Monday, May 16, 2005

Newly Invoked Loophole in MSA Threatens to Cement Bond Between States and Major Tobacco Companies

According to an article in the current issue of Business Week, Philip Morris has invoked yet another loophole in the Master Settlement Agreement (MSA) in an attempt to substantially lower its payments to the states, threatening not only current state budgets but also state reserves that may need to be tapped to fulfill bond obligations in states that have securitized MSA payments (see: Foust D, Byrnes N. The high cost of nicotine withdrawal: cigarette makers want settlement rebates from states. That could hurt taxpayers. Business Week, May 23, 2005, p.40).

According to the article, if all major participating manufacturers invoke the loophole, states may have to pay back as much as $1 billion to the tobacco companies immediately, with further rebates or payment reductions in years to come. The article predicts that such an outcome would result in severe consequences for states that have issued bonds backed by future MSA payments; 12 states, plus Puerto Rico and the District of Columbia have issued $19 billion in such bonds. If future MSA payments drop, these states may need to tap into reserve funds in order to avoid defaulting on these bonds. Thus, the loophole creates an enormous economic incentive for the states not to do anything that will decrease tobacco company revenues.

The attorneys general are apparently planning to contest the request for these MSA rebates, claiming, according to the article, that tobacco companies must "prove the states were negligent in policing the settlement."

The Rest of the Story

The loophole in question is the Non-Participating Manufacturer (NPM) Adjustment, a complex provision described in section IX(d)(1) of the Agreement. Basically, the provision states that if the market share of the participating manufacturers in any given year falls to more than 2 percentage points below the baseline aggregate market share for 1997, then MSA payments for the following year are reduced by a percentage equal to the amount of the market share loss exceeding 2 percentage points (that is, the market share loss minus 2 percentage points) times a factor of 3.

However, there are two exceptions to this adjustment. First, it does not hold if total domestic cigarette consumption is greater than it was from the participating manufacturers in 1997. Since cigarette consumption is falling, this is unlikely to occur and so will not nullify the NPM adjustment. Second, the adjustment only holds if the market share loss in any given year is at least partially a result of disadvantages to the participating manufacturers due to their participation in the MSA. Such a determination is to be made by "a nationally recognized firm of economic consultants."

As an example to demonstrate the provision, assume that the market share for participating manufacturers was 99.6% in 1997 and dropped to 91.9% in 2004 (these are the data cited in the Business Week article). The market share loss that exceeds 2% is 99.6-91.9-2.0, or 5.7%. The adjustment factor is then 5.7% times 3, or 17.1%. This means that total industry payments to the states will be reduced by 17.1% in 2005, assuming that domestic cigarette consumption is not higher than it was in 1997 and that the nationally recognized firm of economic consultants determines that participation in the MSA was a significant factor in the loss of market share by the participating manufacturers for 2004. Based on the $6.2 billion paid to the states in 2004, this would represent a loss of about $1.1 billion in state revenue.

Although the attorneys general are apparently going to fight the cigarette companies' request for this rebate, I don't see that they have much of an argument. Although complex, the non-participating manufacturer adjustment is quite clear. The only defense that the attorneys general appear to have is if they can correctly claim that the MSA was not a significant factor in the loss of market share for the participating manufacturers. However, given the magnitude of the payments being required under the MSA, it is difficult to imagine that a panel of economic consultants would not find that participation in the MSA was indeed a significant factor why non-participating manufacturers were able to make market share gains.

The argument, mentioned in the article and attributed to the attorneys general, that companies need to prove that the states were negligent in policing the settlement in order to make the NPM adjustment does not seem to be valid. It appears to me that the only issue up for consideration is whether or not being a party to the MSA was a significant factor in the loss of market share. My sense is that if this goes to an economic panel or to the courts, the tobacco companies will be successful in their attempt to collect the NPM rebates that are due to them.

All of this supports my earlier contention that the MSA represents the greatest public health blunder of my lifetime. Now, more than ever, the financial well-being of the states is inextricably tied to the economic health of the major tobacco companies, creating an overwhelmingly compelling incentive for the states not to enact any policies or take any actions that may endanger the sales and/or profits of the major tobacco companies. The states are now economic partners with the tobacco companies and as such, deserve a share of the blame for the most important epidemic of the 21st century.

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