Ernst & Young May Settle Lincoln S&L; Lawsuit : Courts: Sources say the accounting firm has agreed to pay $40 million to the U.S. for allegedly negligent audits of the failed thrift.

Ernst & Young, the giant accounting firm, has tentatively agreed to pay the federal government more than $40 million to settle allegations that it was negligent in audits of Lincoln Savings & Loan before the thrift’s collapse in 1989, sources said Tuesday.

The settlement comes as the government was preparing to add the firm and one of its former partners as defendants in a $1.7-billion civil fraud and racketeering lawsuit stemming from the failure of Irvine-based Lincoln.

The payment to the government--$41 million in cash and up to $2.5 million in accounting services--would be one of the largest ever by a major accounting firm. It comes at a time that accountants are facing growing criticism for poor audits of troubled companies.

The agreement also could signal a quicker pace to settlement of the complex litigation involving about three dozen defendants, according to a highly placed source familiar with the litigation.

The tentative settlement must be approved by the Resolution Trust Corp., the agency that manages failed S&Ls.; Approval is expected before March 1, the deadline for adding new defendants to the lawsuit against the former Lincoln operators and their advisers.

An Ernst & Young spokesman confirmed late Tuesday that the accounting firm, one of the world’s largest, had reached a “settlement in principle.” The RTC refused to comment.

Settlement negotiations between the government and Ernst & Young heated up last month as the government prepared to add the firm and one of its former partners, Jack D. Atchison, as defendants to the RTC’s lawsuit.

The government was expected to allege that Ernst & Young’s predecessor firm, Arthur Young & Co., and Atchison aided in the filing of misleading information about Lincoln and were negligent in the 1986 and 1987 audits of the thrift. Arthur Young merged with Ernst & Whinney last year to form Ernst & Young.

Because of the settlement, neither Ernst & Young nor Arthur Young will be added as defendants in the suit. The proposed settlement does not affect Atchison, and it is unclear whether RTC will add him to the suit. He could not be reached for comment.

Lincoln was seized by federal regulators in April, 1989. Its failure is expected to cost taxpayers more than $2 billion, making it one of the largest thrift collapses ever.

The audits of Lincoln and American Continental--overseen by Atchison--showed the parent company was a profitable, financially solvent firm. The reports were used by the company to sell its bonds. But government regulators said its financial condition was actually much worse in May, 1987, when they first recommended that Lincoln be seized.

Atchison later took a job with American Continental, where he was paid nearly $1 million a year.

The accounting firm also provided written assurances to five U.S. senators that Lincoln and American Continental were healthy entities being hampered by overzealous regulators. The assurances provided the senators, including Alan Cranston (D-Calif.), with reason to question regulators in two meetings in April, 1987, about their treatment of Lincoln.

Those two meetings led to the recent Senate Ethics Committee hearings into the propriety of the senators’ interference with regulators. Each received large contributions from American Continental’s chairman at the time, Charles H. Keating Jr., and his associates.

Keating himself has been indicted on state securities fraud and is awaiting trial in Los Angeles. In addition, a federal grand jury in Los Angeles has been probing his actions at Lincoln. His lawyers have acknowledged already that he is a target of the investigation.

Ernst & Young also is facing a pending investigation by the state Board of Accountancy, which has asked a state administrative law judge to revoke the firm’s license to do business in California. While such revocation is seen as unlikely, the judge and the board have other sanctions, including temporary suspensions of licenses, that could be invoked.

The settlement with Ernst & Young surprised lawyers for thousands of small investors who poured more than $200 million into Lincoln’s parent firm, American Continental Corp. in Phoenix.

The company is now bankrupt, and bondholders have lost their money. The accounting is one of dozens of defendants in pending class-action lawsuits brought by those investors.

“I’m real surprised because Ernst & Young has been so hard-line about settling,” said Ronald Rus of Orange, one of the bondholders’ lawyers. “Typically, they refuse to settle any lawsuit.”

He praised the government for its efforts and commended the accounting firm “for recognizing the potential for responsibility.” He said the firm now should put the lives of bondholders at ease by settling with them.