Oppenheimer funds fighting tobacco bond refinancing

When American tobacco companies settled a landmark lawsuit over the harmful health effects of their products 16 years ago, many state and local governments cashed in immediately on payments supposed to last generations.
They sold tobacco bonds against future payments that some critics claim benefited the financial industry more than the public.
But in Rhode Island’s case, a mutual-fund giant is claiming that it’s being taken to the cleaners by the state with a $600 million refinancing plan that was expected to generate $20 million in cash for the state this fiscal year.
In a lawsuit filed in R.I. Superior Court, two mutual funds controlled by Oppenheimer Funds are trying to block the tobacco bond refinancing, which they claim defrauds their investors.
As a result of the lawsuit, a bond issue that had been slated for August has been put on hold pending a resolution and the upfront revenue it would have generated is not there to help officials close a projected budget gap.
The merits of the case will likely depend on an interpretation of dense financial disclosures issued with the old bonds and contained within a five-inch thick stack of printed exhibits in Oppenheimer’s complaint.
Regardless of how it turns out, the case provides a window into the complicated world of tobacco bonds and how at least one state is using them.
Rhode Island issued its first tobacco bonds in 2002, four years after the historic settlement was signed and the country’s four major tobacco manufacturers agreed to pay 46 states at least $206 billion over 25 years.
The settlement required the companies to make annual payments to the states that depended on how much tobacco they sold the year before.
Although the structure of tobacco bonds and motivations behind them differed from location to location, the most common rationales were that they would shift risk to investors and provide upfront cash to plug budget holes.
The attractiveness of short-term money instead of future revenue was obvious and the desire to shift risk grew out of the possibility that smoking-cessation programs would be successful and tobacco sales driving the payments would dry up.
As it turned out, to some extent that’s what has happened.
Smoking has decreased and because only settlement revenue can be used to pay the bonds, they’ve been paid down more slowly than projected. In fact, some bonds sold more recently and subordinate to earlier bonds have been written down out of a high likelihood they will never be fully paid. Rhode Island’s Tobacco Settlement Financing Corporation, an independent legal entity created to sell tobacco bonds, issued roughly $685 million worth of bonds in 2002 and another $197 million in 2007, according to the Oppenheimer complaint. The 2002 bonds were subdivided into two tranches of seniority and the 2007 bonds three tranches of seniority.
The 2007 bonds were zero-coupon bonds which don’t pay any annual interest, but deliver a set return once they reach maturity.
According to the Tobacco Settlement Financing Corporation’s response to the lawsuit, Oppenheimer’s plaintiff mutual funds hold 2002 bonds with a market value of about $100 million, and 2007 bonds worth $1.7 million.
The dispute comes over the state’s plan to issue a new set of bonds and use the proceeds to redeem the 2002 bonds at face value while moving the 2007 bonds up in line for repayment.
According to the Tobacco Settlement Financing Corporation’s response, the refinancing is possible because of current interest rates, which are significantly lower than they were in 2002 or 2007.
“By lowering the costs of its debt, the corporation – a public corporation of the state – will save hundreds of millions of dollars over the life of the bonds,” wrote Tobacco Settlement Corporation attorney Joseph S. Larisa Jr. “The 2014 bond issuance will also provide material economic benefits to all of the holders of the [2007 bonds], including plaintiff, in the form of a substantially earlier payoff than they would receive otherwise.”
A majority of the 2007 bondholders have endorsed the refinancing, including some that have negotiated specific terms regarding how much they will get back in the deal.
But Oppenheimer argues that the $20 million the state is taking out of the refinancing is prohibited by the terms of the 2007 bonds, which say settlement revenue must go to paying off the bonds before it can be used for anything else.
In its complaint filed by attorney Justin T. Shay of Cameron & Mittleman LLP in Providence, Oppenheimer said the state negotiated a special deal with the majority holder of the 2007 bonds, which it describes as a “vulture fund,” to convince it to agree to the settlement. That special deal includes purchasing a chunk of the investor’s 2007 bonds at 80 percent of their face value. Oppenheimer said it was only to be offered about 10 percent of face value for its 2007 bonds, although those bonds were series B and C, and subordinate to the series A of the “vulture fund.”
“The proposed transaction will give the state a minimum of $20 million and the vulture fund a quick payday of approximately $60 million by breaking the corporation’s fundamental promise to other bondholders,” the complaint said.
The state counters that Oppenheimer doesn’t really care about the 2007 bonds at all, but rather the 2002 bonds, which the company has a far larger stake in and would lose a major profit from if they are redeemed early. Those 2002 bonds, after all, are paying the much higher interest rates the state is trying to get out from underneath of with the refinancing.
“Plaintiff and certain of its affiliates own Series 2002 Bonds with a market value of approximately $100 million, dwarfing the market value of the Series 2007 Bonds owned by the plaintiff, which is approximately $1.3 million,” the corporation response said. “Put differently, the plaintiff has a substantial economic motivation to block the 2014 issuance.”
The key question appears to be whether the state taking $20 million out of the deal through a new issuing at lower interest rates would be considered diverting revenue that should, under terms of the 2007 contract, go toward paying those bonds off.
Cautioning that he had not had a chance to review the case carefully, Roger Williams University law professor John Chung said the Rhode Island case may not have too many implications for other states because it hinges on the language of these specific bonds.
As it stands, the lawsuit is already having a negative impact on the Rhode Island budget.
Thomas Mullaney, executive director of the R.I. Office of Management and Budget, said of the $20 million anticipated from the refinancing payment, $5 million was included in the current budget, $10 million to the Information Technology Investment Fund and $5 million to the newly created Municipal Road and Bridge Revolving Fund. •