In a stinging setback for the government, a U.S. District Court judge in Topeka, Kan., yesterday ordered federal thrift regulators to immediately return a large Kansas savings and loan to its former owners.

U.S. District Judge Dale E. Saffels ordered the reinstatement of the former directors and managers of Franklin Savings Association of Ottawa, Kan., who fought the takeover by the government's Office of Thrift Supervision (OTS).

Saffels ruled that the OTS acted in an "arbitrary and capricious" manner when it placed Franklin in conservatorship in February.

The decision was a major blow to regulators, who are facing a growing number of challenges to their legal authority to seize troubled thrifts. Saffels's ruling is the first in which a court has found the OTS was unjustified in taking over an institution.

The government has taken control of hundreds of failed and troubled institutions in the savings and loan cleanup at a potential cost to taxpayers of hundreds of billions of dollars.

Saffels said the government must turn over control of Franklin by 10 a.m. today, but officials at the OTS said they will ask for a stay of the order this morning.

"We firmly believe the government acted in a timely and proper manner in taking over Franklin, an institution that was being operated with insufficient capital and in an unsafe and unsound manner," said OTS chief counsel Harris Weinstein.

Franklin was a small-town savings and loan that grew into one of the nation's largest by paying top interest to bring in insured deposits and then investing the money in high-risk mortgage futures. Franklin founder Ernest Fleischer and a team of inventive financial advisers claimed they had created a system that allowed them to use financial futures contracts and other exotic investment tools to virtually eliminate any risk.

When the government seized Franklin, regulators said Franklin executives had used improper accounting methods that allowed them to record any profit they made but to put off recording any losses. Regulators claimed Franklin had improperly deferred $119 million in losses, paying out $45 million in shareholder dividends when it was short of capital.

But Saffels, in a 94-page ruling capping a five-month trial, said Franklin's capital level in fact exceeded regulatory requirements.

"The facts of this case clearly show that the regulator acted wrongfully in imposing the conservatorship," wrote Saffels, a former chairman of the Federal Home Loan Bank of Topeka. "Members of the OTS Topeka staff appeared to lack adequate training and understanding to evaluate the nature of Franklin's operations."

Franklin, based in a farm town of 11,000, had $11.4 billion in assets at the time it was seized, much of it in the form of deposits wired in by brokers looking for high interest rates.

"This is the result we have been working for all along," Fleischer said in a statement released by his attorneys. Fleischer added that he is eager to retake control of the thrift.

Saffels's ruling noted that "this is not a case involving an infamous or notorious savings and loan association... . This is not a case involving fraud, corruption or self-dealing by the management or directors of Franklin.

"Any problem in the reacquisition of control by Franklin's management is a direct result of the OTS's wrongful conduct in February 1990," he wrote.

Saffels retained jurisdiction in the case for the next 90 days, which prevents the OTS from putting the institution back into conservatorship without his approval. After that time, the OTS could move against the thrift again, which would likely result in more court hearings, Saffels told reporters. "And we'd probably start all over again," he said.