Federal probe into water board may see more charges.

The July indictments of two West Basin Municipal Water District officials may be the first brought by federal authorities as part of the ongoing investigation of the board's complex financial dealings.

It is unknown who is being targeted in the probe. But Thom Mrozek, a spokesman for the U.S. Attorney's office in L.A., which indicted the two water board officials, said the investigation is continuing and "there is a possibility of additional charges being brought."

Last month's 18-page indictment of West Basin board member Tyrone Smith alleges that he extorted $25,000 from M.R, Beal & Co. for a vote favoring the retention of New York-based Rice Financial Products Co., to handle a 2001 interest rate swap. Rice paid M.R. Beal $250,000 for what the Smith indictment called an introduction to the five-member water board, which approved the transaction.

According to the indictment, M.R. Beal paid former Inglewood City Councilman Garland Hardeman $50,000, who in turn gave Smith $25,000. Hardeman has pleaded guilty to charges stemming from the bribery scandal that rocked the Carson City Council earlier this year.

No executives from Rice or M.R. Beal have been indicted, and officials of both companies, while confirming the payments, denied they were anything but appropriate consulting fees.

Since its founding in 1994, Rice Financial, which specializes in interest rate swaps for municipalities, has grown through multiple acquisitions. The firm, founded by Don Rice, a Harvard Business School graduate and former executive at Merrill Lynch & Co., was named Financial Company of the Year by Black Enterprise magazine in 2000.

It has brokered a $140 million interest rate swap in 1997 for Dade County, Fla., and an interest rate swap that saved the Oakland-Alameda County Coliseum Authority $13 million to $16 million in debt related to improvements for the stadium, according to Black Enterprise.

Don Rice, its chief executive, declined to comment on the West Basin indictments.

M.R. Beal's chief operating officer, Stanley Grayson, said the firm, which has been involved in several bond sales for South L.A. municipal agencies over the last seven years, introduced Rice to the West Basin Municipal Water District.

"We do not provide swaps or swap services, and Rice Financial was a Black Enterprise. company of the year," Grayson said. "And it's well known in the swap market."

The water authority issued debt instruments called Adjustable Rate Certificates of Participation to fund capital projects. After they were issued, the board sought to minimize the risk of interest rate swings on the adjustable rate instruments by entering into interest rate swaps.

Interest rate swaps are complicated instruments that generally allow borrowers to pass on some of their interest rate risk to a counter-party. If rates rise, the counter-party shoulders some of the borrower's increased burden. If rates fall, some of the savings is passed on to the counter-party.

The swap was designed to save the West Basin District payments due on its $141.8 million in bond obligations, according to Smith's indictment.

In the past year, the Municipal Securities Rulemaking Board, the industry's self-governing body, has raised concerns about the use of swaps, which Christopher Taylor, its executive director, said have increased in the past two years.

He said interest rate swaps could potentially bring greater savings to a municipality than could traditional, long-term debt offerings. But the risks, he said, are that members of bond issuers aren't knowledgeable enough to understand swaps and must rely in third party financial advisors who are rarely regulated.

"Our concern is for issuers, particularly those who are unsophisticated or don't do their homework," he said. "You can get involved in a transaction and you can end up losing a ton."

Under MSRB regulations, brokerage firms and dealers must report payments and contracts to consultants in association with bond offerings, Taylor said.

The day after Smith's indictment, The Bond Buyer reported that M.R. Beal had misreported the name of the West Basin Municipal Water District in its notification of the Hardeman payment to the MSRB. The financial publication further reported that M.R. Beal named a nonexistent issuer, the West Basin Uptown Development Authority, as the body Hardeman was retained to make the introduction to.

Grayson said the misreported filing was a clerical error "that wasn't caught and was unintentional."

Taylor downplayed the error, reiterating that M.R. Beal did not even have to report the consultation fee because it was tied to an interest rate swap, which is not regulated by the body.

Still, financial experts contacted by the Business Journal said the $250,000 introductory lee Rice paid to M.R. Beal was unusually high.

"So much money was available for consultant fees, that would suggest that perhaps the pricing wasn't right," said Lisa Quateman, a partner at Quateman & Zidell LLP and municipal finance attorney.

Quateman said consultant fees like the one paid by Rice to M.R. Beal are not unusual. But they typically fail in the range of $150,000 to $175,000 on transactions of similar size.

Civil complaint emerges

In addition to the criminal charges against Smith and Keith McDonald, the board's president, the West Basin Municipal Water Authority board has sued P.G. Corbin & Co. Inc., a Philadelphia firm that advised it in the swap.

In a suit filed July 23 in L.A. Superior Court, the water board claims P.G. Corbin, through its former vice president, Leonard Cuenco, caused the board to lose more than $5 million in potential savings because it approved the interest rate swap as a "fair market value," according to the suit.

At the time of the swap, according to the suit, P.G. Corbin could not estimate Rice's profits, which was a breach of fiduciary duty and professional malpractice.

Calls to P.G. Corbin Group Inc., parent of P.G. Corbin & Co., were referred to an attorney who did not return phone calls.

The water board's attorney, Steven O'Neill, a partner at Lemieux & O'Neill, said Rice made $11 million in profits on a transaction that typically would award a swap dealer $850,000 to $2.5 million. The board discovered the discrepancy after it hired two independent financial consultants this summer to evaluate the potential savings of the swap, he said.

Also, while the board has made more than $1 million from the swap transaction in the past year, profits are lower than the $1.3 million promised by Rice, he said.

He said the suit's filing was not related to the indictments of two board members.

In a prepared statement, Rice Financial said, "As a result of the action taken by the board ... West Basin has saved more than $1.4 million since the transaction was executed, rather than having suffered $225,000 on the alternate transaction we understand they had been prepared to implement."

Further adding to the murk is the role of Chapman Co., which advised the water board against the interest rate swap at the time it was proposed, according to Smith's indictment.

Smith and two other water board members voted in favor of Rice's proposal, despite the objections of a Chapman official, Don Backstrom.

Backstrom said he had no problem with Rice's interest rate swap proposal but advised against the transaction because Standard & Poor's and Moody's did not rate the firm.

Officials at Standard & Poor's and Moody's verified Rice Financial was not rated.

"They just didn't take the time to get rated and didn't apply for a rating," said Backstrom, an L.A. advisor who left Chapman in January with several of his colleagues to form Backstrom McCarley Berry & Co.

On June 26, Nathan Chapman Jr., founder of e-Chapman Inc., parent of the Chapman Co., was indicted on charges of defrauding the state pension system and using the pension's money to purchase shares in the 2000 initial public offering of his company, according to a report in the Baltimore Sun.

New York money manager Alan Bond, who assisted Chapman with the purchases, was convicted last year of defrauding pension systems, including Maryland's, and is serving 12 years in prison, according to the report in the Sun.