* The reported earnings are not equivalent to cash earnings. Income maximization section of this report describes a number of transactions which resulted in reported earnings without producing cash.

Because there had been no inflows of cash to support the dividend since some time before the merger, money had to be borrowed at the high interest rates to make the payments. The increases in dividends leading up to the merger were unwarranted, the continuation of the high dividend rate after the merger was reckless. At a time when urgently needed road capital items were being denied to those responsible for the operation of the company, money was being borrowed at high interest rates to pay dividends, including those paid to Saunders and other officers.

The principal purpose of the continuation of the dividend was the desire to project an image of optimism and soundness. The image was. deceptive to investors, many of whom held this "blue chip" stock for its long history of dividend payments. The deception struck most directly at those who invested in Penn Central for its dividends. These investors were suddenly faced with no dividend at all and realization. that the company's condition was much worse than they had been led to believe (with a commensurate decline in the price of the stock).

INTEREST COSTS

Interest rates were rising in the post merger period. Of more importance than the rise in rates, however, was the tremendous increase in borrowings needed to meet the cash drain. On a consolidated basis. the interest on debt was as follows:

The additional borrowing by the Penn Central from merger date through the end of 1969 (after deducting debt repayment) was $405 million. The interest costs of these additional borrowings was in excess of $40 million at an annual rate by the end of 1969.130 These interest payments were, of course, cash payments. It can be said that the additional borrowings were the prime cause of the rise in the interest burden during the postmerger period, because the borrowings in this period were made at interest rates at or above the prime rate 131 while the interest burden on most of the existing long-term. debt was at fixed lower interest rates from earlier periods.

130 The company was required to keep compensating balances of between 15 and 20 percent of funds borrowed, thereby effectively increasing the interest rate.

131 Some investors may have believed that the short-term debt was being increased to avoid rolling over long-term debt at the prevailing high interest rates. In fact, most of the borrowing was being consumed by operations losses.

CASH RELATIONSHIP OF PENN CENTRAL TO GREAT SOUTHWEST, MACCO AND EXECUTIVE JET AVIATION

A principal example of the concealment of the real cash losses of the company under the camouflage of reported earnings is the performance of Great Southwest Corp. (GCS) and Macco. These subsidiaries were the source of profitable diversification according to repeated statements by management. Management also repeatedly stated or implied that these companies supplied cash to the railroad. During the years when the railroad was suffering a staggering decline, Great Southwest and Macco were reporting the following soaring earnings. 132

1967.

1968.

1969_

$11, 408, 000 32, 961, 000 51, 543, 000

Although the earnings were reported in Penn Central's consolidated results, with a minor exception none of these earnings were received by the company in cash.133 Adding further injury, the railroad actually passed approximately $32 million in cash down to GSC (excluding the initial investment) from 1966 through 1969. The flow stopped during 1969 apparently because the railroad had finally run out of money itself. 134

Pennco, the railroad subsidiary which owned Great Southwest and Macco, however, did pay dividends to the railroad.135 The funds for these payments came chiefly from Pennco's holdings of Norfolk and Western stock and Wabash stock and not from the real estate subsidiaries. This source of cash was being diminished however, as the company sold off these holdings:

WABASH AND NORFOLK & WESTERN DIVIDENDS RECEIVED BY PENNCO

In general, management misrepresented the role of the real estate subsidiaries, particularly as to cash contributions. The principal cash contribution was from the long-standing investments such as the Wabash and the Norfolk and Western dividends. The muchtouted diversification into real estate was unproductive. Only Buckeye paid a significant dividend and that dividend of $6 million a year was

132 Before Federal and State income taxes. GSC paid no Federal taxes because of the railroad's tax loss shelter. Under a tax allocation agreement GSC was obligated to pay to the Transportation Co. 95 percent of the Federal taxes which would have been paid without the tax shelter. GSC never paid the Transportation Co. any cash under that agreement.

133 GSC paid Pennco dividends of approximately $1,000,000 in 1968 and $2,900,000 in 1969. However, during that time substantially greater amounts of cash were being passed down to GSC and a total cash debt exceeding $20,000,000 was "forgiven" in late 1969 through the acceptance of GSC stock. During this time GSC was itself suffering financing difficulties which made the payment of a dividend a questionable practice (during late 1969 and early 1970 GSC borrowed over $40,000,000 in Swiss francs at high interest rates).

13 For details of the relationship between Penn Central and GSC, see section of this report on Great Southwest Corp.

135 Pennco dividends to Transportation Co.:

simply a 6 percent return on the initial investment of approximately $100 million. From the other diversification subsidiaries (Arvida, Great Southwest and Macco) no significant cash return on the investment was received and, in the case of Macco and Great Southwest, substantial cash advances were passed down after the initial investment. Worse than the poor performance of the diversification program was the use of the program to pass inflated earnings to the parent and the associated touting of the "performance" of the subsidiaries and the "value" of the holdings of the stock of these subsidiaries in Pennco's portfolio.

Executive Jet Aviation is another example of a concealed cash drain that is more significant in its concealment than in the actual amount lost. Penn Central lost over $31 million in cash from the initial investment to the end of 1969. This may be only a relatively small part of the overall corporate cash drain, but as with the real estate subsidiary investments, the element of deception practiced by management compounded the injury caused by the actual cash loss. The initial investments were made to give Penn Central a foothold in the air cargo business.136 This investment was made with the full knowledge that Civil Aeronautics Board rulings prohibited rail carriers from owning air cargo operations. When the CAB discovered the situation and ordered divestiture, Penn Central continued to invest money in EJA, much of which was squandered by EJA management.137 Finally, $10 million intended for equipment purchases was diverted to Liechtenstein to cover up EJA's European activities.138 Penn Central management engaged in deception to keep the EJA losses confidential, in part to avoid a formal bankruptcy of EJA which would have affected Penn Central's financial statements. The deception was so diligent that even Paul Gorman, the president of Penn Central, who had been charged with investigating EJA affairs, did not realize the extent of the losses until after bankruptcy.

MANAGEMENT'S VANTAGE POINT

(1) CASH SITUATION at time of merGER (FEBRUARY 1968)

Penn Central's cash crisis was well known to management. Management knew, in fact, that the financial situation was perilous prior to the merger. In 1968 the situation quickly became critical and by 1969 the company was drawing on its last available credit. The crisis, however, was concealed from investors. This and the next section describe the declining financial condition of Penn Central and management's knowledge of that crisis.

Railroads traditionally have operated on narrow cash balances. This situation had existed at both the Pennsylvania Railroad and the New York Central Railroad prior to the merger in 1968. At the time. of the merger both railroads were cash short, with the Pennsylvania. Railroad being acutely short of cash. In an early memorandum of November 10, 1966, to Bevan's immediate subordinate, William Gerstnecker, John Shaffer, the Pennsylvania Railroad treasurer,

138 Saunders felt that air cargo service would do to rail freight what air passenger service did to the rail passenger business. Whether Saunders was right or wrong on that point, he could not have done worse than in Belecting EJA as the countermeasure to the presumed threat.

137 See further discussion at page 71.

129 See further discussion at page 74.

indicated that the cash loss for 1967 would be $50 million. He stated: "this preliminary forecast definitely indicates that we will be in a cash bind by the end of the first quarter of the next year and something will have to be done to generate cash."

By 1967 the cash situation had further deteriorated. The situation was complicated by the merger agreement with the New York Central which had placed a ceiling on additional borrowings. In a September 8, 1967 memorandum to Gerstnecker, Shaffer pointed out that net working cash at the end of August was at least $57 million less than it was at the end of August 1966, but that this figure could be viewed as $88 million if a number of unusual transactions were included.

At the same time, Bevan was alerting Saunders to the deteriorating state of affairs. In a memorandum to Saunders of September 8, 1967, Bevan warned: "Because of our present extremely low cash position it is imperative that we plan carefully for the balance of the year and for 1968 * **" The memorandum indicates that even after the receipt of $18 million from the sale of N. & W. debentures "it is still estimated that the cash balance at the end of December will be only $6 million compared with $40 and $45 million which is required for operations and compensating balances in banks where we have outstanding loans." The memorandum goes on to discuss necessary financings and the possible need to obtain New York Central permission again to increase its debt limit under the merger agreement:

As a matter of fact, we cannot get through October and November of 1967 when our cash is reduced by the end of those months to $13 million and $6 million, respectively. On top of this, based on present estimates and historical results, we are faced with a decline in cash between the end of this year and the end of the first quarter of 1968 of $25 million.

Under all the circumstances it is essential for us to raise as early as possible this fall somewhere between $35 million and $50 million with the hope that this will carry us through next year until at least the end of May. We do not have any assets of a substantial nature which can be liquidated to supply our cash needs and, therefore, we must resort to the issuance and sale of debt and our medium would probably have to be an issue of debenture bonds by Pennsylvania company * * * Unless we do the latter, we have no alternative but request the New York Central to approve an increase in our debt limitation.

I have been postponing this inevitable conclusion with the hope that increased rates and business would improve our position but our current and prospective cash position leads me to the conclusion that we cannot delay any longer.

By early November the railroad was considering requesting an increase of $75 million in the debt allowable under the merger agreement with the New York Central. By mid-November of 1967, however, when it became apparent that the merger might take place as early as January 1, 1968, the Pennsylvania Railroad began rethinking its financing needs since it would have to survive only until January under the existing debt ceiling. The revised plans called for a "floater debenture" on Norfolk & Western stock owned by Pennco to produce over $8 million; a drawdown under a revolving credit agreement of approximately $10 million; and a sale to banks of dividends from the N. & W. stock expected to produce another $10 million after the beginning of 1968.

(2) THE IMMEDIATE CRISIS (MID TO END 1968)

As described above, the cash situation of the merged railroad at the time of merger was bleak. In the postmerger period chaotic operations and the resulting deterioration of service quickly put an additional strain on the cash situation. The Penn Central, however, managed to paint an almost flattering picture of its financial posture. In a news release dated August 7, 1968, the Penn Central reported on the sales of commercial paper and on its overall financing program. With reference to the $100 million of commercial paper that had been authorized by the Interstate Commerce Commission on July 29, 1968, the release stated:

"We have been informed by Goldman Sachs & Co., our commercial paper dealer, that the paper has been well received in the financial market,” Mr. Bevan said. He pointed out that the use of this method of financing is virtually new in the railroad industry but it can provide great flexibility in meeting short-term requirements.

The release went on to describe the issuance of commercial paper as the first phase of a three-phase program designed to give Penn Central "more modern methods of financing." The second phase was to be $100 million in revolving credit to replace outstanding bank loans. The third phase involved a long-term blanket mortgage which was expected to become the major long-term debt vehicle for the Penn Central:

"Substantial progress has been made on this work," Mr. Bevan said. "When this program is completed, we will have all the tools necessary with which to meet both long- and short-term requirements, as circumstances dictate, with the greatest possible flexibility."

The picture painted in a memorandum from Bevan to Saunders on July 25, 1968, a couple of weeks earlier is starkly different from that presented to the public. Bevan complained about the absence of an income budget for 1968 and about a recent reduction in the revenue forecast, both of which made planning difficult. He indicated, however, that the situation had become "sufficiently critical" to have forced them to make some estimates. The memorandum indicates that by the end of the year: (1) the $100 million revolving credit would be exhausted; (2) the $100 million in commercial paper would be exhausted; and (3) there would be still a need for $125 million to $150 million of additional financing.139

In an October 9, 1968, memorandum to Saunders & Perlman, labeled "Personal and Confidential," Bevan reported on progress being made to close the $150 million cash deficit projected for 1968. This included a reduction of capital expenditures by $22 million and a proposed $50 million Eurodollar loan. The total reduction was $98 million. Bevan

139 The memorandum reads in part:

"In the absence of an income budget for the year 1968, we have not been able to make a detailed cash flow estimate for the year. However, with two recent major cuts in revenue forecast and the possibility of a steel strike, the situation has become sufficiently critical so that we have felt impelled to make the best estimate possible under the circumstances.

"In connection with the revenue reductions, we are advised of a reduction of $15 million made by the Revenue Forecast Committee on July 12 and an additional $4 million reduction on July 16. This difficult situation has been further compounded by the not unexpected request from the New Haven for additional $5 million on August 1 *** We are preparing further more detailed estimates based on the information presently available, but it now appears that at the end of this year we will have exhausted the $100 million revolving credit and the $100 million commercial paper program and that we will still have a need for somewhere, depending on future circumstances, between $125 million and $150 million. This is without giving further affect to what would be required in the event of a steel strike. When this is coupled with the fact that we almost invariably lose cash for the first 8 months of the year, I believe it is necessary for us to take all possible steps at this time to conserve cash and work toward a very minimum capital budget for 1969."