As described in the beginning of this report, the proposal of a merger between the PRR and the Central was dropped after the death of Robert Young in 1957. Later, following mergers among the other Eastern roads, Perlman became concerned that the Central would be isolated. When this concern arose in late 1961, the idea of merger between the PRR and the Central was revived and negotiating committees of the boards of both railroads were formed. Isaac Grainger chaired the Central committee consisting of himself, Seymour Knox, and R. Walter Graham, Jr. The PRR committee was chaired by Richard K. Mellon and consisted of Mellon, Jared Ingersoll, and Phillip R. Clark. The responsibility of the committee was limited to setting the general terms of the merger including the exchange rate, the composition of the board, and the staffing of the several top management positions.

The negotiating committees began their work in November 1961. It was necessary for the railroads to complete an arangement within several months because other mergers were before the ICC and the Central had to determine its position before the hearings began. The committees each selected an investment banking house to set the exchange rate. The Central selected Morgan Stanley & Co. and the PRR chose First Boston Corp. These two selected the third, Glore, Forgan & Co. The principal problem facing the negotiating committees was the selection of the top officers. The Central directors felt strongly that Perlman should have responsibility for the operations in light of his performance on the Central. James Symes, chairman of the PRR, wanted to be chief executive officer despite his planned retirement in August 1962. Greenough of the PRR was expected to be Symes' replacement and so the PRR directors wanted Greenough as well as Symes to have a high position in the merged company. An impasse developed. On December 27, 1961, Grainger, Symes, and Perlman met to consider the selection of top management. Upon being pressed about problems in the selection of management Symes said that frankly the PRR directors were having difficulty accepting Perlman. The Central directors, however, were desirous of having Perlman as chief operating officer because of his performance on the Central. A caustic discussion followed during which Symes and Perlman bluntly stated their dissatisfaction with the other's management of his road. To resolve the basic dispute, it was finally proposed that Symes and Perlman would become inactive vice chairmen of the board and that the PRR would name a chief executive officer and the Central would name a president. The merger agreement was signed, and the merger began its course through the ICC and the courts.

The road to final approval was not wholly harmonious between the two railroads, and Perlman occasionally expressed the belief that the negotiating committee had given away too much and that perhaps an alternative merger was possible. Meanwhile Sounders had replaced Symes as chairman of the PRR on October 1, 1963. Saunders was formerly head of the N. & W. and was named chairman of the PRR when the railroad was unable to choose one of its own officers (including Greenough and Bevan) for the position. While discussing merger matters with Saunders in March 1965, Grainger broached the suggestion that the merger agreement be changed so that Perlman could be made president. Saunders, who was not an operating officer himself, agreed.

The negotiating committees became inactive after the signing of the agreement in 1962 and, except for isolated instances, neither that committee nor the board was directly involved in any other matters relating to the merger. The only information about the progress of the merger which the board received was oral reports from management at board meetings. Other than what was given in the oral presentations, the board did not review the savings or costs which were being forecast and they never reviewed the kind of planning being done.

As explained elsewhere in this report, the merger planning was inadequate and fundamentally flawed. The Patchell report which was presented to the ICC was not a plan for the merger nor was it intended to be. It had not attempted to set out savings or costs that would result from the actual operations of the merged railroad. Instead it was a vehicle for presenting some cost and savings figures to gain approval of the merger. The planning for some of the departments, other than the operations department was valueless. The departments of the respective roads did not cooperate and a lot of the planning did not take place until the department heads were named at the time of the merger. In the area of rail operations, where a detailed plan was formulated, the plan was ignored. Apparently no detailed plan was in effect on merger day. Little or no training was given yard crews or connecting lines and shippers.

None of the directors who testified was aware of these problems. The directors were under the impression that all necessary planning had been done and that the merger was being carried out pursuant to this planning. Most of the directors never did learn of the lack of meaningful planning or the relation of poor planning to the chaos which, occurred upon the merger of the railroads. They were also unaware that the cost and savings forecasts were not accurate. The directors have emphasized that governmental bodies reviewed the merger and that only management could be expected to be familiar with the details of the planning. It would seem reasonable, however, for the directors to have informed themselves about the underlying theories and the actual planning. According to the testimony of directors, however, no director expressed any concern or reservations about the merger during the premerger period and the board never attempted to verify the representations of management about planning progress or expected savings and costs. Neither board had a committee established for the purpose of reviewing or monitoring the feasibility of, or planning for, the merger.296 The merger of the Central and the PRR was probably one of the most complex and difficult mergers in corporate history and yet it appears that the directors did not make significant efforts to analyze it or evaluate it.

A committee of the board did review one merger related item. Under the terms of the merger agreement, the Central and the PRR were limited to $100 million in additional debt. In March of 1966, the NYC board considered a PRR request to increase their indebtedness above the ceiling. The PRR explained that the debt increase arose out of the acquisition of Great Southwest, Macco, Buckeye, and Arvida. The Central board formed a committee consisting of Grainger, Graham, and Odell to examine the request. Upon the recommendation of the committee, the board approved the increase. The approval recommendation, however, contained some reservations about the real estate investment (these had been raised by Odell):"

Independent opinions were exceedingly favorable for the Buckeye property and for the most part favorable for the real estate acquisitions. However, questions were raised over short-term prospects for the Arvida properties, and there were negative views expressed in connection with the California properties. Therefore, the committee cannot give a definitive appraisal of the overall diversification program of the PRR. While there is a feeling that real estate investments at this time would not be the committee's choice, nevertheless, it has confidence in the judgment of its partner in the merger. (Memorandum from Graham, Odell, and Grainger to Central board May 2, 1966).

POST-MERGER PERIOD

The merger got off to a bad start.2 297 For the first 6 months the directors generally were unaware of the existence of fundamental problems. They were aware, of course, that mergers do not always proceed with complete smoothness but the directors assumed that all requisite planning and preparations had been done and that the merger was being successfully implemented.

By the summer of 1968 management was admitting to the directors that merger difficulties were being encountered. Computer difficulties were cited as a principal cause of operating problems. At this time the directors were relying solely on the oral presentations of management and reports from the news media. They had no written income budget information which would enable them to judge the progress of the merger or to judge the effectiveness of management. They had no written cash flow budgets to see the rate of the cash drain. Some of the directors, however, did begin getting some independent reports on the disastrous performance of the merged railroad. They began getting complaints from shippers, including complaints from their own shipping departments. Many of the complaints were sharply worded and described extremely poor service.298 The directors, however, continued to accept the assurances of management that the company was under control.

297 Some of the directors, like management, cited the short notice they had of the final governmental approval as a major cause of difficulty. They indicated that the roads could not commit themselves to capital expenditures until they were certain that a merger would occur. The Central's management apparently had begun at least some capital items prior to the merger. The PRR, as noted in the section on finance. was desperately short of cash and could not have afforded capital items even if they were willing to commit themselves. Neither the directors nor management considered entering into a mere formal corporate merger before making any attempt to combine the operations of the two roads so that the necessary training, organization and capital investment for the orderly functioning of the merged road could be made. Saunders did emphasize the need to obtain immediate savings through an immediate operational merger. It would seem, however, that merging slowly and well would produce more savings than merging quickly and poorly. If the short notice of final approval threatened any difficulties, the merger could have been delayed until the operating preconditions had been satisfied.

298 Illustrative of the complaints being received orally and in writing by directors are the following complants received by a director located in the western region of the railroad:

(a) "We are getting more complaints on our service to Indianapolis at this time from various customers, brokers and our own sales people than I can ever remember. Most of it is traceable to our inability to get cars and to get delivery of the cars to the customers after they are loaded. It has reached the point where I dread to see any of our sales people as I know they are immediately going to start complaining to me what lousy service they are getting from our master warehouse. Frankly, we would like very much to materially increase our rail shipments and would certainly do so if the car or service problem could be solved... I do not think we would look with favor on any location served exclusively by the Penn Central We are big rail shippers and could very easily be much, much bigger. But frankly we don't know where to turn.. (Letter of Nov. 12, 1968, from an Executive Vice President of a major food processing company.)

(b) "Apparently, neither company has been successful in promptly getting cars in or out of Indianapolis under the Penn Central operation. Along these same lines, numerous meetings have been held with area sales representatives and other Penn Central personnel relating to fantastic demurrage and detention bills resulting from improper placement of cars on the siding, lack of written notice of constructive placement, poor communication and problematical service. (Feb. 27, 1969 letter.) We sincerely appreciate your interest in this problem and your willingness as our banker and a Director of Penn Central to see that this information is brought to the attention of the right people at Penn Central for correction."

"As I explained, customers of ours, such as Morton Foods, Campbell Soup, Kraft, etc., ship products for storage and distribution to our subsidiary. These are long hauls for the railroad and represent considerable volume. We are in danger of losing many of these important customers because they find it almost impossible to get good service from Penn Central in shipping to our plant in Indianapolis. This poor service is jeopardizing new business for the same reasons. Morton, for example, complains that it is taking them from 14 to 17 days to ship by rail from their manufacturing plant in Virginia to Indianapolis. Naturally, they cannot stand this situation." (Feb. 27, 1969, follow-up letter to above.)

(c) "I dislike very much to find it necessary to bring a matter of this type to your attention, but it does seem to me that unless I go higher than the local people there is no prospect of getting these industries serviced by rail. I am also willing to go on record that our dealings with Penn Central have been poor for sometime, but they are much worse since the merger, and I do not feel that Penn Central can service its shipping customers and that there is a total breakdown in the management responsibilities on a local level." (Apr. 7, 1969, letter.)

As the operational problems persisted and associated costs rose, the strain on the railroad's finances grew worse. By the fall of 1968 it was apparent to management that the cash drain caused by the operations debacle could not be absorbed for long. The drains were enormous and Penn Central had only limited access to cash. The directors have testified that while they were aware of some difficulties they were unaware of the extreme seriousness of the operational and cash problems at that time. It appears, however, that a more critical examination of management's statements would have uncovered the enormity of the problems and the urgent need for corrective action. Even if corrective action would have been difficult or impossible (perhaps because of fundamental weakness of the merger) the investors could have been warned of the magnitude of the misadventure.299 Instead they continued to receive optimistic projections.

FINANCIAL PROBLEMS AND A FIRST CHALLENGE TO DIVIDEND

POLICY

The seriousness of Penn Central's plight should have been evident since the board was required to authorize the revolving credit and commercial paper borrowings. The use of commercial paper in particular should have caused alarm because the use of such paper was almost unheard of in railroading.300 The directors have stated that these borrowings appeared reasonable to them because of the prevailing high interest rates. The use of short-term debt as a substitute for long-term debt may be justified as a temporary measure when it is decided not to roll over long-term debt at high rates or where longterm capital investments are being made. In Penn Central's case, however, the enormous amounts of short-term, high interest, borrowings were going principally to meet current operating losses. The significance of borrowing to meet staggering operating losses is that no company can long survive such a condition, regardless of the level of prevailing interest rates.

Most directors did not begin becoming concerned about the conditions of the company or its finances until the spring of 1969 when management sought and obtained authority from the directors to further increase the revolving credit and commercial paper.301 By mid-1969 the directors had approved an increase of approximately $500 million in short-term debt since the merger. Most of this was needed to meet operating losses and dividends.

During this time Penn Central routinely continued to pay dividends at the premerger rate. According to the testimony of the directors, no director expressed any reservation about paying the dividends prior to the events described below. During this time the company had to

In the summer of 1968 the price of Penn Central stock had reached a record high level and numerous officers were selling stock acquired under option prices, which at that time were only one-fourth of the market price prevailing at that time. Under these option stock sales some officers individually made hundreds of thousands of dollars.

500 The Chesapeake and Ohio, through a financial affiliate, had been the only other railroad to ever sell commercial paper. Commercial paper is usually used by companies with seasonal cash needs or by companies which routinely have sizable short-term borrowings. Railroads, however, usually have large cash flows and are more likely to have need of long-term borrowings.

201 One director presciently noted at this time that management's request for more locomotives indicated some fundamental problems because one of the major premises of the merger was that it would require fewer, not more, items of equipment.

borrow at high interest rates to pay the dividends. At the June 24, 1969 meeting the directors were faced with approving, as customary in prior years, a dividend for the third quarter. The board customarily did not meet in July and August when the dividend for the third quarter would otherwise come up for consideration. Saunders realized that there might be reluctance in this year to declare a dividend so far in advance. He inquired of the legal department about the disclosure that would have to be made if the dividend decision were postponed until a special August meeting. He was told that the postponement of the decision would have to be disclosed. This would have an adverse impact on the investing public, and he dropped the idea. At the June meeting, several of the directors began questioning the payments of a dividend so far in advance of the third quarter results. The same problem of disclosure that had troubled Saunders earlier arose again. From the testimony of one director, Franklin Lunding: Question. Was this discussed at all at the June [board] meeting, the consequences that might happen if you delayed the decision [on the declaration of the dividend] until August?

Answer. It had been customary to declare the dividend at this meeting. If you didn't declare it at this meeting, then all kinds of questions would arise, I would judge.

Question. Well, can you recall whether this problem was discussed at the June meeting, that if the decision were formally delayed until August, that this would raise questions in the financial community.

Answer. I am not sure, but my impression is yes, this was raised by either Bevan or Saunders.

The objections of the few directors were answered by having the board declare a dividend payable September 26, 1969 with the understanding that a special August meeting would be held so that the matter could be reconsidered if necessary. According to Stewart Rauch, a director:

It was June that the third quarter [dividend was declared] payable in September. It [the question of whether a dividend should be paid] was under discussion and it was concluded that further consideration should be given to it, so that the board was called in August for that purpose.

The dividend was then declared at the June meeting and was reported in the press. At the August meeting no objection was raised to the payment of the dividend even though Bevan indicated at that time that the cash drain for the year would be $295 million and that he had no idea where the $300 million needed for next year would come from. The dividend was finally dropped at the November 26, 1969 board meeting when the fourth quarter dividend came up.

INVESTIGATION OF BEVAN ABANDONED

The August 26, 1969 board meeting became an important meeting for reasons other than dividend policy. At that meeting it was disclosed that a suit had been brought by a shareholder and former officer of Executive Jet Aviation, John Kunkel.302 The suit named EJA, Penn Central, American Contract Co., Glore, Forgan & Co., O. F. Lassiter (president of EJA), Charles Hodge, and David Bevan as defendants. Kunkel alleged, among other things, that Penn Central

302 There were no public shareholders of EJA. Several insiders held stock and Penn Central had by far the largest investment.