ICC approach to the New Haven repair costs and the long haul writeoff was adopted. While these two items were noted in the footnotes to the 1969 financial statements, no effort was made to clarify for shareholders the complete loss on rail operations. This was true even though by the time the report to shareholders was issued, the company was on the verge of collapse because of still further deterioration in this factor in the first quarter of 1970.

It might also be noted that any one of a number of factors could have turned Penn Central's meager 1969 consolidated profits into a loss. Elimination of the Six Flags Over Texas transaction, for example, would have resulted in a sharp loss. Reclassification of the gain reported on Penn Central's N. & W. investment as extraordinary income would have had a similar impact. Consideration should also be given to what the effect would have been of the consolidation or write-down of Lehigh Valley, the write down of Executive Jet or Madison Square Garden, the expensing of the New Haven repair costs, or the effects of a multitude of other possibilities discussed in an earlier part of this report whereby management took the route of maximizing income. No hint that such a policy was being followed was given to shareholders who were expected to blindly accept what was being handed to them by management.

Actually, while the figures given in the February 1970 release dealing with 1969 earnings were poor, the text itself was remarkably optimistic, or at least very bland, considering the problems then extant. The 1969 annual report sent out a few weeks later was somewhat more realistic. By this point of course the dividend had been eliminated, so the chairman's opening statement in the shareholder's letter accompanying the 1969 annual report could have come as a surprise to no one, "The year 1969 was a very difficult one for Penn Central. Our problems were principally centered in the transportation company and some of them were beyond our control." It might be noted that by this point management knew the first quarter 1970 results were a disaster.

Obviously, no shareholder would be overjoyed by the 1969 decline in earnings, especially after elimination of the dividend. Some explanation was clearly required. Saunders, in the letter to shareholders, went on to list and describe seven problems-inflation, delays in securing rate increases, economic slowdown, passenger deficits, merger startup costs, abnormal weather conditions, and strikes, although he admitted that even under optimum conditions, the company might not have been able to overcome the effect of these problems. He then outlined steps management was taking to improve the situation. The picture thus painted was one of a management aggressively moving to deal with a series of problems, most of which had been listed as excuses for poor 1967 and 1968 earnings as well. While management was in all likelihood attempting to improve the situation, no indication was given of the desperateness of the circumstances.

The discussion thus far has dealt principally with railroad operations. However, management in its statements regarding 1969 earnings results pointed out that the Great Southwest-Arvida-Buckeye group had increased its contribution to consolidated earnings to $53 million, 21 percent over the 1968 level. A very careful reading of the report to shareholders would further show that the growth came entirely in Great Southwest. As described earlier, this company's ability to sustain

that rate of growth was in serious question in light of the nature of the earnings being reported and the efforts being made to generate immediate earnings at the expense of future operations. The then recent action in calling off Great Southwest's proposed public issue because of the feared effect of forced disclosure of such factors certainly brings into clear focus their critical importance. Instead of warning the shareholders about this, Saunders, in his annual letter told them:

The impressive performance of our real estate subsidiaries is described in this report. Income of $137 million-derived from real estate operations, investments, and tax payments from subsidiaries was used to support our railroad operations during the past year.

These assets have proved invaluable to us and we are confident of their continued success. Their health and strength will enable us to use them in our financing program for 1970.

While "renewed emphasis was given to diversification through growth of [Great Southwest] in order to broaden the company's base of earnings," no information was given whereby the investor could judge the quality of that subsidiary's overstated earnings.384

DISCLOSURES RELATING TO 1970 EARNINGS

Announcement of earnings for the first quarter of 1970 came on April 22, 1970, amidst preparation for the $100 million debenture offering. While the disclosure requirements on the part of the company were not increased because there was an impending offer, it seems apparent that the liabilities that could arise from the offering, affecting not only the company but others involved in the underwriting process, had an impact on the degree of disclosure made.

The Wabash exchange involving a $51 million profit and the Clearfield Bituminous Coal intercompany profit of $17.2 million were both of such a size and impact on the disastrous first quarter results that they could not safely be ignored. While in the initial drafts of the release announcing the earnings for the period disclosure as to the items was buried near the end of the release, it was eventually pushed up to the front at the insistence of attorneys for the company and the underwriters. However, disclosure as to the Wabash exchange did not extend so far as to indicate the manufactured nature of that $51 million gain, involving as it did acceleration of a transaction which was to have occurred later in 1970, nor did it encompass information as to the very significant benefits Penn Central had given up to enable it to thus paint the first quarter earnings picture. Likewise, the disclosure that the Transportation Co. statements included an intercorporate profit of $17 million represented improved disclosure. However, that improvement did not extend so far as to indicate that the loss on railway operations was $100 million that quarter, although

384 In contrast, at the underwriters' insistence, the following was included in the offering circular for the $100 million debenture offering:

"Great Southwest records sales of land and buildings in the year of sale and generally takes the full sales price into income even though in many instances a substantial portion of the sales price is payable over an extended period of time and may not include personal liability of the purchaser so that the collection of the total purchase price may be dependent upon successful development of the property. A substantial portion of Great Southwest's real estate sales in 1968 and 1969 are in this category and were made to a limited number of individuals. The Tax Reform Act of 1969 and other recent tax rulings have made investments in properties of this type less attractive to individuals. For this and other reasons, including general economic conditions and the difficulty in obtaining mortgage financing, there can be no assurance that such sales will continue.

"In the past Great Southwest has been able to make substantial real estate sales by accepting the prepayment of several years' interest. However, by reason of a November 1968 release of the Internal Revenue Service limiting the deductibility of prepaid interest, the number of prepaid interest transactions may decrease substantially, and Great Southwest's sales may be adversely affected thereby."

this class of figure was, at the underwriters insistence, being included in the offering circular then under preparation. Obviously, a $62 million figure, the net Transportation Co. result, was bad enough— $100 million would suggest that the entire amount Pennco was then trying to borrow for the railroad's use could be wiped out in just one quarter!

CASH FLOW AND FINANCING

Penn Central's voracious appetite for cash was described in an earlier section. As noted therein, this necessitated huge amounts of external financing. When the company's ability to borrow ran out, it was forced into bankruptcy. Neither of these two elements, the current cash drain combined with the reasons for it, and the company's ability to continue to finance these drains, was presented to the shareholders in any meaningful way, although by this point it must have been clear to management that these were perhaps the most immediately critical factors for investor consideration.

Realistically, shareholder reliance on management to warn them of impending financial disaster in a situation such as that confronting Penn Central is necessarily great. There are many intangibles involved, and management's knowledge and ability to put the pieces together obviously far surpasses that of the average investor. Financial statements alone cannot be counted on to do the job, and most certainly not the financial statements containing the limitations present in this case. Thus, the public was clearly dependent on the willingness of Penn Central officers to provide them with a realistic appraisal of the situation, and management was not "willing." The issue here, however, involves not merely good will or free choice on the part of management, but involves obligations imposed under the Federal securities laws. During the merger hearings of the early 1960's, Bevan, Symes, and others had discussed in considerable detail the difficult financial situation facing the two roads. Railroad operations, they pointed out, were consuming huge amounts of cash. On the other hand, because of the poor earnings record, the securities of most railroads had a very poor reputation and it was difficult to find sources of financing. As a consequence they had often been forced to rely on types inappropriate to their needs-for example, short-term sources to meet long-term needs. Bevan decried the weakened working capital position, which he suggested, reflected a reduced ability to withstand bankruptcy. Symes described some of the repercussions of the earnings and cash situation including deferral of necessary capital expenditures and maintenance, liquidation of assets, and shrinkage of plant and equipment.

The merger finally came in 1968 and, with it, glowing public statements about plans for financing devices which would be employed. At the 1968 annual meeting Bevan reported, "We on the financial side are taking such steps as we deem necessary to meet the challenge of a new and dynamic company by revamping its corporate structure to provide management with the most modern tools available to meet future capital requirements, which we know are going to be large.' Thus, the public was conditioned to view with favor, rather than alarm, the very substantial financing which it was recognized the future would bring. Bevan noted plans for the issuance of debentures, preferred stock, and some time in the future the possibility of a blanket mortgage. Suddenly, the avenues for financing seemed very broad, in

contrast to the bleak picture painted in the merger hearings. Yet realistically, the possibilities of implementing such grandiose plans, although mentioned throughout the 1968 period, were remote.

The most specific plans alluded to involved the revolving credit and commercial paper. These programs, in fact served as the major postmerger financing devices. Purported advantages in the use of these devices were pointed out. At the 1968 annual meeting Bevan noted that "they should provide the flexibility with which to meet suddenly arising problems quickly." An August 1968 press release referred to the flexibility of commercial paper and the lower interest costs it offered in the present market. No mention was made of the risks involved in using short-term capital to meet what were essentially, at best, long-term needs.385

In his speech to the New York Society of Security Analysts on September 5, 1968, Saunders presented basically the same favorable picture concerning the financing outlook. Yet, just a week earlier Bevan had written him a memorandum describing the critical cash situation at the time of the merger, and saying that the difficulties in overcoming this problem had been compounded by a $48 million deficit on railroad operations in the first 6 months of 1968,386 and a cash loss of $131 million in the first 8 months of the year. "This drastic cash drain is going to have a very serious effect, not only this year, but certainly through 1969." The entire commercial paper and revolving credit lines would be absorbed and Penn Central would require another $125 to $150 million before the end of 1968, Bevan had indicated.

The first words in the 1968 annual report to shareholders were: "The cover sculpture symbolizes Penn Central as a strong and dynamic company, supported by the many different elements that comprise its diverse interests." No mention of financing, positive or negative, was made.

At the 1969 shareholders meeting, Bevan was again assigned to make the financial presentation. He boasted of the company's ability to raise substantial amounts of money required by the merger, $450 million to date, despite a difficult financial market. Commercial paper outstanding had reached $150 million-market acceptance was "uniformly good" and the company had no difficulty in disposing of the paper, he reported. The company had just asked the ICC to approve an increase from $100 million to $300 million in the revolving credit plan. The use of short-term maturities was "extremely advantageous" because they could be refinanced later on a long-term basis at lower rates than available in the present market. He expressed publicly the company's "appreciation and deep gratitude" to its banks for their vote of confidence and cooperation at a time when the market for money was very tight. He also noted that Penn Central was now going into the Eurodollar market for the first time, speaking also of this in glowing terms. This was mid-May and, internally, the financial problems were a matter of great concern. Yet the public was left with

385 In a discussion with a railroad analyst in June 1968, Bevan suggested the blanket mortgage as an offset to the short-term debt currently being floated, because of the danger of overextending in short-term securities. This danger was not, however, expressed to the public. Actually, the short-term/long-term distinction is generally drawn between funds put into such items as inventories or accounts receivable, which will be liquidated within a short period, and those invested in plant or equipment where the funds for repayment are generated over a long period of time. The situation here, where the money is going to dividends and operating losses, which themselves will never generate a return, obviously presents a particular problem. 396 This was an instance where, for internal purposes, management was using the full railroad loss, rather than the far more favorable figures being given to the public.

the impression that banks and the institutions which bought commercial paper thought very highly of Penn Central. The poor reputation noted in the merger hearings seems to have evaporated. The deception being practiced on these lenders who purportedly looked with favor on the company, and the huge amounts of the borrowed funds going into nonproductive uses were decidedly not items which management was endeavoring to point out to its shareholders.

The 1969 annual report was sent to the shareholders in March 1970. Perhaps reflecting an attitude that if you can't say something good, don't say anything, there was no reference in the textual material to the financing situation.

By the shareholders meeting in May 1970, Bevan's enthusiasm had blunted somewhat. He noted that the cash position was tight,387 basically because of the capital needs of the merger,388 he suggested, and the company was reviewing all expenditures very carefully. However, the arranging of $935 million in financing over the past 2 years was an "outstanding accomplishment" considering the tight state of the money market.389 Again he thanked the commercial and investment bankers for their cooperation.390

Bevan admitted that the big increase in debt had increased base and fixed charges markedly:

On the other hand, a substantial proportion of this debt is short or medium term in nature. Therefore, when market conditions change. we should be in a position to lengthen our maturities and reduce our fixed charges accordingly. We will not be locked into high cost debt for a long period of time for this portion of our indebtedness.

He did not indicate that by this point the runoff of short-term commercial paper, which immediately preceded and contributed to the final collapse, was in full swing.391 He did mention, however, that, after the sale of the $100 million Pennco bond issue expected in a few days,392 the major portion of the 1970 estimated financing requirements would be met. A shareholder present at the meeting commented that some Wall Street houses were saying that Penn Central would need another $100 million after that and wondered whether the company had the borrowing power. Saunders indicated that he did not think anyone could answer at this time the question of whether Penn Central would need more money. There was no mention that approaches had already been made to the Federal Government for emergency assistance.

The foregoing statement was clearly misleading with respect to the developing financial crisis. Investors were also given very little other information to direct their attention to this situation. Bevan had earlier stressed the importance of working capital 393 as an indicator of financial health. He had also stated in the merger hearings:

In the case of the railroads debt due within one year is not included in current liabilities, although it is now reported as a separate item in ICC reports. This is 287 This was a perennial complaint, but he gave no indication that financing had been stretched to the limit. 25 This was very clearly not the major cause of the drain.

250 $245 million in debt had been paid off during the same period.

He neglected to mention the difficulties the Penn Central organization had faced recently in obtaining financing, the exhaustion of the borrowing capacity of the Transportation Co. and the necessity to now finance indirectly through such subsidiaries as Pennco and Penn Central International, operations which would obviously also have their borrowing limits.

201 The revised offering circular, dated the same day, did make such a disclosure. The underwriters were writing the one presentation; Bevan was writing the other.

32 By this point (May 12) it was problematical whether the issue could be marketed. It was only 9 days later that Bevan met with the bankers to tell them the issue could not be floated.

393 Working capital equals current assets less current liabilities.