tobacco manufacturers also face legal action from individuals. Should they lose, the scale of these cases is considered immaterial to their Financial standing.
Uncertainty over future litigation, coupled with declining consumption of cigarettes – there are ever fewer public places where people are allowed to smoke legally in the US -raises a concern for investors that one of the big tobacco companies might be bankrupted or revenue Flows might be interrupted.
It is an irony of the recent settlement that the former opponents of the tobacco manufacturers now have a big stake in their continued good economic health. Under the MSA, the size of the annual payment to the states and territories is pegged to the volume of cigarettes shipped. Nicole Delz Lynch, director of corporate ratings at S&P says: “Prior to 1999 the volume of cigarettes shipped was declining 1% to 2% a year on average, when you look at the previous five years.”
In 1998, prices increased by 64 cents a pack over the year. In 1999, prices increased a further 18 cents a pack. Delz Lynch says: “Last year, because of the price action in 1998 and 1999, pricing had an impact on volume, shipments declined by 9% for the full year of 1999. For 2000 they have increased 3% so far, but we expect that volume to decline. We are waiting for third-quarter Figures.” The 1999 Figures were also affected by a heavy increase in shipping just before the price increases.
The deals have been structured assuming that cigarette shipments will decline. The table shows the stress levels (reduction in cigarette shipments) assumed by S&P as bearable for issues of varying rating categories. Capacity to bear steepest declines in sales is applied to the AAA rated deals.
The investors
A risk for the investor is the significant decline in cigarette sales above and beyond the already assumed rate of decline. Brad Gewehr, managing director, municipal research, at PaineWebber, says: “The issuers have dealt with this problem by creating a structure with protections against such an event, for example the maturity schedule is extended.” This protects the bond holders because they are entitled to payments for a much longer period.
The maturity of the City of New York bonds has been extended to 40 years with the Flexibility to shorten. Most of the issuers have built some kind of Flexibility into the amortization and planned maturity schedule. Issuers have also promised a trapping event if certain things happen – for example if the tobacco companies are downgraded below investment grade or there is a significant decrease in the volume of cigarette sales the payments will be caught and trapped in a reserve.
Gewehr says: “For certain kinds of investors tobacco bonds are attractive investments. The bonds are a kind of hybrid, they have credit features like asset bonds yet they are tax exempt like a municipal bond and consequently they are a different animal from a credit standpoint. There are some uncertainties. No-one really knows what is going to happen. Some investors think they are being paid for that. The bonds have strong coverage and security features and the yields are pretty high.”
Yet selling these tobacco settlement bond deals to investors requires overcoming objections based partly on questions of political correctness. “There are investors who view this as an untouchable, tainted in a way, for whatever reason,” says Gewehr. “Investing in this kind of bond implies a kind of bet on the continuation of smoking. It is not supporting smoking but benefiting from the continuation of smoking. For some investors this is an issue.”
However, of more immediate concern to most investors is getting the best deal. With so many municipalities heading down the securitization route, later deals may prove to be cheaper for investors. The buyers to date are classic relative value credit-intensive investors such as pension funds. The same few buyers have purchased all of the initial deals and at some point they must reach capacity. Some investors take the view that when they do reach that point, the later deals will provide a better buying opportunity and that’s the time to participate.
The initial deals have all cleared the primary market successfully. However. there has been a lack of secondary market trading in the bonds that is a concern both for investors and the deals yet to come to market. Gewehr comments: “Invariably there will be negative press, with investors constantly reading about the tobacco companies being sued, which will chill the secondary market.”
The one exception has been New York City, which has seen a few trades over the year since it was launched. The other two issues launched in late 1999, Westchester County and Nassau County, have had almost no secondary market activity in their bonds.
New York City paved the way and was the First to develop the structure. Perhaps the reason why the New York City bonds have proved more attractive in the secondary market is the size of the deal. The city plans to launch four issues for a total of $2.8 billion. In the First round it issued $700 million. This is the biggest deal to date and a larger deal is more attractive to investors, provided broader participation and greater liquidity.
Securitizing lawyers’ fee awards
Realising the determination of their adversary, the state attorneys general turned to the private sector to represent them in the tobacco litigation and the law Firms agreed to advance the heavy expenses of the case. Rather than being paid directly by the states, the lawyers representing them will have their fees paid by the tobacco companies. The fees amount to around $10 billion, an amount that is in addition to the $206 billion to be paid to the states and territories, and is to be paid at a rate of $500 million a year.
Twenty of the law Firms have embarked on a joint securitization of their fee awards. Their programme adviser, Ron Borod, senior partner, of Brown, Rudnick, Freed and&Gesmer, says securitization oVers the law Firms not only a way to “diversify the law Firms’ exposure to the tobacco credit, but also for estate planning reasons it is better to have the fees in a more liquid form. If someone were to die then the estate would need to fund the tax liability and it is better to do that now, in our own time schedule.”
Morgan Stanley was appointed by the lawyers’ group in June 1999 as lead manager on what was hailed as being a groundbreaking deal. The transaction was to be launched into the market during the fourth quarter of 1999 but in July 2000, with the deal still not complete, Deutsche Bank was awarded the mandate.
Borod says Morgan Stanley and the lawyers “parted by mutual agreement due to a difference of opinion on how to manage the lawyers’ group”. Industry gossip has it that Morgan Stanley was uncomfortable with the unusual nature of the collateral and that it would only do the deal if the fees were owed to a single issuer. But the collateral is owned by 20 different parties, and one theory is that the lawyers were not keen to cross-collateralize so that the collateral could be treated as one pool from an investor’s perspective.
Michael Raynes, managing director at Deutsche Bank, says: “Working with approximately 20 law Firms makes the deal more complex. However, the asset is unchanged and it is immaterial whether we are dealing with 200 issuers or one. It does make it more challenging to communicate, given the number of parties involved.”
Borod admits that management of the lawyers’ group is no easy task. One banker has described it as being like trying to herd cats. Borod responds: “All you can do is to put the milk out and hopefully we will get to the point where we will have a deal. The key is to keep people informed.”
Unlike the states’ tobacco bonds, which are tax exempt, the law Firms’ bonds will not be. The fee to be paid to the law Firms is a set amount to be paid per annum, unlike the states’ securitization deals which are dependent on the volume of cigarette shipments. For this reason the lawyers’ fee securitization may be considered by investors to be more attractive than the states’ securitization of tobacco company revenues.
Whereas the states’ securitization deals are future Flow deals, the law Firms are securitizing known receivables due from tobacco companies. The major driving factor of the law Firm fee securitization will be the underlying credit quality both now and in the future of the tobacco companies. A change of government might affect the legislative climate in which the tobacco companies operate, which could affect their credit position.
The tobacco settlement securitizations have created a new asset class. What’s clear is that investors still need to form their own view as to the credit outlook for the tobacco industry. Gewehr says: “For a lot of people cigarettes are a necessity and not a choice, and for as long as that is the case then perhaps that’s the ultimate insurance.”
