Macco Corp., and Arvida Corp. Great Southwest acquired Macco from Pennco in 1969. The latter three companies greatly expanded the scope of Penn Central's real estate activities, as reflected in the consolidated statements. The Great Southwest-Macco operation proved a particularly useful device in the maximization program.

REAL ESTATE ACTIVITIES

There was tremendous pressure on those responsible for the company's real estate activities to generate additional income. Whatever could be done within the Transportation Company and its railroad related subsidiaries to generate additional income and cash flow from disposition of property holdings was done. A great variety of avenues, involving a multitude of properties, was explored, although many of the proposed transactions were never consummated. At any rate, revenue potential in this area was limited.57

The real focus, however, came not in the parent but in Great Southwest-Macco. These operations are examined in considerable detail in a later portion of this report. Suffice it to say at this point that there were pressures exerted by Penn Central management which resulted in changes in the scope and methods of operations of these subsidiaries and provided a very sharp increase in income in 1967-69. Such changes so overextended Great Southwest that it nearly collapsed in 1970 and has survived only on the basis of a massive retrenchment in operations.

A considerable portion of the Great Southwest-Macco earnings was attributable to a limited number of very large transactions. Two transactions contributed approximately $15.1 million to Penn Central's consolidated net earnings for the fourth quarter of 1968.58 These purported sales, the Six Flags Over Georgia and Bryant Ranch transactions described in more detail later, involved premature recognitions of income and little immediate cash benefit to Great Southwest. In 1969 there was another similar transaction, involving the purported sale of Six Flags Over Texas (also discussed later), which resulted in an increase to Penn Central's consolidated net earnings of approximately $24.4 million. The following schedule sets forth the estimated incremental effect of these three transactions on the financial statements of Great Southwest and Penn Central, respectively. It should be noted that the effect on Penn Central differs due to: (1) the inclusion of Great Southwest in the consolidated Federal income tax return of Penn Central; (2) the absence of taxes payable by Penn Central due to its tax losses and carryovers and the absence of deferred tax provisions; and (3) the minority interest in Great Southwest. The $13,401,576 and $18,358,003 figures represented approximately 67 and 53 percent of Great Southwest's reported consolidated net income for the years ended December 31, 1968 and 1969, respectively:

"The fact that many of the properties were heavily mortgaged further complicated the situation. The company-only statements of the Transportation Company were not affected, except to the extent of the increase, if any, in tax allocation agreement payments as a result of these transactions.

As a result of administrative proceedings commenced by the Commission on December 8, 1971, and as announced by the Commission on June 6, 1972, Great Southwest has agreed to file amendments to its Form 10-K annual reports for the years ended December 31, 1968 and 1969 which will exclude profits from the above three purported sales, i.e., Six Flags Over Georgia, Bryant Ranch, and Six Flags Over Texas. In substance, the Six Flags Over Georgia and Six Flags Over Texas transactions are to be treated as joint ventures with the purported purchasers, and the Bryant Ranch transaction is to be treated as an incompleted sale where income will be recognized only after all costs relating thereto have been recovered by Great Southwest."

59

A sale in 1969, involving the Rancho California property, resulted in the booking of a large profit in the third quarter. Unlike the others, this was a cash sale and has not been challenged from an accounting standpoint. However, it cannot be considered, either in size or in type, as a routine Great Southwest transaction, a fact which has disclosure implications.

These real estate transactions, both in Great Southwest and in other sections of the Penn Central organization, played an important role in management's attempts to control quarterly earnings. Saunders' calls to the Great Southwest's management shortly before the end of each quarter, seeking income for Penn Central, were an integral part of his operating routine. On transactions within the parent company itself there were frequent pressures from top management to force transactions through before the close of a quarter for income statement purposes. Usually these related to accelerating the closing. However, on at least one occasion Bevan reported that Saunders had suggested that a wash sale should be arranged to get the profit if a transaction could not be pushed through before the end of the quarter.0 In contrast, the next quarter, when income was again below expectations, Saunders inquired of the comptroller as to whether there was a way to avoid recording a loss on the sale of another building in that period. Once again, management's propensity to control the earnings being reported to the public by speeding up the profits and delaying the losses and costs is clearly apparent.

59 See Securities Exchange Act Release No. 9629 (1972).

60 Bevan indicated that he had refused, and that at any rate it was never consummated as the potential buyer was not interested.

61 Again he was told no, according to testimony.

THE SEARCH FOR INVESTMENT INCOME

The same pattern is prevalent in the investments area. During this period of time an intensive effort was underway to find additional sources of cash and profit, and it appears that with a few exceptions (i.e., the four "diversified companies" acquired in the diversification program) virtually any company assets offering such benefits were on the block if a buyer could be found at a reasonable price. Unfortunately, however, the opportunities were limited. The two roads had been cannabilizing their assets for many years and the most saleable items were gone. The N&W stock was being sold as rapidly as possible, pursuant to an ICC order, described later in this section. This was generating both cash and profits ($10.3 million in 1968 and $13.6 million in 1969) and would continue to do so until 1974 when the supply would be exhausted. However, there were limitations on the capacity of the market to absorb the stock and furthermore many of the shares had been pledged or were for other reasons not readily available for sale.

As will be discussed in a subsequent section, attempts were made in the last half of 1969 to dispose of part of Pennco's holdings of Great Southwest and substantial profits would have been generated thereby, but these plans fell through, largely because of disclosure problems, Most of the other investments of Pennco and the Transportation Co. were closely held and lacked marketability, and were often unattractive as well. Efforts were made to dispose of them but they were for the most part unsuccessful. For example, in mid-1969 the sale of one subsidiary was being considered, but since virtually all of this subsidiary's operations were carried out on behalf of its parent, the Transportation Co., Peat, Marwick and Penn Central's own accountants vetoed the transaction. Because the subsidiary's basic means of support was, and would be, the obligation of the parent to use the subsidiary's equipment, the sale would have resulted in no economic advantage to the Transportation Co. Thus, management was told, it would be improper to record a "profit" on such a "sale" transaction. While Penn Central was stymied in its efforts to sell sufficient assets to bring income up to the desired standards, the income account was buoyed by a series of paper transactions which reflected no real change in the company's position. For example, the subsidiaries were examined closely for possible dividends, and a series of "special dividends" was ordered by the parent. These were designed to draw into the parent's income statement any earnings which had been accumulating over a period of years. Obviously, any such dividends did not accurately reflect current earning power. Several such payments were arranged in 1969, and dividends from consolidated subsidiaries increased by $25 million. The two largest items of increase were represented by a $14.5 million dividend from New York Central Transport Co. and a $4.8 million dividend from Strick Holding Co. The Strick transaction was basically noncash in nature.62 In the case of New York Central Transport, Penn Central in effect loaned its subsidiary $12 million to pay the dividend, since the subsidiary lacked the necessary funds, and after some accounting legerdemain, recorded the

"No cash payment was made, but debt owed by the parent to the subsidiary was reduced. And the earnings from which Strick paid the dividend were represented by values assigned to warrants in a newly formed company which had acquired Strick's major assets.

items as income. There were also other similar intercompany dividends. While these transactions would be eliminated upon consolidation, they did help the Transportation Co.'s results, and considering that entity was where the major problem was buried, Penn Central apparently considered this better than nothing.

A device used extensively in 1968 to increase income was the repurchase, in the open market at a deep discount, of bonds of various companies in the Penn Central complex. The difference between the price paid and the par value was then recorded as a profit. The company recorded a profit of $8.4 million in the Transportation Co. and $9.8 million in the consolidated entity from this source in 1968, but found it virtually exhausted when suggestions were made in 1969 that this device be tapped again. These transactions, particularly in light of Penn Central's need to finance the purchases through additional borrowing, apparently offered no real benefit to the company except the generating of paper earnings.

There were also a series of paper transactions involving in essence substitutions of similar securities which resulted in significant amounts being added to reported income in 1968 to 1970. Two such transactions contributed a total of $32.7 million in 1968 to both consolidated and company-only earnings. The first involved a dividend-in-kind from Washington Terminal Co.,65 a 50-percent owned subsidiary. This dividend was in the form of the securities of a newly formed company which Washington Terminal had received when it transferred to the new company a one-half undivided interest in Union Station in Washington, D.C. Union Station had been Washington Terminal's principal asset and an undivided one-half interest therein was the major asset of the new company as well. Penn Central controlled after receipt of the dividend, essentially the same underlying asset as it had had prior to that time, but it recorded income of $11.7 million as a result. The second transaction was in the form of an exchange of securities with Madison Square Garden Corp. and contributed $21 million to reported 1968 results. The Transportation Co. exchanged its interests in two assets held jointly with Madison Square Garden Corp., and which constituted the bulk of that corporation's assets, for shares in Madison Square Garden Corp. itself. Again, following the consummation of the transaction Penn Central had basically the same interest as before, packaged in a slightly different form, but took advantage of the situation to record a large gain.

66

Other transactions of this nature also occurred. 67 In 1964 the ICC had issued an order requiring PRR and its affiliates to divest themselves of all of their extensive holdings of N&W stock by 1974.68 In late 1965 PRR and Pennco entered into an agreement with the N&W, whereby Pennco, which held all of the PRR system's N&W shares, would exchange about one-third of these shares for 15-year N&W convertible debentures,69 with the exchange to be

63 See further discussion of this item on page 60.

64 In 1967 and 1969 the Transportation Co. earned about $500,000 from this source, while consolidated figures were $700,000 and $1,700,000 respectively. 65 See further discussion on page 62.

66 See further discussion on page 57.

67 See also discussion concerning Wabash Railroad Co. stock on page 55.

68 The PRR system at that point owned 2.4 million shares of N&W common, representing 32 percent of the total, and a majority of its voting preferred shares. The reason for allowing a 10-year period was to permit an orderly disposition and to provide certain tax advantages.

69 Pennco was to receive $104 million in 45% percent debentures which were convertible only by holders other than PRR.

made in 10 installments. A gain of about $80 million was recorded on PRR's consolidated books,70 but instead of taking the entire amount into income that year, the company recorded it as deferred income. The deferred income was then to be recognized on a periodic annual basis over the life of the contract, 91⁄2 years." It might be noted that, whereas in the Madison Square Garden and Washington Terminal transactions it was contemplated that the securities received in exchange would continue to be held as an investment, the N&W debentures would, of necessity, be liquidated. Indeed, the securities received in 1966–68 were sold in 1967 and 1968. There were no sales in 1969.

Penn Central took the position that its investment activities were an integral part of its business and classified all income from this source as ordinary income. Such a claim apparently lies at the root of attempted justification of nondisclosure of many of the various transactions noted above. However, not only had the opportunities for conventional sales become severely restricted, but it would be difficult to sustain income of the type derived from such items as special dividends, repurchases of company bonds, and paper transactions like Madison Square Garden, and Washington Terminal.72 The contrast between this and Penn Central's handling of what it considered to be unusual merger related expenses should be noted. In its presentation to the ICC on behalf of Penn Central, Peat, Marwick pointed out that the use of such a reserve would result in a more fair presentation of the results of the merged company by removing the impact of certain unusual expenses on the income statement. Furthermore, as to the $75 million in merger-related costs which did impact the income statement in 1968, management took pains to point out to the shareholders that they were temporary in nature. No similar effort was made to clarify the nature of many of the investment transactions which were generating reported income.

While Penn Central's search for income potential among its investments was broad-ranging, it exhibited a pronounced reluctance toward writeoffs of investments. There was substantial evidence by the end of 1969 of permanent impairment in the value of the investments in Executive Jet Aviation Corp., Madison Square Garden Corp., and Lehigh Valley Railroad. However, formal recognition of this fact would require charges against the income statement, charges which Penn Central could ill afford to report.

Penn Central had invested $22 million in Executive Jet Aviation. Most of this investment should have been written off in 1968 and 1969.

Because of prior intercompany sales, the profit on Pennco's books was smaller-only $59 million. "While this may appear inconsistent with the Penn Central policy of taking everything into profit immediately and worrying about the future later, it might be noted that 1966 was an extraordinarily profitable year in the railroad industry, and thus there was not the pressure for additional earnings which was present in subsequent years. Furthermore, a gain of this size would certainly have been considered nonrecurring and discounted by the public, whereas the smaller amortized gains could perhaps pass unoticed.In this connection it might be noted that while in 1966 PRR made the decision to report the N&W exchange as an ordinary income item, in 1965 when it sold its interest in the Long Island Railroad at a substantial loss, it reported a "Provision for loss on sale of Long Island Railroad" as an extraordinary charge. Perhaps another indication of management's propensity to use artificial devices to increase income is this comment in early 1969 by Cole, in discussing plans to establish the holding company: "I have taken a special interest in this project and have been trying to push it along, because I thought Iresaw the prospect of being able to generate net income by Railroad or Pennsylvania Company declaring wads of low-book value assets which would then be taken in by the Parent at present market values, Che case of the Washington Terminal dividend and the Madison Square Garden transaction. Alas, I just learned that this is prohibited where the declaring corporation is more than 50 percent owned." Magement never did find any additional transactions similar to the transactions alluded to, and 1969 ment income dropped accordingly.