The State Department of Corporations ignored warnings from one of its examiners when the agency last year allowed American Continental Corp. to sell $200 million in junk bonds to the public, according to an agency memo.
The memo, written by senior examiner Ken Endo, questioned the ability of American Continental to repay the junk bonds, which are high-yield, high-risk debt securities. The document also noted that the agency had already received indications from other state officials that American Continental had "little or no net worth."
American Continental, a Phoenix-based real estate developer, sold a total of $200 million in junk bonds in two offerings, primarily through the 29 Southern California branches of its major subsidiary, Lincoln Savings & Loan in Irvine. About two-thirds of the 22,000 purchasers were elderly people--mostly depositors who thought the investments they made were insured.
Could Be Costliest Failure
The company filed for bankruptcy April 13, an action that threatens to wipe out the investment of the bondholders. Federal regulators seized Lincoln the next day and have since declared it insolvent and put it in receivership. Analysts said Lincoln's collapse could cost the federal government more than $2.5 billion, making it the costliest S&L; failure ever.
Lawyers for bondholders say the Endo memo, written April 7, 1988, gives them a powerful weapon in their plan to sue the Department of Corporations over its role in the American Continental debacle.
"We knew the state never should have allowed this offering to be sold," said Frank P. Barbaro of Santa Ana, a lawyer for the debt holders.
Christine Bender, commissioner of the State Department of Corporations, declined to comment because of the potential for litigation.
The state agency approved one junk bond offering by American Continental in December, 1986, and assigned Endo to review a second offering in early 1988. Endo listed five "unfavorable factors" about American Continental and two "favorable factors." He did not make a recommendation.
The memo states that:
- The market value of American Continental's securities holdings was $155 million less than the $1.9-billion value carried on the company's audited 1987 balance sheet. That was sufficient to "wipe out" American Continental's net worth.
- The company's debts were $1.1 million more than earnings on its assets, and it relied on gains from the sales of securities, loans and real estate to cover general expenses. Endo warned that the company "may incur significant operating losses" if the gains were not maintained.
- Federal regulators had "requested" that Lincoln stop paying dividends to its parent company pending the outcome of a two-year regulatory examination. Without those dividends, Endo said, American Continental's ability to make payments on its debt offering could be affected.
- The company had $622 million in high-yield corporate securities, otherwise known as junk bonds. The possibility of default is greater with such bonds than with other debt securities and could impact the company's ability to repay its debt offering, the memo states.
- The agency already was aware that other regulatory agencies believed that American Continental's and Lincoln's real estate investments might be overvalued and that properly stated values would leave the company with "little or no net worth."
Endo said the factors favoring American Continental were that Arthur Young & Co., a major accounting firm now known as Ernst & Young, had given an unqualified opinion about the company's 1987 financial condition and that federal regulators had not taken any action against Lincoln despite "concern" about the S&L.;
Two months ago, officials at the State Department of Savings and Loan said they contacted the Department of Corporations' Bender and her staff to voice their concerns about American Continental's request to offer the debt securities.
Bender said at that time that she had heard numerous rumors but could get no concrete information from regulators or other state and federal authorities that would lead her office to deny American Continental's request.