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Corporate Supply & Flows (APRIL 10)

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CreditSights: The Week In Credit

Litigation risk has once again reared its ugly head as one of the major threats to corporate bondholders with the Miles vs. Philip Morris ("Lights") case. The $12 billion bonding requirement handed to Altria's domestic tobacco subsidiary, Philip Morris USA (PM USA) by an Illinois state court has caused shockwaves through the credit markets, not for the sheer size of the number, but for the various consequences an enforcement of the bond requirement would have on PM USA, Altria (MO), Kraft, the tobacco industry and state budgets across the country. While the potential for an adverse judgment triggering a large up-front payment is hardly a new risk, the industry has benefited from the "performing with a net" theory following the 1998 landmark Master Settlement Agreement (MSA) with 46 states. This theory is clearly being tested with the large "bill is due" judgment pending against the industry's largest player and the implications of this go well beyond the bounds of the credit markets given the states' vested interest in the ongoing viability of the industry.

The heart of the current crisis is still not the question of whether or not Altria/PM USA can "afford" a $12 billion award, but rather if it can afford to make an upfront, one time payment or bond versus smoothing out such payouts over a manageable time frame. The smoothing process was at the heart of the initial MSA settlement, and the threat of using a bankruptcy defense to keep any further large decisions at bay and "encourage" states to enact bond caps has always been a basic underpinning to the willingness of MO (and other industry players) in staying the course. The timing of the Lights case is particularly important as the expiration of the 30-day stay on the bonding requirement (April 21) falls just days after the industry is required to make its annual payment under the MSA this Thursday ($2.5 billion for PM USA alone). Accordingly, all eyes are focused on Thursday and whether or not PM USA will essentially reject the MSA agreement and file for bankruptcy protection. While several actions have been taken to reverse or lower the bonding requirement, time is quickly running out and it appears that the Illinois Legislature is unlikely to pass a bonding cap. Even if that does happen, the legality of a retroactive bonding cap is clearly in question. While we believe the company will ultimately be successful in its appeal of the bonding requirement, if PM USA is forced to post a bond before it can appeal the issue, the company will likely choose bankruptcy over payment.

As a consequence of this the rating agencies swung into action with both Moody's Investors Service and Standard &Poor's backpedaling on both MO's and Kraft's Commercial Paper programs by downgrading their short-term ratings to A-2/P-2. In the aftermath of a few former "investment grade" asbestos litigants having filed with CP outstanding, the pressure remains on the agencies to rebuild credibility, particularly on the CP front, and the MO/KFT situation presents another potential "black-eye". Historically, S&P has maintained a policy of linking the ratings for the two entities given MO's significant (84%) ownership in KFT. However, with its most recent downgrade, the agency reversed itself on this practice after completing a comprehensive review of KFT's potential exposure to litigation risk and the likelihood (or lack thereof) that plaintiffs/creditors would be able to pierce the corporate veil in the event of a PM USA bankruptcy and tap into KFT's assets. It is somewhat remarkable that it took such a severe event to prompt S&P to examine this issue to begin with.

Litigation risk and "better late than never" opinions from the agencies are two unfortunate constants of the credit markets.

Analysis by CreditSights, Inc., an independent online credit research platform. Call (212) 340-3888 or visit www.CreditSights.com for more information.

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