State governments struggling to close yawning budget gaps are fighting to get billions of dollars from a landmark 1998 tobacco settlement that they  counted on to help fund everything from Medicaid to elder care programs.

Since 2006, R.J. Reynolds Tobacco Co., Lorillard Inc., and about 40 other cigarette makers that signed the settlement have withheld about $3.2 billion from the states. The companies claim the states failed to enforce a provision stopping small, rival cigarette companies that didn’t sign the settlement from undercutting them on prices.

That provision requires states to force non-settling cigarette companies — such as National Tobacco Co., Cheyenne International and Smokin Joes — to pay a portion of revenue into escrow accounts as a hedge against future litigation, and to level the playing field with the companies that did sign the settlement.

Philip Morris USA, far and away the largest tobacco company, has made the disputed payments to the states. But it says it is owed a refund of $1.3 billion plus interest, and will contest another $400,000 in payments made over the past two years.

All told, the tobacco companies are disputing about $5.2 billion in payments, according to the National Association of Attorneys General.

A hearing starting today before an arbitration panel in Chicago is the first step in determining whether the cigarette companies will release that money, or whether states must dig into empty coffers to repay billions of dollars more — a potential political and fiscal catastrophe.

Did states hold up their end of the deal?

The 1998 tobacco settlement ended years of litigation over whether companies had knowingly misled smokers about the dangers of cigarettes, resulting in tobacco-related health care costs for state-run Medicaid programs.

The four biggest tobacco companies — eventually joined by more than three dozen smaller ones — agreed to stop cigarette advertisements targeting youth and to make annual payments to 46 states to help defray mounting health care costs. The payments translate to roughly 54 cents for every pack sold. In 2010, the states divvied up $6.4 billion.

Tobacco companies that settled will pay more than $200 billion over 25 years to the states. In exchange, the tobacco companies insisted the settlement include an escrow clause to protect them against a competitive advantage for the companies that didn’t settle.

Under the agreement, the tobacco companies are entitled to withhold a percentage of their annual payment to the states if two things happen.  First, the original four big tobacco companies must lose market share to non-participating cigarette makers, and second, the states must fail to “diligently enforce” the requirement that non-participating tobacco companies pay into a state escrow. The payments, a fraction of one percent for each cigarette sold the previous year, are slightly less than what each company would have paid had it signed the settlement agreement.

In 2006, the first condition was met when an independent consultant agreed with big tobacco that non-participating companies were eating into their market share. Soon after, big tobacco began withholding money from the states, claiming that they had not held up their end of the bargain. States responded with a wave of lawsuits demanding the lost money plus interest.

Both sides’ complaints are now before an arbitration panel made up of three retired federal judges. The panel will decide what to do with about $1.1 billion in disputed funds for the year 2003, a decision that will set the stage for resolving payment disputes for each following year.

This week’s hearing takes place at a Chicago hotel, where representatives from states are expected to attend, as well as dozens of tobacco lawyers and other interested parties such as banks.  

The hearing will address preliminary issues, including whether the money that some tobacco companies have put aside while the debate plays out should go to the states pending resolution of the entire matter, according to a lawyer who is attending the hearing but is not authorized to comment on the proceedings.

The big dollars at stake and the sensitive stage of the arbitration proceeding mean none of the players involved were willing to speak on the record with the Center.

Matthew Berge, a lawyer in the Massachusetts state attorney general’s office who is serving as coordinating counsel for the states, declined to discuss the case. Two attorney generals who lead a committee formed to manage the litigation, Dustin McDaniel of Arkansas and Jon Bruning of Nebraska, did not return calls.

R.J. Reynolds, Philip Morris and Lorillard also did not comment.

States dispute own experts

The states enter the hearing haunted by their own earlier estimate of how many non-participating companies were paying into the escrow accounts.

A footnote in a 2006 reportby an independent consultant hired to determine whether the settlement agreement was costing big tobacco market share, says that the states previously estimated that from 1999 to 2003 the compliance rate of the non-participating cigarette companies ranged from 36 to 72 percent.

The states now disavow this estimate.

Jeremy Bulow, an economist at the Stanford Graduate School of Business who has written extensively about the tobacco settlement, said that estimate is bad news for the states, though it isn’t clear whether it reflects reality.

“I doubt that even the states trust that data, but it is what they submitted,” Bulow told the Center in an email. “Presumably the states will provide some non-quantitative evidence indicating how hard they have worked at enforcement, but how do you persuade the arbitrator that you’ve been diligently enforcing the tax when your own estimate of the compliance rate is so low?”

Bulow said that it was almost inevitable that the “diligent enforcement” clause would cause problems for the states.

The framers of the 1998 settlement did not account for a significant market in counterfeit cigarettes, and the states have “terrible” escrow account data systems, he said.

States also had a tough time, at least initially, forcing offshore tobacco companies to comply with their escrow statutes.

Christian Tweeten, a lawyer in the Montana attorney general’s office, said his state spent a lot of money suing offshore companies to force compliance, with limited success. Often, they would just close up shop and reopen under a different name.

In 2003, Montana and other states began requiring companies that wanted to sell cigarettes to prove they had appropriately escrowed the previous year. Montana now has a directory of approved tobacco sellers, as do most other states. “This dramatically reduced the enforcement burden for us,” Tweeten said.

The money the tobacco companies withheld or didn’t pay in 2006 applies to calendar year 2003. In 2007, they withheld money for 2004, and so on.  But the states say they are making big strides in forcing non-participating cigarette makers to pay into the escrow funds through legislation and other means.

And yet the tobacco companies have continued to hold back payments.

In 2009, the tobacco companies deposited $576 million that would otherwise have gone to states into a disputed payments account at Citibank, the escrow agent for the tobacco settlement, according to a report by the National Association of Attorneys General. Another $21 million was simply withheld or not paid.

One of the surprising provisions of the complicated 1998 settlement punishes states that fail to “diligently enforce” the escrow clause by requiring them to pay the entire amount due from non-participating cigarette makers. Meaning, if half the states did a good job of forcing the small cigarette companies that didn’t sign on to the settlement to pay a portion of revenue into escrow accounts, and half did not, the second group must pay the entire bill, up to every dime they received in tobacco money in a given year.

Iowa attorney general Tom Miller told The American Lawyer last year that the states have been pushing to settle the issue of a refund since 2006. He also acknowledged in the interview the difficulty of coordinating action among 46 states. “When you have 46 sovereigns, there is going to be some difference of opinion,” he said.