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Tobacco Firms Free $540M

Tobacco companies contending billions of dollars in legal settlement payments released $540 million to states last week to advance resolution of the dispute.

A group of tobacco companies is disputing $4.34 billion in settlement payments to states between 2003 and 2007. State attorneys general want the courts to determine the fate of the money, while the tobacco companies would prefer an arbitration panel.

At the end of January, the companies and the attorneys general reached a deal. The states agreed to submit to arbitration over $1.15 billion in disputed payments from 2003.

In exchange, Lorillard Tobacco Co., R.J. Reynolds Tobacco Co., and a handful of smaller tobacco companies agreed to release to the states $540 million that was stashed in a special account to dispute their share of payments for 2005.

Kym Arnone, a managing director at Barclays Capital who has managed more than half of all tobacco bond underwritings, announced the agreement at a Municipal Analysts Group of New York conference last week.

The $1.15 billion from 2003 to be disputed under arbitration includes $724 million from a disputed-payments account, plus money Philip Morris USA and other companies paid but still dispute.

The $540 million released last week is still under dispute, just no longer in escrow. The money was disbursed to the states on Thursday.

The arbitration only applies to disputed money from 2003. The money from each year presents a separate battle.

The wrangling stems from a 1998 agreement between tobacco companies and 46 states known as the Master Settlement Agreement, the biggest civil settlement in U.S. history.

Under the agreement, the big four tobacco companies agreed to make billions of dollars in annual payments in exchange for immunity against legal liability from the states. Subsequently, 44 more tobacco manufacturers signed onto the agreement.

Many states have securitized their share of payments from the MSA, meaning they sold to bondholders the right to cash flow generated by the settlement.

Investors hold about $37 billion of bonds secured by settlement payments from tobacco companies.

Each state receives a fixed portion of the annual settlement payments. Each company's annual contribution is based on its share of the cigarette market.

The tobacco companies participating in the MSA are entitled to dispute their share of the annual payments. The companies' payments can be reduced if they demonstrate they lost market share because of the MSA and prove the states did not "diligently" enforce a statute forcing them to collect money from tobacco companies not participating in the agreement.

In March 2006, the Brattle Group, an economic consulting firm, concluded the companies' share of the cigarette market was slipping because of the MSA.

On this basis, the companies placed $724 million in escrow disputing payments from 2003, $721 million from 2004, and $529 million from 2005.

Philip Morris is also disputing payments from those years, though the company did not escrow money.

A 16-member team representing the attorneys general has been negotiating with a group of lawyers representing the tobacco companies.

Arnone said the tobacco companies would rather go to arbitration so they can present one case in a single venue. The states would rather force the companies to present a slew of arguments in a slew of courts, she said.

"It's logistically more cumbersome and in theory more costly as a result," Arnone said.

Now that the two sides have agreed to head to arbitration over the 2003 payments, each side must pick a neutral arbiter by the fall. Those two arbiters will then pick a third arbiter to complete a three-member panel.

Dick Larkin, director of credit analysis at Herbert J. Sims & Co., called the $540 million cash influx a "temporary reprieve" for states and bondholders.

Should the tobacco companies prevail in the dispute, the money released to states now would be repaid to the companies through reduced settlement payments in the future.

For now, bondholders will receive a jolt of cash for the upcoming securitized payments and states will receive some money just as they are grappling with budget deficits and a recession.

Oregon Attorney General John Kroger last week released a statement saying his state received $6.2 million under the January settlement.

Washington Attorney General Rob McKenna, who co-chairs the National Association of Attorneys General Tobacco Committee, said his state received $11 million.

The money, which he called a "multimillion-dollar booster shot in the arm," will be used to help close a budget gap and bolster anti-tobacco programs for kids, he said.

Delaware received $2.1 million and Idaho received $1.9 million.

Larkin said any signal of progress in this dispute could be welcome news for bondholders, who suffer from almost no disclosure in this sector.

"It's a big uncertainty. ... Disclosure in this is not only subpar; it's actually secretive," he said. "Maybe this is an indication that the dispute is starting to come to a head."

Larkin believes the tobacco companies have a good chance of success at arbitration enabling them to keep at least some of the disputed funds.

He suspects they would not be spending money or wasting time on this unless they thought they could prove the states did not enforce the statutes as required.

"The tobacco companies have a phenomenal track record at winning legal disputes," he said. "I think the tobacco companies are going to somehow win on this."

A spokesman at R.J. Reynolds said the company contributed about $431 million of the disputed payments account for 2005.

Tobacco bonds have been hammered in the credit crisis. Cigarette consumption in the U.S. is declining more than 3.7% a year, according to the Tobacco Tax Bureau. Further declines threaten payments under the MSA. A new 62-cent tax under an expansion of the State Children's Health Insurance Program will raise the average cost of a pack of cigarettes by 15%, Larkin estimates.

It is not uncommon for long-term tobacco bonds to trade at less than 60 cents on the dollar, according to Thomson Reuters.

Yesterday a Buckeye Ohio Tobacco Settlement Financing Authority bond maturing in 2047 traded at a yield of 10.56%.

A Golden State Tobacco Securitization Corp. bond maturing the same year traded at a yield of 9.64%.

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