COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE

HARLEY O. STAGGERS, West Virginia, Chairman

On the occasion of the publication of the "Staff Report of the Securities and Exchange Commission to the Special Subcommittee on Investigations on the Financial Collapse of the Penn Central Company," I feel it appropriate that we take a comprehensive look at the Penn Central bankruptcy, its causes and its results, and the adequacy of the laws and regulatory agencies which administer those laws.

The collapse of the Penn Central is the single largest bankruptcy in our nation's history. The ramifications of that bankruptcy extend far beyond those unfortunate enough to have been stockholders. For them, as for those whose pensions were dependent upon investments in Penn Central, the bankruptcy was a major tragedy. In addition to these investors and pensioners, however, the bankruptcy had a major impact upon our national economy. The run on commercial paper caused by the Penn Central collapse could have created a serious liquidity crisis for our nation's businesses except for the timely action of the Federal Reserve Board. The Eurodollar offerings which were being encouraged as a means of curtailing balance of payments deficits lost their investment attractiveness in the overseas markets. Indeed, the interruption of commerce which is so dependent upon our highly complex and interwoven transportation system was threatened.

A great many recommendations have come out of different studies of the Penn Central Collapse. The first recommendations were included in a Staff Study by the Special Subcommittee on Investigations entitled "Inadequacies of Protections for Investors in Penn Central and other ICC-Regulated Companies." This report limited itself to the interplay of the Interstate Commerce Act and the Federal securities laws. Thereafter, in an extremely careful and detailed study the staff of the House Committee on Banking and Currency reported on its investigation of "The Penn Central Failure and the Role of Financial Institutions." Now, we have the recommendations of the SEC as a result of its staff study. The time has come for serious. consideration of what Government can do to protect the public interest including the following:

1. Elimination of exemptions for rail and motor carriers from the Federal securities laws.-The securities of carriers regulated by the Interstate Commerce Commission are generally exempt from the disclosure requirements of the Federal securities laws. Similar exemptions are not available for airline carriers regulated by the Civil Aeronautics Board; wire carriers regulated by the Federal Communications Commission or gas and electric carriers regulated by the Federal Power Commission. The intent of Congress in 1933 in creating the first of these exemptions for ICC regulated carriers was based on the assumption that the extensive regulation of rail securities then being.

exercised by the ICC would be the best protection for investors. At that time the SEC did not exist and motor carrier securities were not regulated by the ICC. Thirty-nine years later, the SEC does exist and the reasons for exempting rail and motor carrier securities no longer seem valid.

On December 8, 1971, I introduced H.R. 12128, a bill "to extend the protection provided by the Federal securities laws to persons investing in securities of carriers regulated by the Interstate Commerce Commission." The SEC fully supported this proposed legislation. The ICC, on the other hand, generally opposed it. The comments of both agencies regarding H.R. 12128 are included at the end of this volume.

2. Improved legislative and regulatory control over diversification of transportation companies.-Transportation carriers in their function as utilities operating under a public license are in a position to monopolize a segment of the national economy and thereby insure a guaranteed source of funds. Diversion of those guaranteed funds out of the transportation business and into other endeavors offering a more attractive investment return is increasing. There are today significantly more transportation holding companies and holding companies with transportation components than there were a decade ago. There is also greater concentration among the major transportation companies.

One motor carrier, in order to further its program of diversification, was found by the ICC to have exceeded its standard for an acceptable working capital ratio and unreasonably mortgaged the carrier's operating equipment. The experience of the Penn Central with diversification proved that profits on acquired non-rail operations are often illusory while the out-of-pocket costs of acquisitions are quite real. In the same vein the increasing diversification by air carriers may result in unreasonably encumbering airline operating equipment while the costs of acquisition exceed the real benefits thereof.

The record is not clear that diversification is absolutely bad. In the final analysis the process of diversification by transportation companies might possibly prove to be the boon to the transportation industry which its supporters claim. On the other hand, it may be that transportation holding companies will indulge in many of the same abusive practices which electric and gas holding companies engaged in before the passage of the Public Utility Holding Company Act of 1934. Until a thorough analysis is made of the public interest benefits for diversification by the regulated transportation utilities, a proper conclusion may not be reached. In order to make this analysis, I have in structed the staff of the Special Subcommittee on Investigations t collect and study all the available data on diversified transportation companies and to report back to me.

3. Federal incorporation of companies regulated by the ICC and CAB.-Public utility oriented companies which are regulated by the ICC and CAB serve a national interest. As such, they cannot enjoy the same latitude of business discretion as unregulated companies. Directors and officers of those regulated companies may find a conflict in their responsibilities to their stockholders and in their responsibilities to serve the public interest. Incorporation of such companies under Federal laws could insure uniformity of corporate and individual accountability.

4. Increased regulatory restrictions on dividend policy.-For a considerable period before the bankruptcy, Penn Central and its pred

ecessors had maintained a policy of paying dividends out of borrowings rather than admit there were no real earnings. Stockholders were led to believe they were being paid dividends when in effect they were really receiving repayments of capital. It was this policy in particular which lulled the small investors into trusting in the safety of their investments.

In a period of severe negative cash flow, Penn Central continued to pay attractive dividends through massive borrowings at higher and higher interest rates. The great bulk of these borrowings were ultimately subject to ICC approval. Apart from any considerations of fraud under the Federal securities laws, a policy of mortgaging future operations to maintain a current dividend policy not justified by current operations should scarcely be the practice of a regulated utility. A temporary market aberration may warrant occasionally retaining an established dividend in excess of earnings, but not indefinitely.

In the event regulatory controls over dividend policy cannot be implemented with existing laws, new legislation may be needed. I am requesting the ICC to consider this matter and report back to me.

5. Extraterritorial application of the Federal securities laws.-One of the more unfortunate aspects of the Federal securities laws is the limitation of their enforcement to the United States. Capital markets today are not territorial, and overseas investors are not solely large financial houses. Foreign investors apparently are not entitled to the full disclosure protections which U.S. residents enjoy. They should be.

Eurodollar offerings by major American corporations have played an important role in limiting the outflow of U.S. investment. They have also introduced individual European investors to the American capital markets. When Penn Central had exhausted all reasonable capital sources in the United States, it was able to borrow overseas because of the goodwill established by other U.S. companies. Unless overseas investors can rely upon the protections assured to American investors, their confidence in U.S. investment will not be retained.

6. Restrictions on interlocking directorates. Since 1914 Section 10 of the Clayton Antitrust Act has prohibited a carrier from having any dealings in securities in excess of $50,000 per year with another corporation having the same officers or directors except pursuant to competitive bidding under regulations established by the ICC. A note or other evidence of indebtedness including commercial paper is a security. A number of banking and other financial institutions made loans to and engaged in other commercial transactions with Penn Central while maintaining their control relationships through membership on the Board of Directors of the carrier. I am specifically requesting the ICC to examine the record in fulfillment of its responsibility under Section 10.

The SEC report carefully documents the great conflict of interest situations in which the banking and financial institutions found themselves whenever they had dealings with the Penn Central. One bank with an interlocking director chose to make indirect loans "because a direct loan would constitute a conflict of interest." In sum, any benefits from interlocking directorates seem clearly outweighed by the potential abuses which might flow from such relationships. An outright prohibition of interlocking directorates between public utility oriented companies and banking and financial institutions may be in the best interests of the public, the regulated companies and their financial counselors.

7. Insulation of commercial banking functions from bank trust departments. The flow of information into a banking institution which is performing vital commercial banking functions must be of utmost confidentiality. A bank trust department is no more entitled to intrude upon the confidentiality of that banking relationship than any member of the general public.

Whether or not the trust departments of the banks serving Penn Central did intrude upon this relationship I am not in a position to say. It seems to me that the mere appearance of evil is enough to warrant stricter regulatory controls divorcing the commercial and trust departments for all purposes including research and investment advice and interchange of personnel.

The law is quite clear that the actual use of confidential information to profit on a securities transaction is prohibited. To avoid the appearance of evil, I am requesting the SEC to consider whether pursuant to its rule making authority it could and should adopt a rule limiting the investment activity of a trust department when a commercial banking relationship exists.

The chronicling of the Penn Central fiasco is not yet complete. Other reports can be expected. The efforts of the staff members of the SEC who were involved in the preparation of this report are to be commended. Their report will find an important place in the histories of the Penn Central bankruptcy.

HARLEY O. STAGGERS,

Chairman, Special Subcommittee on Investigations,
Committee on Interstate and Foreign Commerce.