Wherever you turn, there is smoke in the tobacco bond sector.
Cigarette consumption has plummeted beyond projections, a trend that e-cigarettes may accelerate. This has depressed the annual payments made under the Master Settlement Agreement (MSA) that was signed by most states and the major tobacco companies — cash flows that are securitized in tobacco bonds.
A halt of turbo redemptions of some bonds; downgrades of longer-term paper and a raid of reserve funds by some issuers to pay current interest. What is more, there are ongoing arbitrations and litigation over whether a portion of past MSA payments should be refunded to participating tobacco companies by states that allegedly failed to diligently enforce qualifying statutes that require compensatory payments from non-participating companies. This casts further uncertainty on future cash flows available for tobacco bonds.
Many expect debt service defaults on some tobacco bonds to occur within the next five years.
Although such defaults have not yet occurred, it is not too early for holders to take a hard look at the applicable bond documents to evaluate both their rights and leverage in the restructurings or refinancings of bonds, which have already taken place and may proliferate in the years ahead.
These adverse developments may hit investors in longer-term maturities the hardest. This includes capital appreciation bonds (CABs) — which are not scheduled to pay interest or principal until maturity — and holders of subordinated maturities. By and large, tobacco settlement securitizations transferred the risk of such cash flow declines to bondholders. Issuers are ostensibly under no legal obligation to provide additional sources of repayment.
All the same, it is possible that certain issuers may deem it in their best interest to take steps to avoid default and mitigate bondholder losses. But such rescues, usually from external funding sources, are likely to be the exception, not the rule. In this low interest rate environment, it is more likely that issuers, underwriters and the senior bondholders will continue to try to refinance or restructure bonds using the reduced cash flow that is now projected from the MSA in order to postpone a default on the lower priority bonds.
Bondholders may find a review of their tobacco bond documents timely as well as productive as there are significant differences among documents. Take, for example, the Buckeye Tobacco Settlement Financing Authority’s Tobacco Settlement Asset-Backed Bonds, Series 2007. Backed by settlement payments to Ohio, the state has repeatedly dipped into a reserve fund to make minimum payments to bondholders. In 2011, the state covered a $7 million shortfall, and in 2013, a $14 million one.
The structures and indenture terms for the billions of dollars in outstanding tobacco bonds, of course, differ from state to state and issuer to issuer. They may even vary among different bond series from the same issuer. We highlight areas below as examples of what to focus on with potential restructurings of troubled deals, but the particulars of any individual indenture must be reviewed and analyzed to determine constraints on specific securities.
Covenants and Events of Default
Although the Buckeye indenture contains covenants restricting certain additional debt, asset dispositions, transfers and other transactions that may impair bondholder collateral, it has no covenants for debt service coverage or other financial maintenance. Non-payment of scheduled debt service may be the only default but, by then, the prospects for a successful restructuring may be greatly diminished.
The events-of-default section in the Buckeye indenture is nuanced — it only triggers an event of default upon the failure to make certain payments (as distinct from any payment). Bondholders need to be conversant with such nuances to determine whether a failure to pay subordinate bonds or interest-rate swaps, sinking fund installments, projected turbo redemptions or similar obligations constitute a default. These nuances also help predict the likelihood of these events.
The remedies section of the Buckeye indenture has very specific rules which limit or condition available remedies, including acceleration, enforcement of bond terms, and enforcement of certain covenants made by the State of Ohio under the agreement by which the MSA payments were transferred to the issuer. The existence and nature of available remedies — or lack thereof — will have a strong bearing on the rights and leverage of bondholders in any restructuring or refinancing.
Flow of Funds
The indenture contains a complicated and detailed flow of funds regime, both before and after a payment default, which determines the priority of payments on bond tranches, the funding of various accounts, and how regularly scheduled MSA payments and funds held in debt service, liquidity and other reserve accounts are applied.
In the Buckeye Indenture, the flow of funds section specifies that cash flow available for the payment or prepayment of senior bonds following a payment default will be applied to senior bonds on a pro rata basis, rather than in chronological order of maturities and sinking fund installment dates. Because current interest is payable prior to principal or accreted value, zero coupon senior bonds are effectively subordinated to current interest senior bonds.
Amendments and Restructurings
As bondholders are unlikely to have recourse to any source of payments other than MSA, on the face of it issuers have scant incentive to restructure tobacco bonds to either postpone or cure a default. But there are potentially at least two incentives: reputation — some may not want their names associated with defaulted obligations — and self-interest — restructuring or refinancing to a lower interest rate increases the likelihood that the state may be able to eventually receive additional MSA payments.
Bondholders likewise may have limited incentives to prompt restructurings that merely reduce or stretch out interest or principal payments. But those faced with a potential loss, particularly if they hold both senior and subordinate tranches, may welcome refinancings or reprioritizations of cash flows that ultimately increase aggregate repayments.
The Buckeye indenture contains some provisions that present challenges for restructurings. For example, the indenture features restrictions on open-market purchases using funds in pledged accounts, which may create obstacles to deleveraging through tender offers. In addition, the indenture includes an issuer covenant not to file for bankruptcy. While an issuer could challenge whether such a covenant is enforceable, it may have reservations about litigating the issue.
Outside of bankruptcy, any restructuring must comply with the indenture’s restrictions on amendments. The Buckeye indenture precludes certain amendments, but permits others with the consent of the holders of a majority in interest of the senior tranches, while those tranches remain outstanding, and thereafter a majority in interest of the most senior class of subordinated tranches outstanding.
History suggests that as bonds approach distress, one or more opportunistic bondholders often accumulate a majority position thought to be sufficient to authorize indenture amendments and/or refinancings that reduce aggregate debt service payable from the pledged revenues and/or produce a timing or priority benefit in their repayment relative to the status quo. Such a restructuring or refinancing may not, by itself, generate any tangible financial benefit to the issuer, so part of the challenge may be the inclusion of features that deliver enough benefits to the issuer so it will participate. But if lower priority bondholders view the situation as a zero sum game, they will deem any improvement in the issuer’s position as occurring at their expense. As a result, any amendments or refinancings involving payments to the issuer may be contested by minority or subordinated bondholders. In short, those wishing to consummate or assess a potential restructuring will need a thorough knowledge and understanding of how the indenture operates, so as to avoid violating the indenture’s terms while incentivizing the necessary parties.
Len Weiser-Varon and Paul Ricotta are members of the Mintz Levin law firm in Boston.