Jury Orders Reynolds American to Pay $23.6 Billion. Time to Sell?

Reynolds American is tagged with a huge $23.6 billion verdict. An old Altria case suggests that this amount will be lowered, but is it time for investors to sell their tobacco holdings anyway?

Ted Cooper
Ted Cooper
Jul 23, 2014 at 4:06PM
Consumer Goods

A Florida jury awarded $23.6 billion to the widow of a man who died in 1996 after smoking Reynolds American's (NYSE:RAI) cigarettes for more than two decades. Cynthia Robinson's husband died after alleged negligence on the part of the No. 2 U.S. tobacco company for failing to inform him that nicotine is addictive.

The stunning amount -- which would make the widow the 15th-richest American -- echoes damages awarded by a jury in a 2002 lawsuit against Altria Group (NYSE:MO). Although the damages will almost certainly be reduced upon appeal, the judgment is a wake-up call to investors who thought the era of huge tobacco lawsuits was over.

Image credit: Reynolds American

Multibillion-dollar judgment
The case of Cynthia Robinson v. R.J. Reynolds Tobacco Company is one of many originating in Florida following the decertification of the Engle class action litigation. In 2006, the Florida Supreme Court ruled that the Engle lawsuit could not proceed as a class action, but the members of the suit could file individual claims and sue for punitive damages. This ruling resulted in thousands of Florida lawsuits being filed against major tobacco companies. This means that similar judgments could be issued in the coming years.

However, the $23.6 billion verdict is unlikely to stand on appeal. The verdict consists of $17 million in compensatory damages and $23.6 billion in punitive damages. Compensatory damages are just what they sound like: compensation for damages caused. In this case, the jury awarded $7.3 million for Cynthia Robinson's loss of companionship and $9.6 million for the man's son's loss of parental guidance caused by the man's death.

The other part of the judgment consists of punitive damages. Punitive damages are designed to punish defendants for inappropriate actions rather than compensating the plaintiff for actual damage caused. The $23.6 billion in punitive damages awarded in the lawsuit is far in excess of the legal norm.

In a 2002 lawsuit against Altria, a Los Angeles jury awarded $850,000 in compensatory damages and $28 billion in punitive damages to a woman with lung cancer. However, the trial judge lowered the punitive damages to $28 million -- 33 times compensatory damages.

The final verdict against Reynolds American will likely be much lower relative to compensatory damages. Past Supreme Court rulings have limited punitive damages to no more than 10 times compensatory damages. That means Reynolds American will probably not have to pay more than $170 million in punitive damages, or $187 million total. The company spends hundreds of millions of dollars repurchasing shares each year, so it can redirect cash flow to pay the judgment without having to cut its dividend.

Other pending lawsuits
Litigation is simply a part of doing business in the tobacco industry. The days of tobacco companies winning lawsuits by arguing against the dangers of tobacco and nicotine are over. However, so are the days when the companies misled consumers about the health risks, exposing the companies to enormous verdicts like the one rendered in the Cynthia Johnson case. Consumers are now much more aware of the risks associated with tobacco use than they were when Johnson's husband was smoking, meaning the number of smokers with valid claims against tobacco companies is shrinking.

Still, tobacco lawsuits remain a significant threat to tobacco investors. Reynolds American is the defendant in 7,703 pending lawsuits. Altria faces thousands of claims as well. Any one of these cases could result in tens of millions of damages levied against Altria and Reynolds American shareholders.

Moreover, Altria and Reynolds American may be under-provisioned for large verdicts. Neither company maintains a balance sheet liability for future verdicts. This reflects the uncertainty of future litigation outcomes.

However, Altria and Reynolds American are taking a growing number of these cases to trial -- and winning. Altria has won half of the 56 Engle cases that reached a verdict, and the industry as a whole is winning the majority of cases brought against it. Reynolds American says it "continue[s] to win the majority of smoking and health tobacco litigation claims that reach trial, and a very high percentage of the tobacco-related litigation claims...continue to be dismissed at or before trial."

As a result, the risk of large tobacco settlements may diminish in the years ahead.

Foolish takeaway
The headline-grabbing $23.6 billion verdict against Reynolds American will surely be reduced upon appeal. However, Altria and Reynolds American face a number of lawsuits, any one of which could meaningfully reduce shareholder value. Fortunately, most Americans are now aware of the risks of smoking cigarettes, thereby reducing the likelihood of large adverse verdicts against tobacco companies in the years ahead. As a result, investors should not ditch their tobacco holdings just because of the latest verdict.