Buy Side

Tobacco Arbitration Rulings Could Help Bonds

CHICAGO — Nine states prevailed in arbitration with tobacco companies in their dispute over the size of 2003 payments due under the 1998 master tobacco settlement, providing a boost for their outstanding tobacco bonds.

Colorado, Illinois, Iowa, Maine, New York, North Dakota, Ohio, Oregon, and Washington won arbitration.

The rulings will benefit tobacco bonds issued by those states including New York, Ohio, Illinois, and Iowa by freeing up disputed payments. For some bonds, the victory potentially could push out projected default dates, particularly for older bonds like those issued by Ohio. More recent issues from states like Illinois built in more significant financial cushions to protect against payment declines.

"HJ Sims will be reviewing states with tobacco bonds for the implications of the arbitration awards. For states that won, projections of bond defaults will be pushed back into later maturities of debt, if not perhaps completely eliminated," said Richard Larkin, director of credit analysis at Herbert J. Sims & Co. in a special commentary issued after the arbitration rulings were announced Wednesday.

The quarrel between the states and other jurisdictions centers on whether the governments have adequately enforced escrow payment rules under the settlement involving the so-called non-participating tobacco manufacturers. The participating companies have argued that the failure of governments to enforce the rules has led to market erosion and so their payments should be adjusted downward.

The non-participating manufacturers adjustment dispute is considered one of major risk factors for tobacco bonds, but consumption declines and legislation also pose challenges to the sector.

"These states, as well as all other tobacco bond issuers, remain at risk for higher than projected tobacco consumption declines which could result from cigarette tax increases and anti-smoking laws, both of which have proven to dramatically decrease smoking and reduce payments under the settlement," Larkin said.

Another six states lost the dispute over 2003 payments. They include Indiana, Kentucky, Maryland, Missouri, New Mexico, and Pennsylvania. None have outstanding tobacco bonds that could be negatively impacted of the rulings. Arbitration decisions are still pending for 11 states and other jurisdictions including tobacco settlement securitizations for bond issuers for Alaska, Rhode Island, South Dakota, Guam, and the Virgin Islands. Another 22 had previously settled the dispute.

Approximately $7.1 billion in disputed payments had been withheld from payments between 2003 through 2010 because of the challenge.

States that lose in the arbitration decisions will share in a reduction in next year's settlement payments of about $642 million.  That could cut deeply into payments that go to repay bonds should arbitrators rule against the Alaska, Rhode Island, South Dakota, Guam and the Virgin Islands.

The rulings handed down so far settle only the three-year-old dispute over the 2003 payments so the arguments between the states that participated in the settlement and the major tobacco companies is far from settled. Challenges to the size of payments between 2004 to 2013 still face arbitration.

"For states that won arbitration yesterday, the likelihood of winning future arbitrations is high, because starting in 2004 & 2005, states began to radically improve their collection and enforcement procedures of the 1998 tobacco settlement's terms," Larkin said.

Ohio's status is slightly more clouded because the arbitration decision was close, with the panel finding many areas of weak enforcement practices despite a finding of good-faith efforts to improve enforcement.

The MSA was entered into by 46 states and the four major tobacco companies. Governments have sold more than $40 billion of bonds that rely on tobacco settlement payments. The MSA was aimed at compensating governments for the cost of treating smoking-related illnesses.

The Ohio Attorney General's office said the ruling would allow the state to keep $35 million in payments under dispute.

The rulings free up $92 million for New York.

"This ruling is a huge victory for all New Yorkers, and I applaud the panel for denying Big Tobacco's efforts to avoid responsibility for illnesses caused by cigarettes-and paid for by taxpayers," said New York AG Eric T. Schneiderman.



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