The High Cost of Easing Off Tobacco


By Dean Foust When 46 states signed a landmark $206 billion settlement with major cigarette makers in 1998, analysts hailed it as a classic win-win situation. The tobacco giants bought immunity from lawsuits by states eager to recoup the costs of treating smoking-related diseases. And cash-strapped states tapped into a new source of revenue that enabled them not only to cover their medical costs but also to plug their chronic budget deficits.

But now Big Tobacco is charging that the states aren't holding up their end of the bargain. Angry at losing business to small cigarette makers that didn't sign the 25-year settlement, the three largest companies -- Philip Morris USA, Reynolds American (RAI), and Lorillard Tobacco -- say they're entitled under the agreement to get back some of the $6.2 billion they paid last year.

In late April, the companies made this demand in writing to all the states in the agreement. What's more, analysts expect the companies to cut future payments as well. That would make the fight an annual event. To avoid such a scenario, the states are finally pressuring the small fry to cough up payments, too.

BOND MARKET REACTION. State officials say the dispute could take two years or more to resolve. The ramifications are enormous for everyone from taxpayers to bondholders. A victory by the tobacco giants may force the states to pay back as much as $1 billion immediately and more each year after that, creating vexing fiscal headaches.

Any sharp drop in the payments would quickly be felt in the bond markets. That's because 12 states, plus Puerto Rico and the District of Columbia, have issued $19 billion in bonds that are backed by future payments from the cigarette makers.

Richard Larkin, a bond analyst at J.B. Hanauer & Co., a Parsippany (N.J.)-based investment firm, notes that if future payments shrink, then Rhode Island, New Jersey, and others may have to dig deep into special reserves to service their tobacco bonds. After a couple of years or so, once those reserves are exhausted, the next step might be a default unless politicians divert state revenues to pay off tobacco bondholders. "It would be political suicide," adds Larkin. "I just don't see it happening."

SHARE CROPPED. In trying to dun the states, the cigarette giants are invoking a little-noticed clause in the 1998 deal. It offers them a break on payments if they lose market share to other cigarette makers that aren't shouldering the burden of the pact, which tobacco companies say adds an average of 42.5? to each pack they sell.

Big Tobacco has lost nearly eight points of market share since 1997, with the combined share of the giants dipping from 99.6% to 91.9%. After allowing for a two-percentage-point loss in market share that the states and the tobacco giants accepted as inevitable, the net loss is six points.

Under the settlement, that number would be multiplied by three, resulting in a potential rebate of as much as 18% of recent payments.

Philip Morris confirmed that it sent a letter requesting the rebate, but it declined to comment further, while officials at Liggett and Reynolds did not respond to requests for comment. In the past, executives have argued that the settlement's cost contributed to their rapid loss of market share. "You've had a boatload of consumers say, 'I don't want to pay $1.70 for a pack of Camels or Marlboros, I'd rather pay $1.10 for a lower-end cigarette,'" Tommy J. Payne, an executive vice-president for Reynolds, said in an interview last fall.

PROVING NEGLIGENCE. For their part, state officials warn they aren't about to give back any money without a battle. "It's incumbent on us to fight," says Lawrence Wasden, Idaho's attorney general. He and other state officials note that, under the settlement, it isn't enough for tobacco companies simply to show a market-share loss. They also must prove the states were negligent in policing the settlement. To level the playing field, the states are required to collect similar payments from nonparticipating companies -- payments that were to be held in escrow for 25 years. The small cigarette makers could then apply for a rebate. The little guys, however, found loopholes that have allowed them to claim immediate rebates.

The prospect of lower tobacco payments is already sending chills through state capitols. In Montana, officials are figuring the Big Sky state will pocket $5 million less next year than the $26.7 million it received this year.

Some states are starting to do more to extract funds from the small tobacco companies. In the past couple of years, more than 40 states have moved to tighten the loopholes in the settlement. In South Carolina, lawmakers are considering a bill that would add nearly $4 to the price of a carton of generic cigarettes -- a move they believe would force the small players to bear the same financial load from the megasettlement as the big boys. But with the settlement suddenly in flux, the states are learning that tobacco may no longer be the cash crop it once was. With Nanette Byrnes in New York

Foust is the manager of BusinessWeek's Atlanta bureau


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