Case study

New Issue: TSASC Inc.  

by Professor Ian H. Giddy
New York University

US$709 million tobacco flexible amortization bonds series 1999-1



Ratings Detail
Profile
New Rating
Classes (single class), (single class), (single class), (single class)
 AA-
Classes (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class)
 A+
Classes (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class), (single class)
 A
Closing date: Nov. 18, 1999
Transaction Summary

Collateral: The city of New York’s right, title, and interest in certain revenues to be received under the master settlement agreement (MSA) of 46 states and participating cigarette manufacturers.
Underwriters: Salomon Smith Barney, Bear Stearns & Co. Inc., J.P. Morgan & Co., Goldman Sachs & Co., Morgan Stanley Dean Witter, and PaineWebber Inc.
Seller: The city of New York.
Indenture trustee: United States Trust Co. of New York.
Delaware trustee: Wilmington Trust Co.
 


Rationale

The ratings on TSASC Inc.’s tobacco flexible amortization bonds reflect a planned amortization schedule, which provides for the coverage and faster paydown of rated debt service even under a series of stress scenarios. The transaction also benefits from a liquidity reserve account funded at the maximum annual debt service level. Other key strengths include:  

However, the ratings are constrained by the limited predictability of domestic shipments of cigarettes over the long term, and the potential impact of present and future litigation facing the cigarette industry and the uncertainties related thereto.  


Transaction Overview

The series 1999-1 bonds are secured by New York City’s right, title, and interest in certain payments to be made pursuant to the MSA by the participating cigarette manufacturers. The MSA, executed on Nov. 23, 1998, is an agreement between 46 states, the District of Columbia, the U.S. Virgin Islands, the Northern Mariana Islands, American Samoa, and Guam (collectively, the settling states), and the four largest domestic tobacco companies: Philip Morris Inc., Brown and Williamson Tobacco Corp., Lorillard Tobacco Corp., and R.J. Reynolds Tobacco Corp. The MSA provides the settling states with approximately US$206 billion over the next 25 years, plus additional payments in perpetuity, in exchange for the release of all past, present, and future claims related to the use of tobacco products. The payment requirements of the MSA include initial, or upfront, payments that are payable from 1998 through 2003, and perpetual annual payments beginning in the year 2000. The initial and annual payments are subject to a number of adjustments and offsets. Payments under the MSA will not be released to the settling states until the earlier of the date on which 80% of the states with 80% of the allocable share of MSA payments achieve state-specific finality, or June 30, 2000. State-specific finality is achieved once the MSA and the related consent decree are entered and deemed final by the appropriate state court. New York state has obtained state-specific finality. New York City’s allocable share of total MSA initial and annual payments equals approximately 3.4%, which is approximately 26.67% of New York state’s share.

According to the transaction’s terms, the city of New York shall transfer its right, title, and interest to the tobacco settlement revenues to TSASC Inc. TSASC is a special-purpose, bankruptcy-remote local development corporation that has the authority to issue tax-exempt bonds. The purchase price paid for the tobacco settlement revenues by TSASC to the city consists of the net proceeds of the sale of the series 1999-1 bonds and TSASC’s 100% beneficial ownership interest in the TSASC Tobacco Settlement Trust (the trust). The trust is organized as a Delaware business trust, with Wilmington Trust Co. serving as the Delaware trustee. The primary asset of the trust is a residual certificate that entitles the trust to the net proceeds of TSASC’s future issues of bonds, and to tobacco settlement revenues not required to pay certain expenses and debt service, or to fund reserves with respect to the bonds. The transaction’s structure, including its debt service coverage levels, currently anticipates the issuance of three additional series of parity bonds. However, since rating confirmation is not a condition precedent to future issues, subsequent issues may have a negative impact on the ratings of the series 1999-1 bonds. The aggregate issuance amount of the program is expected to be approximately US$2.8 billion. The city will use the net proceeds of the series 1999-1 bonds to finance various capital projects.

TSASC issued the series 1999-1 bonds in a number of serial maturities, and three term bonds, pursuant to an indenture between TSASC and United States Trust Co. of New York as indenture trustee. Each subsequent series of bonds will be issued pursuant to the indenture and a series supplement. The series 1999-1 bonds are the first of four parity series of bonds to be issued pursuant to the indenture.

Upon the sale by the city of the tobacco settlement revenue to TSASC, the New York state attorney general issues irrevocable instructions directing the MSA escrow agent to disburse the tobacco settlement revenues directly to the indenture trustee. The initial payment is required to be made by the MSA escrow agent within 10 business days after the agent receives notice of final approval of the MSA.        

The series 1999-1 bonds benefit from a planned amortization schedule, which provides for the coverage of rated debt service even under a series of stress scenarios and can withstand each of the following events:  

The planned amortization schedule results in a more rapid amortization of rated maturities that increases the average annual debt service coverage of the series 1999-1 bonds, as well as the additional three series that are expected to be issued over the next three years. Upon an event of default under the indenture, revenues received by TSASC will be allocated first to pay interest due on the bonds; remaining amounts will be used to pay principal due in the order of rated maturities. In addition, any revenues that would otherwise have been released to the residual holder will be used to pay principal on the bonds.

The bonds also benefit from a number of mechanisms that attempt to “trap” revenues after certain trigger events. The trapping mechanisms may be triggered by events including declines in cigarette consumption; an increase in the market share of NPMs; or the unenforceability of the model statute, accompanied by a growth in the NPM domestic market share above 3%. The consumption and model statute traps are capped at 25% of the outstanding balance of the bonds, while the NPM trap is capped at 65% of the outstanding balance. As a result, the trapping accounts offset, to a limited extent, some of the uncertainties relating to cigarette consumption forecasts, market shifts to NPMs, and the enforceability of the model statute.

The transaction tranches rated maturities, allowing for higher ratings in the shorter term. The tranching of the maturities of the series 1999-1 bonds allows serial bonds with rated maturities of five years or less to experience higher ratings than the remaining maturities, due to the increased predictability of the rating factors mentioned above over the next five years as compared with those of the next 10, 30, or 40 years. Accordingly, bonds with maturities of more than five years, but less than or equal to 10 years, will have higher ratings than bonds with a tenor of more than 10 years. As discussed below, the uncertainties related to tobacco consumption and the impact of present and future litigation facing the tobacco industry are more difficult to assess over the long term.

The price elasticity of demand for cigarettes and the uniqueness of the product further support the strength of the underlying security for the bonds. Although domestic shipments of cigarettes have declined over the past several years, the low price elasticity of demand of the product nevertheless reveals a continued, although declining, underlying demand, despite the recent price increases, a significant portion of which have been driven by the MSA. Demand for cigarettes should continue, despite the potential for additional price increases that may result from future litigation and settlement payments.

The limited joint and several obligation characteristics of the MSA promote an industry approach to settlement costs, and remove some, but not all, of the company-specific risks that may be present. The MSA provides for payments to the settling states, levied on a per-unit basis, to be based on a market-share allocation among participating manufacturers. To the extent that a company ceases to manufacture cigarettes, the market share of such company would be reallocated among the remaining manufacturers. As long as the remaining companies continue to participate in the MSA, there should only be a temporary loss of settlement revenues. These losses would eventually be recaptured to the extent the remaining participating companies absorb the market share of the lost company. The series 1999-1 bonds benefit from a liquidity reserve account that equals the maximum annual debt service on all series of senior bonds outstanding, currently US$52.2 million, which is sufficient to cover a one-year payment interruption by the participating manufacturers. These features of the MSA facilitate an approach that accounts for the overall strength of the industry, as opposed to a company-specific approach.

The MSA protects participating manufacturers from large liability, state-initiated lawsuits, at a cost that has been quantified and absorbed, to a great degree, through price increases. The liability protections afforded by the MSA result in a strong incentive for manufacturers to choose to participate in the agreement. The model statute, which is exhibit T to the MSA, provides additional incentives for manufacturers to participate within the states that choose to adopt it. The model statute requires an NPM to establish a qualified escrow account that is funded through an annual deposit, based on the company’s cigarette sales in a given year. This reserve fund is intended to prevent an NPM from achieving an unfair cost advantage in relation to participating manufacturers, and to provide the state with a source of recovery to the extent that an NPM is proven to be culpable.            

The predictability of domestic shipments of cigarettes over the long term is limited, as a result of uncertainties, including:  

Additionally, the industry faces a number of large lawsuits, including the Engle class-action suit in Florida, and a suit filed by the U.S. Justice Department on Sept. 22, 1999. Although the industry has historically been successful in defending itself against individual lawsuits, it is difficult to reasonably predict the outcome of all present and future litigation. The Engle case, which is in the second phase of a three-phase trial, presents the possibility of a multibillion dollar punitive damage award on behalf of the entire class, whose size has not yet been quantified, against cigarette manufacturers. Although the Justice Department suit does not specify total damages incurred, many damage estimates exceed US$100 billion. Present and/or future litigation may impact the ratings on the series 1999-1 bonds.  


The ratings on the series 1999-1 bonds are based upon a number of forecasts and assumptions that are subject to change over time. The current ratings reflect the increased predictability of these factors over the short term, and consequently, the additional uncertainties faced by bonds of a longer tenor.

Standard and Poor’s will adjust its shipment forecasts and litigation assumptions as the situation warrants. The ratings on the bonds, as well as the forecasts and assumptions that support them, will be subject to Standard and Poor’s surveillance process and therefore are subject to change.    


Standard and Poor’s received legal opinions, based on the reasoned analysis and subject to the qualifications and assumptions contained therein, related to a number of issues present in the transaction. Opinions were delivered regarding the enforceability and validity of the MSA and New York City’s right to sell its interest in the settlement revenues. Opinions were also delivered to the effect that the transfer from the city to TSASC constitutes a true sale; a bankruptcy court would not order the consolidation of TSASC’s assets with the city; there is no litigation in any court which seeks to enjoin the issuance of the series 1999-1 bonds, or which challenges the validity of the bonds or the transfer of the settlement revenues from the city to TSASC; and the indenture trustee has a first priority, perfected security interest in the assets of TSASC.

Standard and Poor’s also requested a number of opinions that relate to the treatment of tobacco settlement revenues upon an insolvency of a participating manufacturer. Opinions were delivered to the effect that a bankruptcy court would treat the MSA as an executory contract, would respect a decision of a participating manufacturer to assume the MSA as an executory contract, and would treat the liabilities of a participating manufacturer under the MSA, following the MSA’s assumption, as administrative expenses under the Bankruptcy Code. Additional opinions received include opinions stating that:    

Contacts
Christopher Howley,
New York (1) 212-438-2490		 Richard Gugliada,
New York (1) 212-438-2474
Nicole Delz Lynch,
New York (1) 212-438-7846		 Steven J Murphy,
New York (1) 212-438-2066
Natalie Abrams, Esq.,
New York (1) 212-438-6607		  
 


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