Non-Disclosure of Regulators’ Concerns at Heart of Keating Case : Courts: Trial focuses on the failure of Lincoln’s small investors to learn of the thrift’s inadequate net worth.

LOS ANGELES —  American Continental Corp. had barely begun selling bonds to small investors when thrift regulators told the company’s chairman that the company’s main unit, Lincoln Savings & Loan, was in shaky financial condition.

The news was delivered in businesslike fashion to the chairman, Charles H. Keating Jr., at a Dec. 5, 1986, meeting with regulators, said Michael Patriarca, who was in charge of the federal examiners then reviewing the Irvine thrift.

Patriarca, testifying in the criminal securities fraud case against Keating in Los Angeles Superior Court, said he was concerned that the company would not be able to repay the debt it was issuing because it had inadequate net worth, which is essentially assets minus liabilities.

Yet small investors who were buying the corporate bonds at Lincoln’s Southern California branches were not told what regulators thought about the S&L;’s condition, and the company’s sales force never got the word either. Rather, the message was that American Continental and Lincoln were rock-solid institutions.

So far, after 19 days of testimony from 27 prosecution witnesses, the failure to disclose those regulatory concerns is the heart of the case against Keating.

He is accused of defrauding 22 small investors--part of thousands who lost more than $250 million in the April, 1989, collapse of his financial empire--by making or causing false statements to be made and by omitting material information.

No one who has testified has linked Keating to any false statements, but former Lincoln Chairman Robin S. Symes, who has pleaded guilty to six securities fraud charges, testified that Keating never directed him to inform bond sellers and bond buyers of the issues raised at the meeting with regulators.

Patriarca testified that he raised his concern about Lincoln’s inadequate net worth after Keating asked for approval for the S&L; to pay a $20-million dividend to American Continental. Patriarca shot the request down.

“I said I had a problem with that because it appeared that Lincoln failed its net worth test,” Patriarca testified. “I could not condone the payment of a dividend because it would reduce the net worth: Lincoln would lose its cushion against losses.”

Keating’s defense, so far, has challenged whether that omitted information was indeed material, especially since regulators later changed some figures, allowed Lincoln to pay dividends again and agreed that the S&L; might actually have enough net worth.

Patriarca and other regulators admitted under cross-examination that the numbers used to calculate Lincoln’s net worth in December, 1986, were preliminary and depended on the value assigned to various assets, including the luxurious, $296-million Phoenician Resort in Scottsdale.

A major loss at what regulators believed to be the S&L;’s biggest white elephant and the greatest point of contention between them and Lincoln could have wiped out the thrift’s net worth at the time.

Keating has asserted that federal regulators, particularly those in San Francisco’s regional headquarters, had a vendetta against him and were determined to find an excuse to shut him down. Symes testified that a federal examiner told him in May, 1986, that his superiors in San Francisco wanted him to redo his audit of the S&L; and keep looking into Lincoln “until he found something.”

As far as the bond sales program went, Keating’s lawyer, Stephen C. Neal, told the jury in his opening statement six weeks ago that American Continental retained the best lawyers and accountants to structure the bond program and that Keating was committed to complying with the law, two major aspects of the defense strategy.

A bond seller, for instance, was fired for being too aggressive, and Symes and Ray C. Fidel, a former Lincoln president, were reprimanded for violating bond sale procedures.

Prosecutors have been hammering hard on the notice Keating had from regulators that his empire was crumbling. Alex Barabolak, a top examiner, testified last Wednesday that by the fall of 1988, American Continental was simply “pyramiding” debt upon debt and using the proceeds to buy stock from Keating and other insiders.

But Neal, who has been poking holes in testimony by prosecution witnesses, showed that it was an inverse pyramid. Barabolak’s own report revealed that debt securities sold by American Continental actually reduced the company’s overall borrowings by $546 million over five years. In addition, neither the company nor its employee stock ownership plan purchased stock from Keating after 1987.

The prosecution, however, doesn’t believe that any of the defense’s contentions mean a thing when it comes to deciding whether bond buyers should have been told about the thrift’s financial troubles in late 1986 and early 1987.

“Would you want to be told (before investing in bonds) that regulators thought Lincoln was failing its net worth test and that a dividend of $20 million couldn’t be paid?” asked William Hodgman, the Los Angeles County deputy district attorney leading the prosecution team.

Hodgman and Deputy Dist. Atty. Paul Turley have been painstakingly building a case that shows that Keating was repeatedly made aware of serious concerns about the company’s ability to survive and its ability to repay its debts.

A series of regulators have testified both to their warnings to Keating about Lincoln’s shaky financial condition and to Keating’s awareness and sometimes flip comments. Patricia McJoynt, a federal regulator in Seattle, said she asked Keating why he wasn’t a director or officer of Lincoln and he told her in a serious tone, “I don’t trust regulators. I don’t want to go to jail.”

The prosecution has had little trouble showing that the American Continental bonds were high-risk junk bonds that should not have been sold to those who couldn’t afford to lose their money. Symes said that that information was given to company employees who were trained to sell the bonds.

The prospectus, inadequate as it was, showed that the bonds were highly risky, said the prosecution’s expert witness, Alfred E. Hofflander, a professor at UCLA’s Graduate School of Management. Even Keating acknowledged two years ago that there was “some parallel” between the securities and junk bonds.

Most of the small investors were elderly Lincoln patrons, and many lost their life savings when the company went bankrupt and regulators seized the S&L.;

So far, 17 bondholders have testified that they were misled into believing that the bonds were safe and that the company was sound. Erika Bachmann of Granada Hills testified that she was even told that the bonds were insured. Robert N. Bowlus of Rancho Palos Verdes, who said he considered himself a knowledgeable buyer, said he didn’t understand the prospectus, which disclosed many risks.

In some cases, bondholders were caught in contradictions on cross-examination. Harriet S. Chappuis of Los Angeles said, for instance, that she never received a prospectus. But her testimony last year before a grand jury and information she gave investigators showed that she received one two weeks before she bought a bond.

None of the investors said they knew or had talked with Keating, but the prosecution has also established that the 67-year-old Arizona businessman exercised enormous control over Lincoln and its operations even though he never held a position at the S&L.; Symes said, for instance, that he couldn’t hang a picture of his wife or family on his office wall without approval from Keating or his wife, Mary Elaine, who handled the interior designing for the Phoenician.

No bond sellers have testified yet. They had little contact with Keating until several weeks before the company halted the program. They were called to Phoenix for meetings with Keating and other executives, who rallied them to sell more bonds.

Fidel, the former Lincoln president who has pleaded guilty to six counts of state securities fraud, is expected to testify later this month.

On Oct. 15, U.S. Sen. John S. McCain (R-Ariz.) is expected to testify about a March, 1987, meeting he had with Keating. McCain, one of the so-called Keating Five senators, contends that Keating asked him to negotiate a settlement of differences between Keating and regulators, a proposition the senator rejected on the spot.

McCain, however, was among five senators who met with regulators twice in early April, 1987, to question the regulators’ yearlong examination of Lincoln.

McCain and three other senators were reprimanded by the Senate Ethics Committee earlier this year for acting on behalf of Keating while accepting more than $1.3 million in political contributions from the businessman and his associates. The committee has not yet determined punishment for Sen. Alan Cranston (D-Calif.), who was found to be the most culpable of the five.

Testimony in the Keating case is expected to continue over the next four or five months, though lawyers on both sides have said they hope to turn the case over to the jury before Christmas. Prosecutors said they hope to conclude their case by the end of this month.

Highlights and Sidelights at the Keating Trial

It was clear from the first day of Charles H. Keating Jr.’s criminal fraud trial that this was not going to be an ordinary proceeding. Here’s a collection of key moments, assorted bits of testimony and real-life theater gathered from inside and outside the courtroom.

Aug. 2--On first official day of trial, an elderly female bondholder accosts Keating in court, grabbing his lapels and demanding to know what happened to the money she put in his American Continental Corp.

Aug. 5--In rare interview as jury selection begins, Keating says, “I’m ashamed that I’m spending my final productive years doing this.”

Aug. 16--A federal judge in Arizona halts for now American Continental’s effort to recoup $24.5 million from creditors--mostly bondholders--who were paid just before Keating’s company entered bankruptcy.

Aug. 27--A 12-person jury and eight alternates are selected. Judge Lance A. Ito rules that prosecutors must show that Keating knew about fraudulent sales tactics.

Aug. 28--In opening statements, the prosecution says Keating pushed the “steady drumbeat” of his company’s bond sales even though he knew his company was financially troubled. The defense says Keating followed the law, hiring the best legal and accounting help to make sure.

Aug. 29--On the first day of testimony, Esther Bonan, 77, referring to the bonds she bought at the company’s Lincoln Savings & Loan unit, says, “To me, junk is something you throw away, not buy.”

Sept. 3--Elderly West Hollywood comedian Skip E. Lowe swats Keating twice with a powdered blonde wig as Keating walks down hallway to court. Ito increases security.

Sept. 17--An auditors’ report filed in federal court in Arizona reveals that Keating and his relatives spent $5.7 million of American Continental funds on travel and entertainment over five years, including $1,948 for some 2,000 cans of Silly String for 4,000 guests at a 1986 Christmas party.

Sept. 18--Former Lincoln Chairman Robin S. Symes testifies that Keating held such tight control over the S&L; that he couldn’t even hang pictures of his family on his own office walls without permission.

Sept. 23--William K. Black, a top regulator Keating once tried to get fired, squares off with his one-time nemesis through contentious cross-examination by Keating’s lawyer.

Sept. 24--The Securities and Exchange Commission takes its first action in nearly five years of investigating Keating by filing civil fraud charges against three former Lincoln executives, all of whom consent to orders barring them from violating securities laws in the future.

Sept. 26--Court records and interviews reveal that Keating spent more than $100,000 of his company’s money in 1987 for a fictional

screenplay about a Soviet plot to assassinate the Pope at Fatima, Portugal.

Oct. 2--Ito rules that U.S. Sen. John S. McCain can testify about a meeting he had with Keating in late March, 1987, to show Keating’s unsuccessful attempt to manipulate federal regulators who were examining Lincoln.