By Nicholas Weill, vice president and senior credit officer, Moody's Investors Service
For investors in tobacco settlement-backed ABS, the Non-Participating Manufacturer (NPM) Adjustment clause contained in the Master Settlement Agreement (MSA) creates some unexpected uncertainty about payments to be made by the Participating Manufacturers pursuant to the MSA.
Key to ascertaining payment flows is each state's diligent willingness to adopt and enforce a model statute it has enacted. A state's unwillingness to diligently enforce its model statute can lead to a lower allocation of settlement revenues and, in some instances, to reduced cash flows available to ABS bondholders
About $7 billion of asset-backed bonds collateralized by tobacco litigation settlements have been issued since November 1999. The settlement payments are made by the Participating Manufacturers (PMs)# pursuant to the MSA signed in 1998 that settled litigation between 46 states and territories and the country's four largest tobacco companies.
These payments are primarily subject to adjustments linked to tobacco shipments in the U.S. and to inflation. The purpose of this special comment is to analyze the credit impact of another adjustment - the NPM Adjustment - that has added some uncertainty to cash flows in recent payments.
Mechanics of the NPM adjustment
The NPM Adjustment links the payments owed by PMs to their aggregate market share in the U.S. domestic market and protects them from an erosion in market share attributable to the MSA. The NPM Adjustment reduces the amount due by the PMs to the states. This mechanism reduces the likelihood of putting the PMs at an economic disadvantage based on their participation in the MSA.
To protect the states against the negative impact of an NPM Adjustment, the MSA allows for a unique mechanism: the enactment and diligent enforcement of a model statute. The model statute requires NPMs to make escrow payments to the states roughly equal to the payments that would have been required under the MSA. These funds are held by the state for 25 years and are available during this period to make payments to potential plaintiffs in connection with future suits against such NPMs.
As an incentive for the state to pass a model statute, a settling state that adopts and diligently enforces a model statute is not subject to a reduction in the payments due to an NPM Adjustment. Each state that has securitized its tobacco settlement revenues has passed a model statute. However, what constitutes diligent enforcement of its model statute by each state remains unclear.
Four steps are required for an NPM Adjustment to be implemented.
1. Calculating a Market Share Loss
The MSA uses end 1997 data as the reference point for calculating any change in aggregate market share in the cigarette market of the PMs. An aggregate market share is computed for the PMs and compared to the 1997 aggregate market share. Each individual PM's market share is measured by excise taxes collected. Based on this calculation, the MSA's independent auditors determine whether there has been any aggregate market share loss for the PMs.
The calculation of individual market shares has proven more challenging than expected. Indeed, in Moody's understanding, the numbers presented by the Bureau of Alcohol, Tobacco and Firearms (BATF), which has responsibility for collecting these taxes, have been revised several times and have been challenged by certain PMs.
2. Determining the Cause
A determination must then be made to assess whether any aggregate market share loss by the PMs is the result of a disadvantage caused by the MSA. This determination has to occur on or before February 2 of each year in which there is a market share loss and must be made by a "nationally recognized firm of independent consultants" (Section IX (d) (1) (C) of the MSA). The MSA states that the PMs and a majority of the attorneys general of each state that is a party to the MSA should choose this firm as soon as practically possible after the execution of the MSA.
It is Moody's understanding that no such firm has been selected and that the criteria for assessing the cause of a market share loss have not yet been established. But even in the absence of an independent firm, some recipients, including Puerto Rico and the U.S. Virgin Islands (which did not have model statutes in place in the last six months of the calendar year preceding their securitizations), have seen their payments reduced as a result of an NPM Adjustment. Moody's is concerned that the assessment of an NPM adjustment was made in the absence of an independent firm and was the result of a non-consensual interpretation of the MSA.
3. Calculating the NPM Adjustment #
Once an aggregate market share loss is established and attributed to the effects of the MSA, an aggregate NPM adjustment is calculated in accordance with the following formulas:
If the aggregate market share decreases by 16.66% or less, the adjustment factor is equal to three times the percentage decrease.
If the aggregate market share decreases by 16.66% or more, the adjustment is calculated as follows: Adjustment = 50% + [50%/ (base aggregate participating manufacturer market share-16.66%)][market share loss - 16.66%].
An additional layer of protection is given to a state that has enacted a model statute. If a court of competent jurisdiction declares its model statute invalid or unenforceable, the NPM adjustment will not exceed 65% of the allocated payment to the state.
This amount will be allocated among the individual PMs that actually contributed to the aggregate market share loss and will reduce payments to the states.
4. Implementing the NPM adjustment among the states
The aggregate NPM adjustment is solely born by those states that (i) did not have a model statute in place in the last six months during the period in which an NPM Adjustment is assessed, or (ii) did not diligently enforce their model statutes. This mechanism increases the potential severity of loss in revenues for states that do not enact or diligently enforce a model statute.
For example, certain entities such as the U.S. Virgin Islands that did not have a model statute in place for the last six months of 2000 have set aside a special reserve account, dedicated to covering the risk associated with an NPM Adjustment. As they were among the very few entities without a model statute, these entities could see the full amount of their 2001 annual payments clawed back for an NPM adjustment during the four years following the year in which a market share loss occurred. The special reserves have therefore been sized to equal the full 2001 annual payment.
Importance of diligent enforcement
The MSA does not define what "diligent enforcement" of the model statute entails, thus creating interpretational uncertainty. Until the states and the tobacco manufacturers agree to some precise guidelines regarding the interpretation of "diligent enforcement," some uncertainty remains regarding the payments from the tobacco manufacturers.
Because an NPM Adjustment is only allocated among the states that do not enforce diligently, such states could potentially incur the majority of the adjustment and lose most of their annual payment. The severity of the impact of the NPM Adjustment to states that are not "diligently enforcing" the MSA is a concern to Moody's.
Certain states have securitized only a portion of their tobacco revenues - Puerto Rico, Louisiana, and Arkansas, for example - and therefore will continue receiving a significant portion of tobacco settlement revenues. Similarly, in securitizations sponsored by the counties of California and New York, the states, which are in charge of enforcement on behalf of the counties, continue receiving a significant percentage of the tobacco revenues. This ongoing cash flow presents a strong economic incentive for the state to enforce its model statute.
When securitizing their tobacco revenues, certain other states have included strong positive covenants to enforce the model statutes for the benefit of ABS investors. Even if the covenants fall short of an immediate guarantee of a shortfall to ABS investors due to the non-diligent enforcement of the model statute, Moody's expects that these covenants are likely to be upheld. A breach of a covenant by a highly rated state would, in affect, have adverse consequences for the state's reputation in the capital markets.
Finally, certain transactions have sized the operating expenses that are senior to investors in the cash waterfall to finance a portion of the costs of model statute enforcement or to reimburse the state for the resources allocated for that effort.
To monitor the ratings on these transactions and their exposure to enforcement risk, Moody's has approached the states sponsoring issuance of tobacco settlement-backed bonds to gather information about the level of model statute enforcement in their jurisdictions. Moreover, Moody's has specifically inquired about the level of NPM activity in the state, the level of collections in escrow, the personnel dedicated to enforcement, and the number of lawsuits against recalcitrant NPMs.
Moody's will continue to monitor these transactions with the information that is available through issuers and it will convey to investors its timely opinion on this credit issue.
The Participating Manufacturers that were the first signatories to the MSA are Brown & Williamson Tobacco Corporation, Lorillard Tobacco Company, Philip Morris Incorporated, and R.J. Reynolds Tobacco Company. Since November 1998, about 20 subsequent participating manufactures have joined the MSA.
See Moody's Rating Methodology: Moody's Approach to Rating Tobacco Settlement Revenues Securitization, N. Weill, May 2001