Unfortunately, disclosure of the fiasco surrounding this situation 73 would have been embarrassing to management, in addition to its detrimental effect on earnings, and so no writedown was taken. The market value of the Madison Square Garden shares had dropped by more than 50 percent between the time Penn Central's investment in the project was in effect written up in connection with the previously described exchange of securities in late 1968, and the close of 1969. 74 Again, the investment was not written down. In the case of Lehigh Valley Railroad, as suggested earlier, that company should have been consolidated and not carried as an investment, but even as an investment, the earnings and financial history of the company clearly called for a writedown to realizable values. 75

EARLY 1970-THE LAST GASP

When Gorman came to Penn Central in late 1969, and began to familiarize himself with the company, he became concerned about an earnings pattern he discerned. In connection with his testimony he submitted a table of quarterly earnings results for 1969 and 1968, which has been attached as exhibit IB-3. This table, prepared by a Penn Central statistician early in 1970, presents in a readily comprehensible format not only the full loss on railroad operations, but also a chart of "significant items," including many, although not all of the items described in previous parts of this section-e.g., New Haven capitalization, merger reserve charges, the Washington Terminal dividend, the New York Central Transport dividend, the Madison Square Garden exchange, the three Great Southwest transactions and the profit on reacquisition of company bonds.

On the basis of the pattern exhibited, Gorman requested a special meeting of the finance committee of the board, which met in early May 1970. The minutes of that meeting record the proceedings as follows:

The President then stated that he was deeply concerned about a number of management practices, although there was no indication that they were illegal or had not been approved by outside counsel and outside auditors.

He did state, however, that he was disturbed by certain matters because in his view an item must not only be right but must look right to outside sources. He stated that he had followed this code for over 40 years and did not intend to change at this stage of his career and that he would like to discuss certain matters with the Committee to determine whether the practices would be continued in the future. He emphasized that his action did not imply criticism of the Chairman of the Board, the Chairman of the Finance Committee to the Finance Committee, but, nevertheless, what he was talking about was practices which he believed had been followed for some time in the past.

While not all the practices related to reported earnings, it was clear that this was the dominant theme. He specifically mentioned such matters as the "declaration of dividends by subsidiaries on a hit or miss basis to satisfy a current underrun", profits on transfers of investments between segments of the Penn Central organization, writeups of investments such as Madison Square Garden with the holdings then locked in because of subsequent price declines, and unrealistic budgets. He also questioned certain other practices which he felt did not reflect a conservative approach to reporting earnings.

73 See discussion on page 71.

74 It has remained at lower levels since that time:

75 See discussion on page 64.

Apparently it was in substantial part events in the first quarter of 1970 which alarmed Gorman. As noted earlier, the first quarter was operationally a disaster, with $100 million in losses from railroad operations. This was unfortunate because, with a critical cash situation, Penn Central, through Pennco, was about to go into the public markets for financing. Some way had to be found to improve the apparent earnings picture if the issue was to succeed. Gorman objected to the two major devices adopted, however, to accomplish the goal.

In connection with the channeling of the proceeds of the proposed offering from Pennco to the Transportation Co., Pennco was to purchase from the Transportation Co. the stock of Clearfield Bituminous Coal Corp., a 100 percent-owned subsidiary." The transfer was made at net asset value, and a profit of $16.9 million was recorded on the Transportation Co. books. Gorman indicated he questioned booking paper profits such as this, even with full disclosure. He recognized these intracompany sales would be wiped out in the consolidated statements but asked the question "why do we bother with those kind of things?" The reason was clear-to dress up the Transportation Co. figures.

77

That transaction was dwarfed, however, by the other one, which involved not the Transportation Co. but the consolidated statements. Pennco owned virtually all of the common shares of Wabash Railroad Co. and pursuant to an ICC order dated 1964 had agreed with the N&W to exchange them for N&W shares. The date of the exchange was established as October 15, 1970. However, when it was recognized the first quarter profits would be very bad, hurried plans were made to accelerate the exchange to March 31, 1970. As a result, profits of $51 million were booked as ordinary income in that quarter." Gorman, who was in the hospital at the time, knew nothing about it until after the transaction was consummated and reported. He was irritated and reported to the finance committee that if he had known about it he would have dissented. This was a writeup of paper profits, with a flow through to earnings but no cash benefit, he stated, reflecting to the committee "a general feeling that where there is no cash involved why do you do things. And certainly we were in need of cash." Furthermore, he was particularly distrubed by the fact that the acceleration had cost Penn Central $1.8 million in Wabash cash dividends,78 which he felt he could certainly have used to repair freight cars which seriously needed repairing. It might be noted that Penn Central management had made a number of other expensive concessions to N&W as well, to gain the income acceleration.79

The impact of just these two transactions on reported earnings in the first quarter of 1970 was as follows:

The carrying value on the Transportation Co. books was only $82,000.

The gain on Pennco's books was $47 million.

"This reflects the difference between the dividends which Pennco received from the N&W shares in the interim period and those it would have received had it held the Wabash stock.

It appears that under the terms of an escrow agreement in connection with a $50 million debenture offering of Pennco, debenture holder approval was required before the terms of the exchange agreement could be amended. Such approval was not obtained.

It might be noted that there were also other devices discussed by Saunders and Bevan during the early 1970 pcriod whose effect would have been to increase reported earnings. The accounting department suggested an upward revaluation of inventory, although this idea was dropped on Gorman's objection. The possibility of allocating part of the overhead and management costs of the Transportation Company to the holding company and the subsidiaries was brought up. Gorman said he had no objection but asked why now? Bevan instructed Hill to check with other railroads on amounts being accrued for 1970 wage increases, stating that it was important not to exceed what was necessary in this respect. And the old possibilities of expensing off the winter's heavy snow removal cost over the entire year and increasing use of the merger reserve were raised once again. Šaunders also asked the appropriate people to look at the reserves for injuries, damages, and so forth, to see if a lower figure could be justified.

ACCOUNTING TREATMENT

The foregoing activities clearly illustrate the course of conduct being pursued by Penn Central's management. All manner of means were being employed to make the situation appear better than underlying circumstances warranted. Very significant portions of the reported earnings of this cash-starved company were noncash in nature. Moreover, the figures were replete with income derived not from routine, on-going investment and real estate activities but from forced liquidations of assets employed in these activities in order to meet the earnings and cash needs of the railroad. These assets were not available in unlimited supply, a fact clear to management long before Penn Central's final collapse. And the pressures applied by top management to alter cost and expense figures to meet management's desires in all probability had an impact, of unknown extent, on the reported figures.

At a minimum, the course of conduct illustrated above called for clear disclosure of the nature and effect of the policies management was following in this respect. Thus, under the circumstances of this case shareholders were entitled to be provided with the information necessary to permit them to fully and fairly assess the quality of the earnings being reported. Beyond this, however, it is clear that in a a number of instances the recording of income or failure to record deductions from income involved the stretching of generally accepted accounting principles to the point where the total impression given may have been highly misleading. A few of the most significant situations are described in the following section.

ACCOUNTING-MADISON SQUARE GARDEN CORPORATION

Background.-In connection with the construction of the new Madison Square Garden Center over Pennsylvania Station in New York City the then Pennsylvania Railroad Co. (PRR) acquired a 25 percent stock interest in Madison Square Garden Center, Inc. (Center). These shares were received as part of the lease arrangements for air rights over the station and were carried on PRR's books at $1. The other 75 percent stock interest in Center was owned by Madison Square Garden Corp. (Garden). Center constructed the facility and after it was completed in early 1968, all of the revenue-producing activities and certain related assets of Garden, which had owned and operated the old facility, were transferred to Center.

As part of, and in connection with the construction of the new facility, a joint venture was entered into for construction and operation of a 29-story office building above the easterly third of Pennsylvania station in New York City. Participation in the venture was as follows:

1 A corporation 100-percent owned by PRR directly or through one of its wholly owned subsidiaries. 2 A corporation 100-percent owned by Garden.

Under the terms of the joint venture, in exchange for an increased participation,80 PTRE undertook to loan funds to cover costs of construction in excess of the construction loan and PRR, which owned all the stock of PTRE, agreed to furnish funds to PTRE for such purpose.

Just prior to December 31, 1968, the equity interests of Garden and Penn Central in Center and in the joint venture are illustrated by the following chart:

80 The agreement, as originally structured, provided for a 25 percent interest to the PRR subsidiary and 75 percent to the Garden subsidiary. Because of difficulties in obtaining needed financing, this was later renegotiated, with PRR receiving an increased participation in return for an agreement to provide financing.

Pursuant to an agreement dated December 18, 1968 Garden acquired as of December 31, 1968,81 Penn Central's interests in Center and PTRE. In addition certain indebtedness owed Penn Central in connection with the office building project was forgiven. In exchange, Penn Central received 1,168,664 unregistered shares of Garden's common stock and 100,000 shares of Garden's participating preferred stock. Contingent upon approval of Garden's stockholders, it was agreed that the participating preferred would be exchanged for 1,151,000 shares of common. This approval was obtained on April 9, 1969 and the exchange made about 10 days later. 82

In connection with the above, on December 18, 1968, Garden and Penn Central also entered into a stock purchase agreement whereby Penn Central agreed to purchase shares of Garden's common stock to furnish the financing necessary to complete the office building. This related directly to Penn Central's obligation under the joint venture agreement, as mentioned previously, to furnish funds to PTRE for that purpose.

83

Analysis of Changes in Equity Interest of Penn Central, as a Result of the Exchange.-Penn Central indicated that the reason for the transaction was as follows:

The purpose of Penn Central in agreeing to the purchase and proposed purchase of Securities of the issuer was to concentrate and unify Penn Central's interests in

81 This date was selected because of Penn Central's desire that the transaction be closed before the end of the year.

82 The interim step was necessary because Garden did not have the authority to issue the full 2,300,000 shares in December 1968.

83 Penn Central agreed to purchase up to 180,538 shares at $11.078 per share. PTRE would request the advance needed. Penn Central would then purchase from Garden the shares required to provide that sum and Garden would advance the proceeds to PTRE.