which had been provided for in the merger reserve. Hill, who was instrumental in obtaining the necessary ICC approval, claimed that the separation of mail and baggage handlers had been delayed as a result of a fire in the related facilities and that otherwise they would have been separated prior to the merger. However, when asked to provide documentary evidence of this, he furnished two memoranda, one prepared in December 1968 which does not refer to a fire, and one in January 1969, which makes only incidental reference to a fire.

The December 1968 memorandum, which was prepared by Hill, does, however, clearly indicate that in the absence of other authority, the severance costs would have to be recorded as charges against income in the year 1968. The memorandum further states that while it would appear likely that the ICC would grant authority for such a charge, it was unlikely that Peat, Marwick would accept it:

"The principal reason for rejection by independent accountants is that the costs arise as a result of decline in business under an agreement which the company was willing to adopt as a price for doing business on a merged basis. Under such circumstances, independent accountants would conclude the costs are expenses of the period and therefore chargeable against income without regard to any prior period provision of reserves."

Indeed, it is clear that in the railroad industry, contracts giving extensive protection to labor and entered into to "buy" the cooperation of labor are by no means unique to the merger situation, and related costs are typically considered as operating expenses.

The period in mid and late January was one of substantial activity by a Penn Central management bent on avoiding this charge against operations. On January 22, 1969, Hill and Tucker (a Penn Central vice president who had a short time earlier served as ICC Chairman) met with Mrs. Brown, the current ICC Chairman, and Commissioner Bush to discuss the propriety of the charge. About a week earlier Saunders had met with Walter Hanson, senior partner of Peat, Marwick for what he described as a general get-acquainted meeting. In a memorandum dated January 21, 1969, Cole advised Saunders that Hill had that day spent a considerable length of time with Peat, Marwick and that "... they didn't understand that Mr. Hanson had changed his position about the propriety of including mail handlers' separation pay." The following short memorandum, prepared by Cole, was given to Hill on the morning of January 22, 1969, the day of his meeting with the ICC:

Your interpretation of the Saunders-Hanson conversation about separation pay for mail handlers is correct. That is to say, PMM will not take exception to the charging of this expense to the Reserve if the ICC will approve that accounting. By letter dated January 23, 1969, Peat, Marwick expressed its opinion to Penn Central that the $4,672,000 costs would not constitute an appropriate charge against the reserve." However, Peat, Marwick then went on to state the following (emphasis added):

We understand that you intend to petition the Interstate Commerce Commission to review the facts concerning the separation of the mail and baggage handlers and to rule on the question of whether such separations are, in fact, merger-related. We have reviewed the letter addressed to the Commission by Mr. Saunders. Under the circumstance, if the Commission in its judgment deems the separations to be merger-related and the costs incident thereto chargeable against the reserve, we would no longer have a basis for objection to a charge against the Merger Reserve for this purpose.

Henry Quinn, the writer of the January 23, 1969, Peat, Marwick letter, testified that he may have been expressing his own personal opinion in such letter. He explained by saying that the Peat, Marwick staff had discussed the matter and several felt that the $4,672.000 was an appropriate charge to the "merger reserve." He stated further that his opinion was not whether the charge was in accordance with generally accepted accounting principles but was whether the charge was in accordance with the criteria initially approved by the ICC. Accordingly, it was Peat, Marwick's position that if the ICC said that the $4,672,000 charge was appropriate then Peat, Marwick would not object.

By letter dated January 29, 1969, the ICC notified Penn Central of its decision:

This will advise that a majority of Division 2 107 in conference today voted to grant the letter request filed January 23, 1969, for authority to charge an amount of $4,672,000 expended during 1968 in connection with separation of mail and baggage handlers against the "merger reserve" established in 1967.

It should be noted that the ICC's letter did not address itself to the question of whether the charge met the criteria originally established; instead, it merely gave permission to charge the reserve. The decision was made by Division 2 without the benefit of a written Bureau of Accounts analysis and recommendation.

Conclusion. With respect to the special charge relating to the termination of mail and baggage handlers, the facts expressed in Saunders' January 23, 1969 letter to the ICC clearly disclose that the $4,672,000 charge did not relate to recalled surplus furloughed employees or appropriate substitutes. Such letter clearly indicates that the $4,672,000 charge related to a curtailment of services after merger and that such curtailment was not merger related. The additional facts available to the staff clearly indicate that the curtailment was a nonmerger related reduction in the demand for the railroad's services by the Post Office Department. The accounting rationale for setting up the original $116,928,000 liability for the recall of surplus furloughed employees was that solely as a result of the effectiveness of the merger a liability had been created and the combined railroads had therefore suffered an expense (loss), unrelated to future operations, that had to be recognized. This accounting rationale does not apply to the facts leading to the $4,672,000 in payments. The operative fact leading to such payments was the curtailment of services, not the mere fact of the effectiveness of the merger. The liability, and hence the expense, did not exist as of December 31, 1967 nor February 1, 1968. Nor was there a known contingent liability as of such dates.

The $4,672,000 in separation payments incurred during 1968 as a result of the curtailment in services of mail and baggage handlers appears not to come within the letter or intent of the original "merger reserve" criteria. Accordingly, even though the ICC allowed it for ICC reporting purposes, such amount should have been reflected as a period expense during the year ended December 31, 1968 in Penn Central's annual report to shareholders.

107 Division 2 is the three Commissioner panel responsible for hearing appeals in ICC accounting matters.

ACCOUNTING EXECUTIVE JET AVIATION

Background. In 1965, as part of its diversification program, PRR, through a wholly owned subsidiary, American Contract Corp., acquired 655,960 shares of class B nonvoting common stock of Executive Jet Aviation, Inc. (EJA) at a cost of $327,980 representing a 58-percent interest in the company's combined class A and class B shares outstanding. American Contract's largest investment in EJA, however, was in the form of loans and advances. Between 1964 and 1969, loans totaling $21 million 108 were made by American Contract with funds provided to it initially by PRR, and later by Pennco.

EJA had been formed in 1964 as an air taxi operation, to furnish air transportation when and as needed to executives at a fixed rate per mile under a minimum usage contract. PRR looked upon its investment primarily as a way of entering the air transport and air cargo fields. In August 1966, EJA negotiated for the acquisition of Johnson Flying Service, Inc., whose principal asset was a permanent certificate as a supplemental air carrier, which it had received from the Civil Aeronautics Board. Shortly thereafter, EJA committed itself to purchase four large jet aircraft at a total cost of $26 million. However, unless and until EJA received the required CAB approval for acquisition of Johnson Flying Service, EJA had no use for the aircraft since it lacked the authority to operate them.

In late 1966 EJA applied to the CAB for approval of its acquisition of Johnson Flying Service. After a lengthy hearing before a CAB trial examiner a decision to approve of EJA's acquisition was made, with the condition that PRR divest itself of control of EJA within 6 months. The divesture was ordered because the examiner found that PRR was in control of EJA in violation of the provisions of the Federal Aviation Act, which requires CAB approval before any surface carrier can acquire control of an air carrier.109 The CAB adopted the examiner's decision, with certain limited exceptions, in June 1967.

Subsequently, PRR and EJA prepared and submitted for approval to the CAB a financing and divesture plan. In this connection, a preliminary registration statement was filed with the SEC, covering certain aspects of the proposed financing.110 On December 22, 1967, the CAB held that the plan, which contemplated considerable continuing investments in EJA by PRR, did not meet the requirements the CAB had established. It indicated that complete liquidation of PRR's investment was required.

Meanwhile, the PRR was quietly continuing to advance moneys to EJA. And EJA itself was still thinking in terms of expansion. In the last half of 1967, it embarked on a "world operating rights" program designed to acquire controlling interests in various foreign supplemental air carriers. At the same time, Penn Central was also purportedly trying to find a buyer for its interest in EJA, although its desire to retain some sort of "buy-back" rights was making this more difficult. In mid-1968 U.S. Steel Corp. and Burlington Industries Inc.

10% The advances were as follows:

Through 1966.

1967.. 1968. 1969

Total.

1 PRR had been aware of this problem earlier and taken steps to obscure its effective control. This was later withdrawn.

$13,864, 877 2, 441,000

2,714,000 2,000,000

21,019, 877

entered into a memorandum of understanding whereby they would purchase Penn Central's equity and debt interest in EJA, subject to EJA's receiving CAB approval to acquire Johnson Flying Service." However, Burlington withdrew from the agreement in December 1968 and U.S. Steel followed. Other attempts by Penn Central to dispose of its interest in EJA proved unsuccessful.

In late 1968 the CAB hearings resumed to consider the steps being taken toward divestiture. EJA's surreptitious foreign air carrier acquisitions and the continuing control being exercised by Penn Central were brought to the attention of the Board by other supplemental air carriers. After the CAB began to inquire into its overseas activities, EJA, in January 1969, withdrew its application for permission to acquire Johnson Flying Service and filed a request that the proceeding be terminated. On June 4, 1969, the CAB instituted proceedings to determine whether EJA and Penn Central had violated provisions of the Federal Aviation Act. Subsequently, in October, the CAB issued a cease-and-desist order, to which Penn Central and EJA consented. In addition to levying substantial fines against both, the order directed EJA to divest itself of control of foreign air carriers and Penn Central to divest itself of control of EJA.112

EJA's Operating and Financial Condition. Since starting its operations in 1965, EJA sustained continuing losses in its domestic 113 and foreign 114 operations. At the same time that these losses were draining the financial resources, substantial amounts of capital were required to meet the demands of the company's expansion program. With the assistance of senior financial officers of Penn Central, arrangements were made for outside financing, but this could be obtained only under terms requiring that the loans be secured by aircraft and that Penn Central agree to subordinate its interests in the assets of EJA. This meant a reduced security position for American Contract. In addition, Penn Central, despite its own difficult financial situation, was forced to agree to deferral of interest and debt payments from EJA as they became due. And by the end of 1967, the financial condition of EJA's foreign subsidiaries was so bad that in order to meet minimum capital requirements under Swiss law, EJA had to subordinate its interest in these subsidiaries to that of all other creditors.115

Early in 1969 Lybrand, Ross Bros. & Montgomery, EJA's auditors, informed their foreign correspondent, who audited EJA's foreign subsidiaries, that the subordination agreement might be open to attack in view of the parent's financial condition. Penn Central was informed that, because of this, before the foreign auditors would sign the auditors' report, they were insisting on a statement "that during the year 1969 the danger of EJA going into liquidation does not exist" or "that EJA Inc.'s parent [Penn Central] has agreed to subordination." The statement was to be signed either by EJA's auditors or by Penn Central or someone with power of attorney to sign for Penn Central.

The withdrawal of the application to acquire Johnson Flying Service in early 1969 effectively meant the end of EJA's grandiose

111 If EJA was successful, Penn Central would realize a small profit; if it were liquidated, it would incur a small loss.

112 The order directed Penn Central to place all debt and equity interests in EJA into an irrevocable liquidating trust and to divest all of its interest no later than Mar. 1, 1970.

113 1965 loss. $992,000; 1966 loss, $2,214.000; 1967 loss, $869,000; 1968 loss, $3,830,000; 1969 loss, $4,101,000. 114 1965 profit, $10,000; 1966 loss, $747,000; 1967 loss, $533,000; 1968 loss, $489,000; 1969 loss, $265,000.

115 The companies had a very substantial equity deficit.

plans and further meant that the company had substantial equipment which it could not operate. EJA was forced to search for purchasers for the large jet aircraft and allied equipment it had acquired. The company was obviously in extremely serious difficulty, since this would undoubtedly result in additional severe losses, on top of the already unsatisfactory results. Indeed, because of this and other matters, Lybrand wrote to O. F. Lassiter, EJA's chairman in February 1969, outlining to him four major areas that would have to be resolved before they could complete their audit for 1968. No audited financial statements were issued for 1968 or 1969 until after Penn Central's bankruptcy. At that point the auditors disclaimed an opinion on the statements.116

In the summer of 1969, a former EJA officer, John Kunkel, filed suit alleging mismanagement by EJA's president and naming Penn Central, American Contract and Bevan, among others, as defendants. There appears to be considerable evidence that mismanagement and corporate waste were indeed adding to EJA's substantial operating losses. Even then, however, Penn Central did not insist on being provided with audited financial statements for this company in which it had a major investment.

As indicated earlier, Bevan and other top Penn Central financial officers had been instrumental in obtaining substantial loans for EJA, through Penn Central's banking connections. The largest loan was from First National City Bank and by late 1969 their concern. at the situation in EJA was reflected in frequent conversations between bank officers and Bevan and Jonathan O'Herron, vice. president-finance of Penn Central. One bank employee reported in an internal bank memorandum dated March 6, 1970 that EJA_was "both insolvent and on the verge of bankruptcy" but that Penn Central did not want to take a loss that quarter on the investment. Internal Penn Central management concern during the same period was evidenced in a memorandum to Saunders, dated March 8, 1970, in which Cole reported:

But what about now? It should be clear by now that no one is willing to take our position and Mr. Bevan apparently admitted to you last week the probability of a loss in EJA some time this year in suggesting the Wabash gains be used as an offset. Indeed, if the rumors are true, EJA is not meeting its current fuel bills, one of the big New York banks is calling a $2 million loan within the next 10 days and Lassiter has been diverting funds for some enterprise of his own.

In contrast, Bevan's stated position, as reflected in a "comfort letter" addressed to Peat, Marwick concerning the necessity for a writedown to be reflected in the 1969 statements, was as follows:

Pursuant to order of the Civil Aeronautics Board, we must dispose of our investment in Executive Jet Aviation by March 1, 1971. Consequently we are at this time carrying on negotiations with a number of interested parties with a view of disposing of our holding just as soon as practicable. It is a complicated situation and consequently negotiations as between interested parties vary widely. We anticipate that our holding will be disposed of in the relatively near future but only at that time will it be possible to evaluate intelligently the consideration to be received for our investment. It is almost certain that we will receive various types of securities in exchange for our stock.

They stated that although the statements were prepared on a going-concern basis, continuing operations were contingent on resolution of the following matters:

(1) Realization of assets and liquidation of liabilities connected with discontinued operations;

(2) Stopping of losses of foreign subsidiaries;

(3) Preventing default actions available to creditors; and

(4) Stopping losses of domestic operations.

It might be noted also that EJA had a reported capital deficit of $13,400,000 as of the end of 1969 and $9,000,000 at the end of 1968.