At first glance, the settlement would appear to be an unqualified boon to the states—filling their coffers with money for disease research, treatment and prevention. Actually obtaining the settlements funds, however, has proven to be a little tricky. The states are to receive the settlement funds in equal payments over the course of 25 years.

The equal payment schedule under the settlement, however, has a couple wrinkles. First, the MSA contains a provision that allows certain “volume adjustments” to be made to the base payment amount in accordance with domestic tobacco consumption. These adjustments are to be calculated using a formula contained in Exhibit E to the MSA. To state it simply: As domestic consumption decreases, the required payout decreases. There are many reasons to think that domestic consumption will fall in the coming years—not the least of which is the fact that the MSA itself contains severe marketing restrictions with respect to tobacco products.

Second, the stability of the cash payouts under the MSA may be undermined by the tobacco companies’ ability to pay. The MSA does not preclude litigation by foreign governments and private individuals or our own federal government. Future lawsuits and shrinking markets for their products could send some of the companies into bankruptcy.

For this and other reasons, some states have been looking for ways to better guarantee that they get all the cash they can as soon as possible. One method gaining favor is to “securitize” the settlement payments. Generally, this securitization entails the states issuing bonds backed by the future settlement proceeds in exchange for an immediate lump-sum payment of a portion of the settlement.

How should these bonds be valued? Specifically, what factors would you consider when determining an appropriate discount rate? The investment banks underwriting the bond issuance will determine an interest (discount) rate according to their calculations of the likelihood that the debt will be repaid.State watchdog groups and others fear that the underwriters will use what is termed a “weakest link” approach: that is, basing the discount rate on the most troublesome or risky debtor.Some tobacco companies that face more severe litigation pressures or have not diversified their product line away from tobacco products (e.g., R.J. Reynolds) have poorer credit ratings than others that are not fighting as many serious court battles and/or are not primarily dependent on tobacco revenue (e.g., Philip-Morris).If the underwriters follow the weakest link approach, the states that opt to securitize their settlement payment could lose millions of dollars.

See Kelly Nicholson, “Securitization: An Option for State Tobacco Settlement Funds,” published by Nat’l Governors’ Association Center for Best Practices (Sept 8, 1999); Walter H.C. McKay, Comment, “Reaping the Tobacco Settlement Windfall: The Viability of Future Settlement Payment Securitization as an Option for State Legislatures,” 52 Ala. L. Rev. 705 (2001).

Securitization of settlement proceeds is not limited to state governments. The plaintiffs’ lawyers who fought big tobacco are eager to obtain their fees (also billions of dollars) sooner rather than later. See Daniel Wise, "Bond Issue Planned for Tobacco Fees,” New York Law Journal (April 22, 1999). Marke Raines & Gabrielle Wong, Aspects of Securitization of Future Cash Flows under English and New York Law, 12 Duke J COmp & Intl L 453-464 (2002); David M. Eisenber, Securitazation of fudure cash flows under English and New York law: A Comment on Raines & Wong, 12 Duke J Comp & INtl Law 465-67 (2002).