Once Foes of Big Tobacco, States Have Been Hooked

By Gordon Fairclough and Vanessa O’Connell
First published in The Wall Street Journal
, April 2, 2003

Editor’s note: Two years ago, we wrote about the perverse incentives that would be created by linking states’ income to the success of the cigarette industry. Now several states are helping the most powerful cigarette corporation stay in business to addict more new customers to the world’s most widely fatal drug.

State governments, once among the tobacco industry’s fiercest foes, now find themselves in an unusual position: They are poised to try to rescue the country’s biggest cigarette maker in one of its darkest hours.

In 1996, Washington state Attorney General Christine Gregoire sued the country’s biggest cigarette companies, eventually extracting hundreds of millions of dollars in settlement money for her state’s citizens. “The tobacco industry has targeted our kids, withheld safer products and deliberately misled the public about the safety of smoking,” Ms. Gregoire said at the time.

Her efforts, along with those of other state attorneys general, constituted the first large-scale, successful legal assault on the tobacco industry. Opening the door for a slew of additional litigation, the state suits changed the terms of the debate on the cigarette business, shattering the aura of invincibility that had surrounded tobacco companies.

Now, however, Ms. Gregoire and other state attorneys general may go to court to protect Philip Morris USA, the maker of Marlboro. At issue: an Illinois state judge’s order that Philip Morris, owned by Altria Group Inc., post a $12 billion bond in order to appeal a massive defeat in a class-action lawsuit. Philip Morris USA suggested the bond requirement could force it into bankruptcy court. Until a recent image makeover, Altria was known as Philip Morris Cos.

The enormous bond “could create a chilling effect on the ability of the defendant to appeal,” Ms. Gregoire said last week in a press conference. And, more importantly, it “could deal a significant, unnecessary financial blow to the states.”

Altria’s current plight, rife with irony and contradiction, demonstrates how private and public interests can become entangled in surprising ways. The very states that won huge tobacco settlements in 1997 and 1998 became hooked on the money, which for many states is staving off budgetary catastrophe. The Illinois court order threatens the tobacco cash flow and has sent the states scurrying to switch sides.

All of this has angered public-health activists and some of the attorneys general who were part of the settlements. “Certainly many of us never anticipated that states would become addicted to the tobacco money as a way to finance their operations,” said Scott Harshbarger, who was attorney general of Massachusetts at the time of the settlements. “It’s a perversion of the intention of the litigation, and it’s very unfortunate, both as a matter of public policy and a matter of health policy.”

The settlements didn’t restrict how states could spend the tobacco money. But the purpose of the state lawsuits was to generate funds to cover public-health costs and smoking-prevention programs, not general budget needs, Mr. Harshbarger said.

What changed? Under the tobacco settlements of the late 1990s, major cigarette manufacturers agreed to pay the states a total of $246 billion over 25 years to settle lawsuits. The companies also agreed to a series of restrictions on the way they sell cigarettes. The settlements have given state governments a huge additional interest in the continued financial health of the tobacco industry, especially in these days of declining tax revenues and widening state budget deficits. Many states also have relied increasingly on cigarette-excise taxes.

Philip Morris, for its part, is aggressively playing on the states’ dependence. The company is due to pay $2.5 billion to the states by April 15 but is warning it may not be able to do so because of the Illinois bond order. Philip Morris is responsible for roughly half of the yearly settlement payment to the states. Its annual payment is usually made early, on March 31, but on Monday, the states didn’t get their fix.

‘Real Money’

William H. Sorrell, the Vermont attorney general, said he has already warned the state’s governor and legislators that “they might not be getting money they have already spent” — $13 million, in Vermont’s case. Said Mr. Sorrell: “Thirteen million dollars is real money in Vermont.”

Several states that had planned to issue bonds backed by expected tobacco-settlement payments were scrambling to come up with new ways of raising money to close budget deficits. Virginia’s treasurer, Jody M. Wagner, Tuesday put on hold $767 million in such bonds, sales of which were scheduled to close on Thursday. “We spoke with the underwriters this morning, and they told us they couldn’t proceed with closing this deal,” Ms. Wagner said. The state had planned to use the bond money to revitalize the economy of its slumping tobacco-growing regions.

Also now in doubt: California’s plan to sell $2 billion of bonds backed by tobacco payments in mid-April to help finance its huge deficit. Similarly at risk is a plan in New York to float a hybrid $4.2 billion bond offering backed by personal-income tax revenues and tobacco money. Kansas had planned to float $175 million in capital-improvement bonds, funded partly by tobacco-settlement payments, which would have covered that state’s $105 million budget gap for the current fiscal year.

With the possibility of the Philip Morris money not arriving, several state attorneys general were preparing to enter the fray. Vermont’s Mr. Sorrell said the states would most likely file a formal motion to intervene in the Illinois case. That would allow the states to urge the court to impose a lower bond to protect their voters’ financial interests. (The states wouldn’t challenge the underlying verdict against Philip Morris.) Illinois law ordinarily requires a bond equal to the entire trial judgment — a mechanism to ensure that if the plaintiff wins on appeal, the full amount will be available.

The bond requirement stems from a $10.1 billion verdict late last month against Philip Morris in a suit over its low-tar cigarettes. In the first class-action alleging that such labels mislead smokers into thinking that those cigarettes are less harmful, Judge Nicholas Byron of the state court in Madison County, Ill., ordered the company to pay $7.1 billion in compensatory damages and an additional $3 billion in punitive damages. The judge tacked on $1.8 billion in fees for the plaintiffs’ lawyers.

To be sure, the same state officials who want Altria and its rival tobacco companies to survive continue to attack cigarette makers. Various states recently have taken legal action to enforce marketing restrictions that the settlements imposed on cigarette makers. New York, which is hoping to sell bonds based on tobacco-settlement payments to deal with its current budget woes, last week enacted one of the nation’s toughest laws restricting smoking in public places. R.J. Reynolds Tobacco Holdings Inc. and Loews Corp.’s Lorillard Tobacco unit Tuesday filed a lawsuit against California alleging that the state is improperly “vilifying” cigarette makers in the state’s antismoking ad campaign.

But there has been a broad alignment of economic interests between cigarette makers and the states. Considering both cigarette taxes and the settlements, “the states make more money from each pack of cigarettes sold than anyone else, and they have an enormous financial stake” in tobacco sales, said Tommy J. Payne, executive vice president of Reynolds, the nation’s No. 2 cigarette maker.

In the years since the settlements, legislators in 16 states, egged on by the attorneys general, have passed laws limiting the size of bonds that must be posted by corporate defendants seeking to appeal trial defeats. In four of the states — Louisiana, Nevada, Oklahoma and West Virginia — the laws only apply to cigarette companies that settled.

States have helped the big cigarette manufacturers in other ways as well. Twenty-two have passed laws that would essentially force small makers of bargain-basement cigarettes out of the market if they don’t make certain payments required by the major tobacco settlements or related legislation. These laws hinder deep discounters that have been eating into the larger cigarette makers’ profits. Propping up the bigger players makes economic sense to the states because their settlement payments rise and fall in line with cigarette sales by the big manufacturers.

Between November 1998, when the tobacco industry signed its main settlement with 46 states, and 2002, cigarette makers paid those states more than $21.6 billion. An additional $5 billion is scheduled to be paid this year.

States have increasingly come to rely on this money — as well as on rising cigarette-excise taxes — as they struggle to cope with their worst financial crisis in 20 years. “These dollars are becoming more and more important,” said Lee Dixon, who tracks health policy for the National Conference of State Legislatures.

In the 1990s, states became accustomed to plentiful tax revenue, in part because the rising stock market inflated taxes on capital gains and income. Governors and legislatures pushed through popular spending programs and cut unpopular levies.

Short-Term Solutions

Then, when the economy began to sour, many states chose short-term solutions, such as tapping the settlement payments and draining cash reserves, rather than realigning their budgets to reflect new economic realities. For the current fiscal year, which ends for most states on June 30, 21 of the 46 states that signed the main 1998 tobacco settlement agreement tapped that money to help close shortfalls. The previous year, 16 states relied on settlement money.

As of February, the collective deficit for the 50 states for fiscal year 2003 was $27 billion, according to data supplied by the National Conference of State Legislatures, which is based in Denver. Next year, the states are looking at even bigger deficits. Most states, unlike the federal government, are required by law to balance their books at the end of their one- or two-year budget cycles. This forces them to cut spending, raise taxes, or both.

That’s why state officials across the country are watching the situation in Illinois so closely. Philip Morris’s general counsel, Denise Keane, last week sent a letter to Ms. Gregoire, the Washington state attorney general, saying that the company was “not financially able to post the enormous bond that the Madison County court has demanded” and warning that “it is presently uncertain” whether Philip Morris would be able to make its $2.5 billion payment to the states.

Illinois Attorney General Lisa Madigan said she will take Philip Morris to court if it doesn’t make the payment.

Altria has long prided itself on its high credit rating, so it was particularly striking Monday when Moody’s Investors Service cut Altria’s rating by two notches, to just three levels above “junk.”

Illinois lawmakers are now considering legislation that would limit the amount of money Philip Morris must put up as a bond in order to appeal. Representatives of Philip Morris and the states’ outside trial lawyers met Tuesday in Chicago under the auspices of the speaker of the Illinois House of Representatives to try to cut a deal.

Philip Morris wants the cap set at $100 million. The trial lawyers were looking for a cap of between $500 million and $1 billion. State Rep. Robert S. Molaro, a Chicago Democrat, said Tuesday that once the parties agreed on a figure, lawmakers would move forward with a bill.

Public-health groups say they oppose any legislation that would protect Philip Morris. “We don’t think the Illinois legislature ought to pass a bill to help one company, especially a company that’s been found to have injured more than one million citizens of the state,” said Matthew L. Myers, president of the Campaign for Tobacco-Free Kids.

Mr. Myers said that Altria, which isn’t a defendant in the Illinois case and thus isn’t technically liable, could pay the bond for Philip Morris. Altria has an $8 billion credit line and pays about $5 billion in dividends each year. “Philip Morris wants the court to relieve it of any obligation to make any sacrifice,” Mr. Myers said.

Altria responded to this assertion by pointing to a filing it made last week with the Securities and Exchange Commission in which it said Philip Morris can’t post a $12 billion bond.

The Illinois share of the Philip Morris payment due April 15 is $150 million, according to former Illinois Gov. Jim Thompson, who is now lobbying for the company. Most of that money is earmarked for health-care programs for the elderly, Mr. Thompson said.

“We’re very concerned that the amount of the appeal bond will adversely affect budgets in 46 states,” said W.A. Drew Edmondson, attorney general of Oklahoma. There is “no benefit to public health by putting Philip Morris in the financial position” of having to declare bankruptcy, he added. “They’re going to sell just as many cigarettes even if they’re in receivership.”

Gregory Zuckerman, Christopher Lawton, Richard A. Bravo and Stan Rosenberg contributed to this article.