In an article on Saunders appearing in Nation's Business in January 1970, William Lashley, Penn Central's vice president of public relations, pointed out that American railroads, largely because of mergers, were in far better financial condition than in many years. Five months later, after extended efforts to stave off bankruptcy, Penn Central filed for reorganization. And despite the months and years of optimistic statements emanating from Saunders' office, he now began to characterize the prebankruptcy situation as basically unmanageable.

EARNINGS

The steps being pursued to minimize apparent earnings problems and the necessity of full disclosure of the course of conduct adopted have been described previously in the section on income management. Yet disclosure both as to the overall picture and as to the material individual items incorporated in the course of conduct was negligible. As with the operational situation just discussed, the picture was one of deliberate overoptimism. The pattern was reflected not only in an overstatement of earnings, but in deficiencies in other disclosures as well. These deficiencies encompassed the manner of presentation, as well as the content and emphasis, of information which was provided, and the omission of significant information required to adequately inform the investing public. Indeed, the situation was such, according to testimony from the former Penn Central comptroller, that there were some quarterly earnings releases to which he would not have put his name.

RAILROAD EARNINGS

Since the focus of Penn Central's earnings problems lay in the railroad area, it was essential that results in this area be made clear to shareholders, investors, and the public. Instead, the manner in which operating results were presented served to conceal the problem. Railroad operations were clearly deemphasized, and never presented in a form in which their full impact was shown. Consolidated results were emphasized and for a period, over the objection of the press, analysts, etc., were the only figures presented. Even Transportation Co. results, on an unconsolidated basis, contained very substantial amounts of nonrailroad income and expenses, which greatly improved the company's apparent results. This factor was further confused by the company's practice of referring to Transportation Co. results by such descriptions as "railroad system" or "parent railroad company" in quarterly earnings releases and similar situations.

The figures showing the full loss in the Transportation Co.'s rail operations were available for internal management purposes. Rail industry security analysts also make a practice of computing such figures, further emphasizing their significance in assessing company results. Saunders' testimony indicates that he fully recognized the dominant importance that professional analysts attached to the railroad-only aspects of the total earnings picture. Furthermore, the underwriters in preparing the offering circular for the $100 million Pennco debenture offering insisted on recasting the reported figures to focus on the unsatisfactory status of the rail activities. This form of presentation was particularly critical, they felt, in light of the rapidly

**

deteriorating trend in this area.364 The suggestion by Day to Saunders in December 1969 that "we have been tending to cover up poor results from railroad operation rather than exposing them ** presenting the railroad operation by itself would require a number of adjustments but I really feel this should be done," reflected his concern that the Government, rather than the shareholders, be made aware of the existing situation.365 Nonetheless, it illustrates once more the critical nature of this information.

The reported income figures over the postmerger period have been included in exhibit IG-1, which indicates consolidated figures, Transportation Company figures, net railway operating income figures, and the full loss on railway operations. The emphasis in press releases was on the consolidated figures. In no instance was the loss on railway operations clearly labeled, although in some cases the net railway operating income, which did not include such factors as fixed charges, was given. The "loss on railway operations" figures were not given to the public until 1970, when they were included in the Pennco offering circular. However, they have been included herein for comparative purposes. It is suggested that the reader review the annual reports of 1967, 1968, and 1969 in light of the results from railroad operations given in the chart.366

While not indicating the full extent of the drain from railroad activities, management did attribute the somewhat lower reported earnings in 1968 and 1969 to poor rail results. However, they took pains to suggest that future results would be better. "We regard our railroad as the asset which has the greatest potential," Saunders stated in late 1969. Predictions as to earnings, even those for the next quarter, were consistently overoptimistic. The merger savings potential was constantly alluded to. Even where problems were admitted, they were couched in optimism. The situation was particularly misleading during the later periods where, while citing the potential for longer term improvements, the company's immediate solvency was at stake. Future improvements were hardly relevant if the company could not survive that long.

NONRAILROAD EARNINGS

Concealment of the full impact of railroad losses was aided by the policies pursued in the nonrailroad area. As noted, the railroad losses and total reported earnings, whether on a company-only or a consolidated basis, were two very different figures. Helped along by the various investment and real estste transactions described previously, Penn Central thus managed to show profits, or at least reduced losses, despite the rapid deterioration in the railroad. If these represented regular cash earnings which could be maintained over subsequent years to offset the inevitable rail losses, it was one thing. But, to paraphrase a remark attributed to Saunders as early as 1967, the attitude seemed to be that if no other avenue was available, the

364 Under current SEC rules, adopted in 1970, there is a requirement that total sales and revenues together with income or loss before taxes and extraordinary items be reported for each line of business which provides 10 percent or more of either the revenues or the income reported. This rule was proposed and published for comment in September, 1969.

365 See further discussion on page 165.

366 See exhibit IG-1 at end of this section. It should be noted that the calculation of railroad-only earnings, at least on a rough basis, was not difficult since it involved merely a rearrangement of figures already provided in the company-only statement. However, the reader had first to recognize the relevancy of the fig ures and what to base the calculations on.

company should mortgage its future, and take the income now.367 This is clearly what was happening in many instances in Penn Central in 1968 and 1969, as earnings were manufactured under the needs and circumstances of the moment. To make the situation still more serious, despite Penn Central's voracious appetite for cash, many of these transactions generated paper, not cash, earnings.

Such factors, if brought to the shareholders' attention, would certainly raise concern. The question becomes whether this was in fact done, an issue which involves not only what information was and was not provided, but whether the information which was given was sufficient. The complexity of the Penn Central operation is relevant in this context. Illustrative of the problems entailed is a comment contained in a letter from one of Penn Central's directors to Saunders in late 1969, complaining about the quality of the information being provided to that body: 368

Even if you yourself have a clear picture of these objectives, it is most difficult for your directors to have one unless a careful job is done of painting a clear one for us.

Cole, noting that the writer seemed to have put his finger on the problem, commented to Saunders:

This is a valuable reminder. Being immersed in these matters, it is easy to forget that people outside of management may not understand where the various items covered in the reports fit into the overall picture.

However, considering the overall pattern of conduct by the management group, as illustrated throughout this report, it is clear that management did not "forget" the complexity involved, it "used" it. And obviously the shareholders were in a far poorer position to demand information than were the directors.

Some information was provided; e.g. the financial statements themselves and limited descriptive data related thereto. However, it was left up to the investor to attempt to figure out from the melange of information given, just what these earnings consisted of. This was difficult to do. Even the limited information which was provided was scattered throughout the reports in such a way that it was a real challenge, even for the expert, to put it together. Under these circumstances, and with management continually extolling to shareholders the benefits of diversification, it is easy to see that investors would be misled. Indeed, considering the complexities of the situation, even a complete list of all the questionable items entering into the earnings picture would not constitute full disclosure unless the presentation was structured in such a way as to make the pattern evident. And in the actual situation, not only was the overall picture not drawn by management for the investor or shareholder, but he was not even given many of the pieces. The following discussion of the various releases and statements concerning earnings will focus principally on these individual pieces.

DISCLOSURES RELATING TO 1968 EARNINGS

The improvement in earnings in the first quarter of 1968 which was attributed by Penn Central to merger benefits has already been mentioned. A 17-percent increase in consolidated income and a 15

See p. 40.

See further discussion on p. 164:

percent increase in earnings for the "railroad system" was reported. The first full quarter after the merger was the second quarter of 1968. Penn Central reported a 15-percent increase over the earlier period. This reflected, it was stated, the continuing benefits of the diversification program with a 57-percent increase in net income from sources other than railroad operations. "The true index of Penn Central's profitability is in the consolidated figure and not those of the railroad alone," and thus in the future, only consolidated earnings would be reported, the company indicated in its press release. For this period, however, earnings of the "railroad system" were still reported. The figure given was profit of $2.1 million. It was not disclosed that the railroad had lost $20 million and the difference was derived from real estate and investment activities of the Transportation Co.369 The release closes with the statement that Penn Central anticipated that earnings for the rest of 1968 would surpass 1967 results, a reference apparently to rail results, although this is somewhat unclear. When third quarter results were announced, they did show an increase over the 1967 period, an increase of 48.6 percent. Reported earnings were $15.2 million, compared with $10.2 million reported for the prior year. Once again it was noted that this reflected the continuing advantages of the diversification program. Actually, however, it reflected the one-shot advantage of the Washington Terminal dividend. While the release did disclose that the earnings figure included a "nonrecurring dividend of $13.5 million from a company in which Penn Central has a half-interest," shareholders were assured that there were substantial nonrecurring items of net income in practically every quarter. An alert shareholder would have perhaps discerned that Penn Central had very little profit except for that dividend, although there was nothing from which he could deduce its noncash_nature. And as indicated earlier, there is a real question as to whether this was properly booked as income.

True to its word, Penn Central did not report railroad earnings for the third quarter, although a reference to the fact that results of the railroad system had been adversely affected by several factors would give some indication of possible problems. In fact, net railway operating income was down sharply and the loss on rail operations, including fixed charges, was over $40 million. Saunders, while not giving these figures, did indicate that he felt the third quarter marked the low point in railroad business for the year.

The company's decision not to release company-only results had repercussions. A memorandum from the public relations department to Saunders on November 4, 1968, noted the following:

Attached is the only newspaper account we have seen to date on our figures reported to the ICC. I understand that many brokerage firms, however, get Xerox copies of our R&E and IBS statements from a service in Washington which gathers this information as soon as it is filed with the ICC.

In view of this, I suggest that we reappraise our decision not to report railroad system earnings when we report our consolidated earnings quarterly. Not reporting them has irritated both newsmen and security analysts. Their reaction is to probe deeper into railroad figures than they would ordinarily if we give them highlights of the railroad picture along with our consolidated earnings.

If you decided to reinstate giving railroad earnings, it could be announced at our November 21 meeting. I am sure that this announcement would be greeted with great enthusiasm.

369 The term "Transportation Co." is being applied to the Company-only operations of Penn Central throughout the postmerger period, although the name was not adopted until late in the period.

And the policy was thereafter reversed. It had been a failure. Rather than deemphasizing railroad losses, as management desired, it had merely served to emphasize them.

On January 30, 1969, Penn Central reported consolidated earnings of $90 million for the full year 1968, a 27-percent increase over 1967, and fourth quarter earnings of $38 million, up 32 percent. The release indicated that the growth came through the diversified holdings and from certain nonrailroad transactions, mentioning in particular Madison Square Garden and Washington Terminal. No indication, however, was given as to the size and type of these two transactions. The Bryant Ranch and Six Flags Over Georgia transactions of Great Southwest were not mentioned.

Analyzing first the fourth quarter figures, if the effect of the $36.1 million in paper profits recorded on the Madison Square Garden and Great Southwest transactions were eliminated, the profit would be virtually wiped out, and, for reasons stated earlier, the staff believes that these were improperly booked as income. Likewise, elimination of the Madison Square Garden profit would have turned a $2 million loss of the Transportation Co. in that quarter into a $23 million loss. Furthermore, had it not been for a $5 million profit on the reacquisition of company bonds the Transportation Co. loss would have been larger. A $12 million profit of Pennco's disposition of N. & W. securities further improved results that quarter, although this item, unlike the others, was in part a cash transaction. Nonetheless, considering the nature, size and impact of these transactions, disclosure was called for, although none was made.

From the foregoing discussion, it is clear that Penn Central on a consolidated basis earned virtually nothing in the second half of 1968 and on an unconsolidated basis had a large loss. A profit had been recorded in the first half of the year, and on a full year basis, after elimination of improper items, some profit, although only a fraction of the original amount, still existed. However, in appraising these earnings, the various items described previously in the discussion relating to Penn Central's course of conduct should be considered. This includes in particular the charging of the mail handlers to the merger reserve, the failure to write off Executive Jet or consolidate Lehigh Valley, and the $10 million in profits generated from repurchase of company bonds.

The 1968 Penn Central report to shareholders, mailed in late March 1969, contained basically 370 the same earnings figures as did the January release, and with the same limitations. The letter to shareholders included in that report stressed the positive, beginning with an announcement of the 27-percent increase in consolidated earnings, which "underscores the importance of our diversification program.' Saunders and Perlman, who signed the letter, further stated:

We hope this Annual Report will help our stockholders to understand more thoroughly the diversified nature of the new Penn Central. Our company has grown from traditional railroad operations, which utilize about half of our total assets, into a broadly based organization with increased earning power.

They further went on to note that the four companies involved in the diversification program of the mid-1960's had doubled their contribution to Penn Central's net income, from $22 million in 1967 to

*70 There was a small difference in the company-only figures.