The three largest tobacco companies last week exempted 12 states and four territories from arbitration that would force the municipalities to refund money from 2003 settlement overpayments the companies believe they made.

As a result, 34 other states — plus the District of Columbia and Puerto Rico — that signed the 1998 Tobacco Master Settlement Agreement may have to do without up to $1.1 billion they otherwise would receive from the tobacco companies as early as 2013.

That money would instead go to refund the participating cigarette manufacturers for their overpayments made in 2003, if the arbitration is successful.

The share refunded to the cigarette manufacturers would be taken from the approximately $6 billion in payments the municipalities receive annually from tobacco firms that include Philip Morris USA — owned by Altria GroupReynolds American, and Lorillard. The tobacco companies allege they overpaid in 2005 for 2003 sales.

If the cigarette makers win their arbitration, the states and territories are liable for around $1.1 billion — the amount the cigarette manufacturers overpaid them in 2005 for 2003 sales, according to Dick Larkin, director of credit analysis at Herbert J. Sims & Co. This could lead to funding problems for tobacco bond issuers as early as 2013, as they could see significant weakening of cash flow, Larkin wrote.

The states and territories that the tobacco manufacturers are not contesting include Alaska, Delaware, Hawaii, Idaho, Massachusetts, New Jersey, Rhode Island, South Dakota, Utah, Vermont, Wisconsin, Wyoming, Guam, the Northern Mariana Islands, American Samoa, and the U.S. Virgin Islands. Those states and territories stand to gain around $58 million of disputed funds that will be released to them, according to a statement written by San Francisco-based broker-dealer Mesirow Financial.

“We believe a reasonable conclusion to draw from this list is that the participating manufacturers have performed some sort of cost-to-benefit analysis and decided not to contest those states against which they would have had a low likelihood of success in the 2003 arbitration proceedings,” Mesirow wrote.

The states removed from the arbitration for possible overpayment in 2003, as issuers, “may see market improvement for their outstanding bonds,” Larkin wrote.

According to an estimate by Thomson Reuters, the muni tobacco bond market has seen $55 billion in inflows since 2001. The figure includes $13.5 billion of refunded bonds, which have moneys set aside to pay for them.

Because tobacco bonds are all based on the same cash flows, they are evaluated by maturity, according to Chris Ryon, a co-portfolio manager at Thornburg Investment Management.

“Shorter tobacco bonds are generally less risky, a little less sensitive to rulings like this, than the longer ones,” Ryon said.

Upon receiving the news last week of the municipalities excluded from the arbitration, yields on some of the long tobacco bonds faded up to 25 basis points, he added. Since then, they have recovered somewhat, around five to 10 basis points, Ryon said.

The decision to exclude the municipalities from the territories does not change whether or to what degree Thornburg includes muni tobacco bonds in its funds. For its part, Thornburg has in its core portfolios Illinois tobacco bonds known as railsplitters, which it considers less risky because they are less levered than the old tobacco bonds, Ryon said. In its strategic fund, which is built for more risk, it has about one-third of the position on some of the longer tobacco bonds.

For prices, long Ohio buckeyes, one of the more highly quoted issues, trade in yields of around 8.75% for 5.875% coupon bonds maturing in June 2047. Short Ohio buckeyes, by comparison, trade in yields of around 8.30% for 5.375% coupon bonds maturing in June 2024.

In signing the agreement in 1998, the municipalities — representing 46 states, the District of Columbia, and five territories — agreed to certain terms. An important term required the states to charge fees to the tobacco companies that didn’t sign the settlement.

The tobacco companies that signed the MSA launched the arbitration process in the belief that the municipalities were not diligent in enforcing these payments.

“The list is based on who has diligently enforced,” said Steve Callahan, spokesman for Philip Morris USA, on of the manufacturers included in the MSA.

But Callahan could not say whether the decision to exclude specific municipalities from the arbitration would set a precedent for the arbitrations for subsequent years.

For Vermont, the tobacco companies’ decision to not contest their diligence was the right move, according to William H. Sorrell, the state’s attorney general. The state took its enforcement responsibilities seriously, he added.

“In some cases, it costs us more to effect service on some of these small, international corporations than they owed in to our escrow fund in Vermont,” Sorrell said.

The contested states legally could pull the uncontested municipalities back into the arbitration. But Sorrell does not think that is too likely.

“My guess is the states that remain being contested will perhaps look at the level of efforts of the states that were let out and make decisions accordingly,” he said. “I would be surprised if many of the states that were let out, if any, are contested by other states.”

Tobacco companies say they are due refunds of past MSA payments because of the non-participating manufacturer adjustment. This adjustment was written into the settlement to protect tobacco manufacturers from losing market share to companies that did not sign the MSA.

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