WASHINGTON -- The Securities and Exchange Commission's new disclosure guidelines have triggered an investigation by the Maryland attorney general into whether a financial adviser for tax-exempt housing bond issues was compensated twice with state funds for the same work.

Merrill Lynch & Co. disclosed in a May 1 prospectus for the sale of single-family housing bonds that Thomas P. Caine, principal of CGMS Inc. and Maryland's financial adviser on the $125 million deal, received compensation twice for cash flow analyses. The disclosure by Merrill Lynch, a senior managing underwriter for the sale, was made in response to the SEC measures, Maryland officials said.

The disclosure "was a surprise to us," said Jacqueline Rogers, secretary of Maryland's department of housing and community development. "That's an example of the SEC working well," she said. "I was real tickled to think, oh my goodness, look, they have these new rules which are a pain in the ass to comply with. Sure enough, they smoke out things that people need to know."

The SEC issued proposed rules and a legal interpretation last March that call for, among other things, disclosure of potential conflicts of interest and material financial and business relationships among issuers, advisers, and underwriters. The commission now is reviewing comments on both the legal interpretation and the proposed rules.

According to Merrill Lynch, Caine was compensated once by the state for financial advice under a 12-year contract with the issuer, Maryland's Community Development Administration, that expired June 30. He was paid a second time by the rotating senior managing underwriters, including Merrill Lynch, out of bond proceeds and treated as cost of issuance - Caine said his firm did not double-bill the state. The CGMS services that were paid for from the bond proceeds by the managing underwriters, which included Alex. Brown & Sons Inc. and Legg Mason Wood Walker Inc., "were entirely separate from services that were paid for under our advisory contract to provide services to Maryland's CDA," Caine said.

The underwriters' request that CGMS prepare cash flows and yield calculations was fully discussed with and approved by Trudy McFall, director of the Maryland housing agency, Caine said.

McFall, who resigned her post last month, could not be reached for comment. All payments were disclosed to both McFall and the agency's director of finance, Caine said.

Caine's contract with the housing agency called for direct payment of $225,000 a year. The adviser received additional compensation in the range of $30,000 to $40,000 through the bond dealers in various sales, Rogers said. She could not say what total dollar amount is being investigated.

CGMS has not been contacted by the state attorney general's office, Caine said. The firm's activities and compensation met standard industry practice, he said. "We haven't done anything wrong or unethical," and "I hope when they finish their investigation, they will find this is [a] misunderstanding."

The investigation will seek to determine whether Caine performed different work for each form of compensation, and if so, whether the level of compensation was appropriate. The SEC is not involved in the inquiry, state officials said.

Rogers formally requested the inquiry in July, but the investigation began within the attorney general's office in April when the offering statement came under review. As part of the inquiry, attorney general J. Joseph Curran Jr. is scrutinizing the underwriters as well as Caine, officials said.

A Merrill Lynch spokesman said, "The fact of our disclosing this in bond documents can in no way be interpreted that we have any reason to believe that this arrangement was inappropriate." Caine was paid "for work done directly in connection with the bond issues and work that is essential for the bond issue to go forward," he said.

"We wanted to make sure bond offering documents disclose all of the relevant details," the spokesman said.

Rogers said the state will rely more heavily on Merrill Lynch in the short term to make computer calculations for two upcoming bond sales -- a $25 million multifamily housing issuance and a single-family issuance in an amount to be determined. Merrill Lynch is setting up a database now for the housing agency, she said.

Beyond that, Rogers said she hopes to sign a long-term contract with a financial adviser by early next year for which CGMS is "welcome" to compete, Rogers said.

Curran has no timetable for completing the inquiry. Officials said the investigation should not have any material effect on bondholders or bonds.

But even if no improprieties or legal violations are uncovered, state officials said they are troubled that they did not know about compensation from bond proceeds that exceeded the contract.

"If you look at what's going on, it's not illegal," Rogers said. "It's perfectly normal for people to charge expenses of issuance to the bond issuer, and the second form of compensation to CGMS was billed as a cost of issuance," Rogers said. But while the practice is legal, it may not be appropriate, she said.

"We are thoroughly reviewing the record to establish a clear paper trail to see what was done and paid through the state contract and what was done and paid for through the cost of issuance," Rogers said.

Caine said he prepared cash flow and yield calculations for the underwriters that were different from the management cash flows performed for the issuer. The management cash flows involved review of the issuer's other active bond indentures "in order for management to stay on top of the financial situation with their outstanding bonds," Caine said.

"All of the costs may be legitimate, we just don't know," Rogers said.

The practice that was disclosed dates back to 1988, so the inquiry is covering at least that period, Rogers said. She could not comment in more detail on the scope of the inquiry.

Rogers said she has empaneled a group to review industry practices and how other states and local issuers "are configuring the distribution of responsibility between what the agency itself does, what the financial adviser does, and what the underwriter should do." The panel, which consists of a representative of the Maryland treasurer's office, a bond lawyer, bankers, and Roger's deputy, will report back in September. At that point, the housing agency plans to change its procurement process, she said.

One area where Rogers foresees change involves use of technology. Issuing agencies are developing computer capability to run their own bond calculations. CGMS "did all of our bond runs," and had all the computer capability in its office, she said. "Looking back on that I am a little uncomfortable with that and I don't think I'd ever want to be in a situation where I didn't have and couldn't run a parallel database that was controlled directly within the agency," she said.

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