contrary to standard accounting procedure and the practice in other industries, and in my judgment gives a completely false picture, since obviously there is no difference between one type of liability and another if both have to be paid in the same period of time.

However, in the annual report to shareholders Penn Central continued to classify it as long-term debt,394 rather than as a current liability,395 thereby improving reported working capital.

Perhaps even more important than the working capital situation was the rapid exhaustion of the sources of credit available to Penn Central. The public statements previously described definitely showed the positive side, with no indication the limit was fast approaching, although this matter was obviously of concern internally. Each annual report included, in a graphic form, a statement of source and application of funds for the year, but the information contained therein was so general as to be virtually useless.396 For example, no indication was given as the the level of noncash earnings. Considering the admitted importance of the maturity schedule, and the heavy reliance on relatively short-term debt in situations where long-term finarcing was called for, an item in the source and application of funds labelled "financing" is not very informative, and this is doubly true in a company like Penn Central where such diverse activities as railroad operations and real estate development and sales are being combined. Actually the company did provide more meaningful figures for its own internal purposes, although these were not available to the general public.397

Other financial statements were scarcely more useful than the source and application of funds. As noted earlier, lenders had turned money over to Penn Central, without much inquiry into the company's ability to repay, because of the very great assets and equity of the firm. How was the average investor to measure such factors? While the accountants' report generally indicates the CPA firm's opinion as to whether the balance sheets and related statements of earnings and retained earnings "present fairly" the information contained therein, such statements do not reflect current economic values of the assets involved nor do they attempt to do so. Thus, at least insofar as the balance sheet is concerned, it appears to be of very limited value to the average investor in gauging the value of Penn Central as a going concern.398 Further, if the investor is not knowledgeable about accounting practices he might even be misled by the information contained therein. This is particularly a danger in a railroad company where fixed assets loom large in the balance sheet.

The management of Penn Central clearly recognized the limitations in such figures, as reflected in their frequent complaints about the highly unsatisfactory rate of return being earned on railroad assets. Low rates of return mean low economic values on those assets. In

394 Penn Central broke this category down into long-term debt due within 1 year and long-term debt due after 1 year.

395 In the case of commercial paper, totaling nearly $200 million by yearend 1969, even Goldman Sachs had to ask where that item appeared in the balance sheet. The answer was that roughly half was included in current liabilities and the remainder in long-term debt due in more than 1 year, although all was in fact due within 1 year.

396 See exhibit IG-2 at end of this section.

397 At the present time, the SEC requires detailed statements of source and application of funds under article 11A of Regulation S-X in registration statements and reports filed pursuant to the 1933 Act and the 1934 Act. Further, through the proxy rules (Rule 14a-3(b) (2) of the 1934 Act), the SEC also requires such information to be included in annual reports (Section 14A of the 1934 Act and Rule 14a-3(b) (2) thereunder,) to shareholders.

398 At December 31, 1969, Penn Central's balance sheet showed shareholders' equity of $2,800 million, while the market value of the outstanding stock was only $700 million. At present prices, market value is $120 million.

light of this, Saunders' suggestion at the 1969 shareholders meeting that, in the railroad, Penn Central held an asset which could not be replaced for less than $15-$20 billion (book value was perhaps $3-$31⁄2 billion) was unconscionable.399 This is an example of the situation described at the beginning of this section where the distinction was drawn between technical accuracy and what was reasonably conveyed. While it may perhaps be true that the asset could not be replaced for less than $15-$20 billion, the property clearly was not worth anything remotely resembling that figure and based on economic factors no one would replace it at such a cost.

Another difficulty which reflected on the financing area was that the company's assets were already heavily pledged. It is true that the company did indicate in the notes to the balance sheet in the 1969 annual report that:

Substantially all investments and properties included in the consolidated sheet and substantially all the properties of the transportation company, together with certain of its investments, principally Pennsylvania Co.. have been pledged as a security for loans or are otherwise restricted under indentures and loan agreements. 400

This represented a marked deterioration in position over the prior year, although that was not stated.401 Furthermore, the burying of this information in footnote 7 to the financial statements does not meet the requirements of a company which is on the verge of collapse, because of the inability to market further long-term debt, to fully disclose the imminent danger to its shareholders.

Considering Penn Central's financial predicament, it was misleading for management to continue to make dividend payments.402 When the practice was finally stopped, although it was long overdue, management, in a letter to shareholders dated December 1, 1969, explaining the reasons, cited "the necessity to conserve cash in keeping with responsible management." The possibility of renewed dividend payments in 1970 was held out as a favorable trend in operating results. Thus, although dividends were stopped, the true nature of the crisis was still concealed. "Responsible management" was merely taking prudent and timely steps to conserve cash, it was suggested. No indication was given that the action was long overdue and the situation was critical.403

That letter also pointed out that Penn Central had spent nearly $600 million for "merger connected capital projects" since the merger. Reports filed with the ICC show that merger related capital expenditures were $43 million in 1968 and $54 million in 1969, far short of the figure given above. This illustrated another difficulty the investor faced in assessing the financing situation. Huge sums were borrowed, it is true, but the investor had been led to expect this he had been warned that capital expenditures would be abnormally high in the postmerger period, because of merger-related projects. These expenditures of course were to be temporary in nature. This theme was reinforced by postmerger statements about the very rapid progress being

He repeated it however in his speech before the Financial Analysts Federation in October 1969. 400 Generally accepted accounting principles clearly require such a disclosure, so the company was not going out of its way to make full disclosure in light of the perilous condition of the company. See also the Commission's Regulation S-X, Rule 3-19

The prior year's report did indicate that "substantial portions" of both categories of assets were restricted. Apparently, however, the final limit had not yet been reached.

402 Dividends far exceeded income of the Transportation Co. for both 1968 and 1969.

The letter was rife with what had to be deliberate overoptimism. It is included in its entirety as Exhibit IG-3. This letter should be contrasted to the tone in other events occurring the same day-Day's letter to Saunders (p. 165) and Saunders' luncheon meeting with the staff (p. 177).

made in physically implementing the merger. To state that mergerrelated capital expenditures were $600 million was definitely misleading. This figure apparently included all capital expenditures, the bulk of which would be recurring in the future and were not temporary in nature. Many were nonrailroad. Further, the rate of capital expenditures in the postmerger period was in line with the expenditures in the immediate premerger period. And the statement in a special press release put out for year-end editions and dated December 19, 1969, to the effect that capital expenditures in 1970 would be substantially less than in 1969 and suggesting that this was because of a decline in merger costs and plans to improve equipment utilization is misleading. It is obvious that the real reason was simply lack of financing.

The favorable picture painted throughout the entire postmerger period of the state of the road's track, facilities, and equipment must also be considered misleading in tending to divert attention from financing problems.404 If the truth were told, the condition of the plant and equipment was highly inadequate, causing serious service problems, and this was because the company could not provide the financing to do better.

Further indications of financial strength were also present. On January 21, 1970, Pennco announced it was acquiring additional shares of stock for the $25 million owed to it by Great Southwest. This forgiveness of indebtedness would hardly appear to be the action of a company whose parent was deeply concerned about where it could obtain additional cash to keep operating.

THE PROFESSIONAL ANALYST

It is very clear that the average shareholder could not be expected to make sense out of the information selectively provided to him by management. This is further emphasized by the fact that, as noted earlier, apparently the directors of the company, who had access to considerably more information than did the public, were unable themselves to piece together the then existing situation.

As indicated, the problem was apparently in part inadequate information and in part the complexity of the situation. While the professional analyst should not be the standard to which disclosure is directed, examination of what the professional is able to discern, and how, is enlightening. The fact that some astute analysts were able, using information from a variety of sources and reflecting an awareness that very significant information seemed to be lacking, to obtain a fairly reasonable assessment of the situation, militates against charges made by some persons that criticism levelled toward Penn Central involves an unjustifiable use of hindsight.

It is clear that over the postmerger period Penn Central developed a large "credibility gap" among significant members of the investment community. It is equally clear that management recognized the problem. On occasion it went on the offensive. For example, in late 1969 some deterioration was showing up in the company's earnings and

404 This tendency appears to have been exacerbated by Penn Central's desires to convince the shipping public, through press releases, that its service was improving.

However, even before that time, on Sept. 5, 1968, Saunders told the New York Society of Security Analysts "one of our greatest accomplishments in preparation for our merger was the remarkable transformation of the equipment fleets of both railroads," indicating that $1.1 billion had been expanded on equipment by the two roads since merger proceedings were instituted.

operational figures, and rumors were spreading about Penn Central's condition.

Saunders, appearing before the Financial Analyst's Federation 1969 fall conference in October, opened his prepared speech as follows:

I don't know whether I should ask you to give me a medal for bravery or folly in appearing before this very influential group today. At least you should be grateful that our merger has provided you so much to write about in the past year and a half. Penn Central is enjoying the dubious honor of being probably the most talked about company in the railroad industry, if not the business world.

One phenomenal thing that our merger has achieved is that it has produced a host of experts on Penn Central many of whom seem to know far more about our business than anyone on our payroll.

He then moved on to discuss again the industry:

Speaking to a group of financial analysts at this time is a particularly challenging assignment for any railroad inasmuch as it seems obvious that members of your profession are not overly optimistic about our industry. But if I may say so, I fear that some of us in our concentration on figures and statistics sometimes tend to overlook and underestimate many good things which are taking place in our industry.

After some discussion, he went on to treat Penn Central individually, stressing the positive steps the company was taking to improve service, lower costs and increase profits. An article to the same effect, based on an interview with Saunders, entitled "Penn Central Sees a Light in the Tunnel," appeared in Business Week on November 22, 1969. He was quoted as saying that Penn Central's problems had been exaggerated out of all proportion on Wall Street and in the press, and that unfounded rumors were generating pressure on the stock. Four days after appearance of the article the directors voted to omit the payment of the fourth quarter dividend.

The credibility gap was very obvious by this point. However, investment community dismay at the situation had begun as early as September 1968 when Saunders gave a talk before the New York Society of Security Analysts. One analyst characterized the speech in a report as follows: "Management's recent presentation at the NYSSA was generally disappointing. While many of the known profit potentials were discussed, there was an abundance of vague, unsure and contradictory answers." Forbes magazine, indicating that the group was looking for answers for the sharp decline in the stock's price in the past 2 months, labelled Saunders' performance as a "letdown" in an article entitled "Weak Script" appearing in its October 1, 1968, issue. Other examples of analyst concern can also be cited. Rumors were circulating widely by the summer of 1969 about a likely elimination of the dividend, and by September even Equity Research Associates, which had distributed a favorable report on Penn Central in January 405 and continued to recommend the company through the year, indicated that "ERA hates to give up on this one but we have to for now. The 'explosive' potential we spoke of as recently as last week is still there and will one day be realized, but before that day

Management, hearing the report was underway and fearing an adverse report, had been working very closely with the analyst involved. An interesting incident took place in this connection. David Wilson, in-house counsel for Penn Central, called Dechert, Price and Rhoads, outside counsel, on January 3, the day after the report was issued and 3 days after the Madison Square Garden transaction was consummated to inquire as to whether Penn Central would have to make any statement about the profit recorded in MSG. A memorandum indicates that:

Dave and I agree it has no duty to its own shareholders to do so, despite the magnitude of the transaction because of the accuracy of the ERA statement against the background of the rather optimistic release by Mr. Saunders" [probably his year-end statement issued on December 26, 1968].

Apparently, Penn Central felt that if they gave the information to one analyst, they had met their disclosure obligation.

dawns we now believe the dividend will be cut or eliminated." An analyst from Spencer Trask in early August pointed to the substantial and increasing cash drain from operations as the most significant single indication of the company's progress, suggesting that "reported earnings are a meaningless guide to the position of the company.'" Continuing deterioration in passenger and freight operations and the continued dividend payments were making necessary sales of prime real estate, extraordinary dividends and debt financing, he reported. It is clear that if Penn Central management had been meeting its responsibilities to shareholders, it would have been alerting shareholders to these same factors.

Other professionals were also evidencing awareness of critical problems which were not being stressed to shareholders. After a visit with Perlman in August 1969, Morgan Guaranty Bank analysts came to the following conclusion: 406

(1) Our earlier expectations of a rebound in rail operations by the second quarter failed to occur because of continuing merger costs. (2) We are increasingly concerned about the weak consolidated financial position in view of the fact that approximately 30 percent-40 percent of reported earnings are estimated to be of a noncash nature, resulting in a situation whereby the payment of common stock dividends might well be from bank lines or short-term commercial paper borrowings. (3) Our 1969 estimate of $4.75 per share now implies that management might resort to additional nonrailroad sources to meet this objective and to raise additional working capital-in this regard management could well decide to sell more nonrailroad investments, that is, Great Southwest Corp., Norfolk and Western common stock, or a variety of other low cost assets. While such an occurrence would have been indicated to us early in the year, we feel the quality of these earnings will be substantially lessened, and more importantly such an occurrence would mark the second straight year of railroad deficits in excess of $122 million. (4) The apparent lack of harmony in top and middle management is gradually being resolved, though we feel this is still somewhat of an inhibiting factor in achieving operational improvement and also in obtaining a successor to Mr. Perlman who will retire in October 1970. (5) Management in general continues to divulge little in the way of analytical information, thus leading to investor confusion as to the extent of Penn Central's overall problem and resources.

The contrasts between these impressions and the official company position, described earlier, should be noted.

Over the ensuing months, the analysts at Chase Manhattan Bank continued to view Penn Central with suspicion. A check with certain shippers in late 1969 indicated that there was still much dissatisfaction with service. After reviewing operating results for the fourth quarter of 1969, these analysts wrote that the credibility gap between management and the investment community seemed to be widening and contrasted the poor results with recent statements by management. They further commented on the "lack of meaningful published information and the reticence on the part of management to thoroughly discuss the now-sensitive area of railroad operations," indicating that this further complicated attempts to assess near term prospects and the status of certain recognized variables, such as business lost because of poor service, high per diem costs and merger costs and savings. In like vein, another analyst, this one from Black & Co., wrote in early 1970: "with the credibility gap existing in this railroad and, keeping in mind the many unique adjustments which this railroad has made and can continue to make, it is evident that the course of their earnings over the next several years cannot be accurately determined."

406 These were the negative conclusions; there were some positive ones as well.