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Posted on 02/16/2004 8:04:47 AM PST by CSM

LOS ANGELES - A steady stream of tobacco-settlement money into state coffers seemed like a sure thing after the $200 billion settlement between Big Tobacco and the states' Attorneys General in 1998. But that well may run dry sooner than anyone anticipated.

Both states and the holders of the "tobacco bonds" that they have issued have long been concerned that lawsuits by smokers could bankrupt the big tobacco companies that owe them money. Now they have another set of worries. Sales are plummeting at the four major tobacco companies: Altria (nyse: MO - news - people ); R.J. Reynolds (nyse: RJR - news - people ); Brown & Williamson and Carolina Group (nyse: CG - news - people ), which is the tracking stock of the Lorillard tobacco operation of Loews. This in turn is rapidly shrinking the settlement fees that states collect, since payments correspond to tobacco sales. Also looming is an anti-trust suit that could destroy the tobacco settlement that made the bonds possible.

Owners of tobacco bonds receive cash that tobacco companies originally owed state governments under the terms of the famous 1998 settlement. The states had vowed to use the money to cover tobacco-related health care costs and anti-smoking efforts.

But as sales by the four major tobacco companies drop--and sales by importers who don't pay into the settlement rise--the amount of money tobacco companies owe is dropping rapidly. According to a confidential memo from the National Association of Attorneys General, these "volume adjustments" are shrinking so fast that if the rate as of September 2003 (when the memo was written) were annualized, it would result in a 29% drop in state tobacco revenues this year alone. Most tobacco bonds still have plenty of cushion. But if settlement revenues continue to drop at anything like the current pace, tobacco bondholders eventually will take a haircut.

It's not just bondholders at risk. A few states, notably New York and California, guaranteed the tobacco bond payments with money from their states' general fund. That boosted their one-time payout from the bonds, since it made the paper more creditworthy. But it came at a real (if little-noticed) risk: If something happens to the tobacco payments, the states, not the bondholders, will be on the hook.

Suddenly, that risk looks real. In January a three-judge panel of 2nd Circuit Court of Appeals in New York unanimously decided that the 1998 settlement should be opened to antitrust challenges, and strongly hinted it thinks the whole settlement is anticompetitive. (See: "Cozy Cancer Cartel.") The plaintiffs in the case, Freedom Holdings Vs. Spitzer, charged that the settlement created an illegal state-enforced cartel by effectively locking in the tobacco giants' market share at the date of the agreement. They plan to ask the court to freeze tobacco settlement payments to New York, which this year alone will total $737 million.

New York Attorney General Eliot Spitzer, the defendant in the case, remains confident that the recent decision will be struck down, the states' immunity from anti-trust litigation fully re-established, and the bond payments protected. David Dobbins, the lawyer who represented Freedom Holdings against Spitzer, is equally confident. He thinks the unanimous decision by the three-judge panel will be sustained--and New York left paying its special tobacco bonds out of general revenues.

Plummeting Payments State % Of Payments 2004 Payments Alabama 1.62% $93,412 Alaska 0.34% $19,734 Arizona 1.47% $85,180 Arkansas 0.83% $47,882 California 12.76% $737,766 Colorado 1.37% $79,235 Connecticut 1.86% $107,307 Delaware 0.40% $22,858 D.C. 0.61% $35,091 Georgia 2.45% $141,867 Hawaii 0.60% $34,787 Idaho 0.36% $20,998 Illinois 4.65% $269,015 Indiana 2.04% $117,900 Iowa 0.87% $50,286 Kansas 0.83% $48,186 Kentucky 1.76% $101,794 Louisiana 2.26% $130,353 Maine 0.77% $44,488 Maryland 2.26% $130,554 Massachusetts 4.04% $233,452 Michigan 4.35% $251,642 Missouri 2.27% $131,471 Montana 0.42% $24,551 Nebraska 0.59% $34,380 Nevada 0.61% $35,254 New Hampshire 0.67% $38,490 New Jersey 3.87% $223,512 New Mexico 0.60% $34,471 New York 12.76% $737,645 North Carolina 2.33% $134,806 North Dakota 0.37% $21,155 Ohio 5.04% $291,168 Oklahoma 1.04% $59,888 Oregon 1.15% $66,394 Pennsylvania 5.75% $332,188 Rhode Island 0.72% $41,552 South Carolina 1.18% $67,993 South Dakota 0.35% $20,160 Tennessee 2.44% $141,083 Utah 0.44% $25,714 Vermont 0.41% $23,768 Virginia 2.04% $118,186 Washington 2.05% $118,576 West Virginia 0.89% $51,273 Wisconsin 2.07% $119,783 Wyoming 0.25% $14,354 Puerto Rico and other 1.18% $68,391 TOTALS: 100.00% $5,779,993 Source: National Association of Attorneys General. *Does not include states that were not part of "Master Settlement Agreement."

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