III-A. THE SALE OF PENN CENTRAL TRANSPORTATION CO.'S COMMERCIAL PAPER BY GOLDMAN, SACHS & CO.

INTRODUCTION

On July 22, 1968, the Interstate Commerce Commission authorized Penn Central Transportation Co. (the Transportation Co. or the company) to commence selling commercial paper. By late 1969 the Transportation Co. had $200 million in commercial paper outstanding. All sales were effected by Goldman, Sachs & Co. acting as dealer. During the first half of 1970, the amount of the Transportation Co.'s commercial paper outstanding dropped from $200 million to approximately $82 million. This $82 million in commercial paper was held by 72 customers who had purchased between November of 1969 and May of 1970. As commercial paper is universally believed to be a very low-risk security, these customers were shocked to learn, prior to the maturity date of their paper, that the Transportation Co. had filed a petition in bankruptcy. Penn Central has repaid none of this indebtedness, and there is little likelihood of repayment.'

While in this section the focus will be on the role of Goldman, Sachs in selling commercial paper, it should be noted that while the company's paper was being sold, the company and certain of its executives were making false and misleading statements to the public concerning the company's financial condition. These activities are being covered in other portions of the staff report.

Goldman, Sachs continued to sell the Transportation Co.'s commercial paper after they had received information about the financial condition of the Transportation Co. which should have raised serious questions as to the safety of an investment in the company's commercial paper, and Goldman, Sachs did not disclose such information to its customers. The information which Goldman, Sachs received should have put them on notice that a thorough examination of the financial condition of the Transportation Co. would seem appropriate in order that they, and through them, their customers would be apprised of the current position of the Transportation Co. Despite these warning signs, Goldman, Sachs made no meaningful investigation. Such an examination would have disclosed that the financial condition of the company was more serious than had been revealed to the public.

COMMERCIAL PAPER

CHARACTERISTICS OF COMMERCIAL PAPER

Commercial paper is a corporate, short-term promissory note. It is sold either directly by the issuer (borrower) to the purchaser (lender), or by the issuer to a dealer who resells to the purchaser.

There are suits pending against Goldman, Sachs by almost all of the holders. Of these, $20 million in claims have been settled for $0.20 on the dollar.

The most noteworthy factor in the commercial paper market (at least until the Transportation Co. bankruptcy) was the common belief held by purchasers, to a degree not even found among those who invest only in the bluest of blue chip securities, that commercial paper was designed to be entirely riskproof. Because safety of principal so far and away transcended rate considerations, a very large number of purchasers of commercial paper did not shop for rates at all. Most looked upon commercial paper as the equal of U.S. Treasury notes or bank certificates of deposit (CD's) in terms of safety. Because of the short-term nature of the investment (average term is 90 days) it is extremely important that the notes are repaid at maturity and thus the liquidity of the company becomes a matter of vital concern to the

customer.

The importance of safety to those who invest in commercial paper becomes apparent in a crisis. In the 30-day period following the Transportation Co. bankruptcy, the runoff in commercial paper is estimated to have reached $3 billion. Only quick action by the Federal Reserve, which had been alerted to the approaching bankruptcy a day or two before, appears to have saved the day. On June 19, 1970, in anticipation of trouble, the Federal Reserve had agreed to let commercial banks borrow freely at its discount window. And on June 23, it voted to change its regulation Q, which limits what banks can pay for deposits, thus allowing them to buy money freely. And the banks borrowed heavily from the Federal Reserve in the weeks that followed-$1.7 billion in just 1 week in mid-July. More than $2 billion in bank money went to aid corporations in paying off maturing commercial paper. This rescue operation not only took some companies out of trouble, it also restored lender confidence in the commercial paper market. What could have blown into a major liquidity crisis vanished almost before it began.

A second most noteworthy factor is that those who purchase commercial paper are loaning funds to corporations which most often they know little about. Furthermore, the purchasers have no control over the use of the proceeds or any other of the borrowers' activities, as a lender normally does.

It is impossible to secure restrictive convenants limiting the commercial paper borrowers' freedom to raise additional debt or governing the use of proceeds. In addition, the purchaser who becomes dissatisfied with the issuer usually has no readily available market to which he can resell his paper before its maturity.2

The only information the purchaser can get, and in almost all cases does get, is either through the public media or through the dealer who is selling him the paper. In addition to their dealers' recommendations, most purchasers relied on the ratings given various commercial paper by the National Credit Office (NČO) as a basis for making an investment decision.

The problems of making informed investment decisions about commercial paper were aggravated by the rapid growth of the commercial paper market just prior to the company's bankruptcy on June 21, 1970. Witness the following:

2 Paper which is purchased directly from the issuer, however, will usually be repurchased by the issuer at the purchaser's request. Some dealers also, subject to market conditions, maintain a limited secondary market in paper they handle.

A. In 1960 there was $4.5 billion in commercial paper outstanding: On December 31, 1965, $9 billion outstanding;

On December 31, 1967, $16 billion outstanding;

On December 31, 1969, $31.6 billion outstanding; and

On June 30, 1970, $39.9 billion outstanding.

B. In December 1967, NCO was keeping tabs on 227 commercial paper issuers. By April 1, 1970, its list had increased to 615.

Much of the growth was directly related to the monetary squeeze in which U.S. industry found itself at the end of the 1960's. In December 1968, the Federal Reserve Bank imposed a ceiling on CD interest rates. The banks, expectedly, strenuously objected to regulation Q, as it is known, which had the effect of diverting funds from the banking system and into commercial paper and other money market instruments, but the banks themselves were contributing to the increase in commercial paper outstanding. Bank holding companies began to issue commercial paper, and the banks put hundreds of disappointed loan customers in the direction of commercial paper as a cure to corporate liquidity problems.

It appears that commercial paper will remain an important money market instrument. Some of the advantages are that the seller raises short-term cash at less cost than bank borrowings, the investor receives a higher rate of return than is otherwise possible through purchases of other short-term money market instruments, and commercial paper is also relatively easy to sell, as it requires no registration with the SEC. To make it possible for more institutions to issue commercial paper, legislation has been passed in Massachusetts and New York to enable savings banks to put their cash into commercial paper. Like Ohio, several other States have been authorized to purchase commercial paper. Recent legislative moves have authorized the New York State Teacher Pension Fund and the California General Funds to acquire commercial paper. On the other side of the coin, dealers are engaging in promotional activities to show small- and mediumsized companies the advantages of selling commercial paper.

APPLICABILITY OF FEDERAL SECURITIES LAWS TO COMMERCIAL PAPER

The rapid growth of the market for commercial paper has involved its increased use as a substitute for long-term financing. This has made it more important than ever to reconsider the adequacy of Federal securities law with respect to commercial paper. Almost all commercial paper is exempt from registration pursuant to section 3(a)(3) of the Securities Act of 1933.3 Thus, commercial paper customers have not been furnished with all the current material information that would be required by a registration statement.

In the absence of registration requirements, there are no customary standards requiring dislosure of material information, to the extent the same is disclosed in a statutory prospectus, to purchasers. In many cases the information available to purchasers is limited and out of date. Furthermore, there is no investigation undertaken by the dealer which would even approximate that which is required of an

Under Section 3(a)(3) of the Securities Act of 1933 commercial paper, if used for "current transactions" and having a maturity "not exceeding nine months," is an exempt security. In the case of the Transportation Company's paper, the Section 3(a) (6) exemption would apply to "Any security issued by a common or contract carrier, the issuance of which is subject to the provisions of Section 20a of the Interstate Commerce Act, as amended," without regard to whether it was used for current transactions or whether its maturity was more than nine months.