Any such litigation would presumably be predicated upon an assertion by such a shareholder that the alleged 5 percent tax saving afforded GSC by filing consolidated Federal income tax returns with the Penn Central group, and utilizing the group's tax loss carryovers, is more than offset by the tax liability incurred by GSC in failing to avail itself of all possible tax savings in an effort to produce needed profits for its controlling shareholder. In any such suit, I would certainly testify that I have always been advised by officers of the Penn Central that I had a duty to avail myself of all tax minimizing devices possible, and that I have certainly never been coerced to produce profits at the expense of tax savings. However, and by the same token, I would have to admit under oath that GSC has always had, and we certainly value, an excellent day-to-day working relationship with our Penn Central parent, take great pride in our contributions to its earnings, and consistently make every effort possible to increase that contribution. While such evidence should conclusively show that the Penn Central has never forced GSC, through its majority control, to produce profits against the best interests of the subsidiary's minority shareholders, I can nevertheless foresee a judge and/or jury concluding (with that famous 20/20 hindsight) that we, as officers and directors of GSC, had been guilty of a conflict of interest between our majority and minority shareholders, to the detriment of the minority. A perfect example of a transaction which might give rise to such a conclusion is the sale of the Georgia and Texas amusement parks. Although both sales made excellent sense, for all the reasons previously advanced to you, and while I have no reservations about their economic validity, a disgruntled minority_shareholder_could nevertheless easily argue that GSC, at the direct instance of the Penn Central, sold two of its substantial and profitable assets solely to produce substantial profits for its majority shareholders within given financial periods.232 In making the sales, and as a necessary consideration to the investing syndicates for achievement of such substantial profits, GSC gave up all depreciation which had theretofore been available to offset the income from such profitable and productive assets. Therefore, and again with the benefit of 20/20 hindsight a group of minority shareholders could well argue that, not only was GSC's income from such assets reduced, but there was no longer available any depreciation whatsoever to offset such income; the result being that every dollar of the substantial tax savings that would otherwise be lost to the Internal Revenue Service by GSC (on a separate return basis), now amounts to a loss of 95 cents to Penn Central, at least in the form of an account payable (on a consolidated return basis), as a result of the tax allocation agreement. (Without even considering the large tax liability generated by the sales themselves.)

The threat is only thinly veiled and its presentation brought a hostile response from Bevan. Was Baker prepared to say that these transactions were done by Baker to please Penn Central at the expense of Great Southwest minority shareholders, Beven inquired. Baker was, of course, not willing to make such a statement. Bevan's point was clear: if Penn Central had harmed minority shareholders of GSC, so had the management of GSC.

Baker also noted in his memorandum that Pennco was only hurting Great Southwest by burdening it with a debt to Pennco and that, in any event, Pennco could not reasonably expect to have Great Southwest pay the debt:

As I noted earlier, if called upon immediately to pay its full account payable to Penn Central, arising from the tax allocation agreement, GSC would be unable to do so, because it just does not have the cash. By the same token, we are expected to independently finance our own operations insofar as possible, but, at the same time, our ability to do so is lessened by the fact that our balance sheet must show this resulting substantial account payable to our Penn Central parent. Again theretofore, I personally question whether, in the exercise of reasonable business judgment this is proper utilization of group financial resources.

Baker concluded the memorandum with the observation that proposed tax law changes would make Great Southwest's position even more difficult under the tax agreement. One change, a then recent 232 Emphasis added.

change in deduction of prepaid interest, was seen as bearing on Great Southwest's way of doing business:

While it cannot be termed new tax legislation, the recent change in the IRS ruling on deduction of prepaid interest has already adversely affected GSC's ability to make and consummate certain profitable real estate transactions, both as vendor and vendee.

The "certain profitable real estate transactions" included the large syndication sales that accounted for most of the spectacular rise in Great Southwest's earnings. The difficulty in completing further deals. of that sort would not have any relation to the tax agreement but it would affect Great Southwest's abilty to continue its growth rate in earnings.233 It appears that the reference to this difficulty appears principally to inform Bevan that Great Southwest management could not hope to repeat past performances regardless of the pressure from Penn Central. Indeed, despite continuing pressure and frantic efforts by Baker, Great Southwest was not able to find other deals.234

The tax agreement was not cancelled but Great Southwest was never required to pay any cash. On the last day of 1969, Pennco accepted GSC stock in exchange for debt arising out of the agreement and for debt existing from previous cash advances from Pennco to GSC. The tax agreement did not affect activities because Great Southwest had already sold its principal assets and the changes in the tax ruling made these and other schemes more difficult to complete. At this point Great Southwest was well on its way to generating its own tax losses.

OFFICER EMPLOYMENT CONTRACTS

When Macco was acquired by Pennco, the principal officers were required to enter into employment contracts providing for their exclusive employment and for additional compensation when Macco's earnings exceeded certain amounts.235 The terms for compensation were based on the performance levels of Macco which were projected at the time of Pennco's acquisition of the company. No employment contracts existed for Great Southwest officers.

By the late spring of 1968, many of the original officers of Macco had left. They had been replaced by Baker and his appointees. At the request of Penn Central, Baker, Ray, Wynne, and Caldwell 236 executed employment contracts on June 3, 1968. The contracts provided that Wynne would receive as additional compensation over and above his regular salary, 3 percent of the net income before taxes in excess of $10 million; Baker would receive 2 percent of such an amount and Ray and Caldwell would receive 1 percent.237 Based on 1968 results Wynne earned $299,027, in additional compensation; Baker earned $199,158 and Ray and Caldwell each earned $99,675.288 In the years preceding 1968, there appeared to be little likelihood that the employment contracts would require any payments. The results for Macco and Great Southwest even when combined were well below the $10 million threshold.

233 In October 1969, GSC had to abandon a proposed public offering because, among other things, it would have had to disclose that tax changes made it unlikely that its profits could continue.

24 The last such deal was Six Flags Over Texas which was sold at the end of the second quarter in 1969. This sale coincided with the highest price for Great Southwest stock (40). From that point the value steadily declined to 16 at year end and to 5 at the bankruptcy of the railroad.

25 Wynne was to receive 3 percent of earnings in excess of $10 million and four other officers would each receive 1 percent of such earnings. Wynne was an officer of both Macco and Great Southwest.

226 Wynne and Caldwell had previously been Macco employees under contract.

The contract period was from Jan. 1, 1968, to Dec. 31, 1972.

a These sums were in addition to basic compensation of $25,000, $60.000, and $55,000, respectively.

1964.

1965 1966. 1967

1968_

$928, 857 1, 918, 974 4, 731, 631 6, 711, 616 25, 426, 215

Baker and Ray have stated that they were reluctant about entering into these contracts because they disliked the requirement of exclusive employment for the duration of the contract. However, at the time they entered into the contract, the idea of syndication was well developed and much planning had been completed. They would have known of the benefits they could reap through syndications. It appears that Bevan had determined that the bonsues would be worth the price in the encouragement they would give Baker and Ray to push for profit maximization.

The size of the remuneration being received by the officers for 1968 alarmed Saunders when he learned of it. He was particularly concerned by the possible reactions of Penn Central directors if they were to learn of this generous remuneration.239 Gerstnecker was assigned the task of negotiating a new employment contract. New contracts were entered into on June 4, 1969. In settlement of the previous contracts Wynne was paid $3 million in cash. Baker was to be paid $2 million over 10 years and Ray and Caldwell were to receive $1 million each over 10 years. The new contracts provided additional compensation for Wynne, Baker and Ray of 3, 2, and 1 percent of earnings of the combined Macco and Great Southwest entity in excess of $35 million in 1969; $40 million in 1970; $45 million in 1971 and $50 million in 1972.240 The contracts were to expire on December 31, 1972. The additional yearly compensation was limited to $125,000 for Wynne; $100,000 for Baker and $75,000 for Ray.

241

Disclosure about the agreements was a concern shared by Saunders and others at Penn Central. Great Southwest itself could look forward to disclosure in a prospectus for a public offering then being planned. Gerstnecker informed Bevan that the settlement as worked out would avoid the more damaging aspects of disclosure:

If approved by the Board of Great Southwest, it [the termination and new agreement] will, of course, become an accomplished fact and can and will be discussed in only general terms in any future prospectus with the settlement agreements being only a historical fact which will have resulted from the merger of two companies and the new contracts having a ceiling on compensation to the extent of no more than twice of their base salary.242

Saunders was also concerned with whether the new agreements would insure the continued performance of the GSC management:

I understand Mr. Gerstnecker believes, and I gather you also agree, that the new settlement and agreement will provide sufficient incentive for these officers to maximize earnings.243

As with many of Penn Central affairs in these years, attempts to conceal one aspect of the activities created a chain reaction which itself had to be covered over as best as possible. With the employment contracts, the initial incentive payments exceeded propriety when 239 The Penn Central directors were unaware of the compensation being paid or the amount paid for renegotiation. Most of the directors admitted to surprise or shock when informed of the magnitude of the compensation and settlement. 240 Base salaries were $125,000, $100,000, and $75,000 for Wynne, Baker, and Ray respectively.

241 Caldwell was to receive a base salary of $55,000 plus compensation of 1 percent of the excess of Macco earnings only. 242 Memorandum from Gerstnecker to Bevan, May 29, 1969.

243 Memorandum from Saunders to Bevan, June 2, 1969.

Great Southwest and Macco engaged in schemes to maximize reported earnings. Costly settlements then were entered into to limit the exorbitant compensation. The terms were described in the April 22, 1970, Great Southwest proxy, but as Gerstnecker observed, Great Southwest was able to describe it in terms that were historical and whose impact was unclear to one who did not know of the full circumstances or the true nature of the earnings on which the compensation was based. In fact, the settlement was made necessary because of the Macco "earnings" surge which was caused principally by the Bryant Ranch transaction.244 Macco never repeated such a sale so it can be said that Macco paid the principal officers $7 million for producing a booked profit of $10 million.245 Penn Central shareholders were not informed of this cost of producing the Macco "profit" and the Penn Central directors remained ignorant of the matter.

ABANDONMENT OF PROPOSED OFFERING OF GREAT SOUTHWEST STOCK

By the late spring of 1969 plans were being made for a public offering of Great Southwest stock. At the annual shareholders meeting in Philadelphia on May 13, 1969, Bevan told the Penn Central shareholders:

In this connection, and I think this is important, we anticipate in all probability selling a relatively small portion of our Great Southwest stock this year. This will allow us to recoup a part of our investment, but what is probably more important, it will also create a floating supply of Great Southwest common stock and a good market for that company's stock. At the same time it will enable Great Southwest to finance its future needs through the use of convertible issues or through the sale of stock in the market, thereby again enhancing its potential and ability to grow in the future.

At a board of directors meeting of Great Southwest Corp. on June 4, 1969, the directors approved the preparation of a draft of a registration statement under the Securities Act of 1933, in connection with a proposed issuance of 1 million shares of preferred stock and an additional offering by "certain shareholders (in reality Pennco] of shares of common stock of the corporation held by them.'

By October 1969 the offering had taken the form of a sale of 700,000 shares of GSC cumulative preferred stock for $35 million together with a secondary offering by Pennco of 500,000 shares of Great Southwest stock from its holdings.246 The origin of this proposed offering is not clear, but it appears to lie with Penn Central management.247 248 As Bevan told the stockholders, Pennco could recoup part of their investment and also create a larger market for the stock.249 The offer

24 See page 127.

245 The formula used by Penn Central management was purportedly based on projected increasing profits through the years of the contract. Penn Central management, however, was aware of the kind of transportation that had produced the "earnings" surge and must have known that there was no hope of continuing the charade, particularly in light of Great Southwest's critical cash problems.

It appears that the offering was delayed in part by possible problems under Sec. 16 of the Exchange Act because of other recent transactions in GSC stock by Pennco.

247 Most of the parties to the offering gave vague answers about the origin and demise of the offering despite the extensive work done and the sudden termination.

24 From Baker's testimony:

A. This was something that the railroad specifically wanted done in terms of this offering. I don't think anybody at Great Southwest was very much in favor of this kind of offering, because of the difficulties it presented to us management-wise.

Q. Who at Penn Central was the individual or who were the individuals?

A. Mr. Bevan was the only one we reported to.

As Bevan spoke to the shareholders, GSC stock prices (high bids) were touching record levels: 1964-28; 1965-42; 1966-4%; 1967-4; 1968-13%; Jan. 2, 1969-13.7; May 13, 1969-40.25 (record high bid); May 19, 1969-33.25; Dec. 31, 1969-16.

Adjusted to take into account a 10 for 1 split on Apr. 11, 1969.

ing of cumulative preferred would, of course, produce badly needed cash for Great Southwest. This motivation would grow greater later in 1969 when the railroad itself increasingly began to rely on Pennco to meet the railroad's desperate cash needs. There was one major obstacle to satisfying the desires of Pennco and Great Southwest: the offering would have to be made by means of a prospectus which met the disclosure requirement of the Securities Act.

In light of the way the affairs of the company were being conducted by the managements of Penn Central and Great Southwest, it was inevitable that the price of full disclosure would be very great. Indeed, it would appear that from the beginning the price would have been more than Penn Central or Great Southwest could pay. Full disclosure about the affairs of Great Southwest would certainly cause a drop in the market price of Great Southwest stock. Pennco's most valuable asset in mid-1969 was its approximately 25 million shares of Great Southwest stock (when valued at market price). Pennco, in turn, was about to be used as a financing vehicle for the railroad. Every drop of one point in the price of Great Southwest decreased the value of Pennco's portfolio by $25 million and such a market decline would clearly threaten the ability of the railroad to use Pennco as its last source of cash,250 251

By the end of September, a draft prospectus was in existence and was being reviewed by Penn Central counsel. The offering was almost ready for filing of a registration statement with the Commission. Wynne told the Great Southwest directors on September 23, 1969, that the company planned to file the registration statement within the next 10 days. A draft prospectus bears a proof date of October 13, 1969. This was the last draft that was printed. At this time John Harned of Glore Forgan, the underwriters for the proposed issuance, was in Dallas for the final arrangements. Harned, who had been involved in the initial planning in the summer, was becoming increasingly concerned about the kind of disclosure that would have to be made. Most of Great Southwest's earnings had come from the selling off of their principal saleable assets and there was considerable doubt as to whether this activity could be continued.252 253 Harned was particularly concerned about the impact that disclosure would have on the market price of Great Southwest stock:

I had analyzed the company in great detail of the Great Southwest, in great detail, and I had come to the conclusion if the company were to make full disclosures of the business as it was then operated, then, in my judgment the more sophisticated community would tend to discount the earning power they had and there would be a serious selloff of the stock in the company.

250 The market value of Pennco's portfolio was also important in connection with existing financings. In connection with certain borrowings the lenders had been assured through debt coverage provisions that Pennco's assets would not drop below a certain percentage of the outstanding debt. A serious decline in the market price of Great Southwest stock could create difficulties under these coverage provisions.

251 In the last week of 1969, after GSC stock had been in constant decline, several members of Penphil (including the two officers in Penn Central's Securities Department) began buying GSC stock. Their purchases constituted most of the buy side that week and it is possible that this was an effort to hold up the price of GSC as of the last day of the year against a time when Penn Central might need to cite Pennco's portfolio market value as of year end. The buyers denied any such effort.

252 The sale of Six Flags Over Texas in June 1969, was the last major sale that GSC was able to make despite what GSC management admits were feverish efforts to devise further sales of property.

258 There were other activities which presented disclosure problems, but the dubious nature of most of GSC's earnings was a decisive problem of disclosure for GSC.