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financial condition and performance of U.S. corporations whether they are dealing in domestic or foreign markets.

The staff report examines the role of the directors. The responsibility of directors is primarily a matter of State corporate law. But directors have a responsibility to see that their corporation and the management they select obey the Federal securities laws.

It is difficult to see how this responsibility can be satisfactorily discharged unless the directors themselves obtain from management information which is adequate in both quantity and quality. To be adequate, this information has to be both factual and judgmental. It has to deal with the past, present, and future. This was brought out very effectively by a new director, joining the Penn Central board in May of 1969, in a memo to the chairman of the board pointing out that lists of new equipment did not particularly help hím discharge his responsibilities as a director and spelling out the kind of information about objectives and performance and about problems and plans for overcoming them which he would need to do his job as a director. Today's more sophisticated investor needs, perhaps in a broader and more general way, the same kind of picture and he is entitled to it if the disclosure process is to do as well in the future as it has done in the past in maintaining general public confidence in our securities markets. The Commission, taking a look at the future, has paid increasing attention to the role, the qualifications, the responsibilities, and the independence of corporate directors, which appear to be called for. Last month the Commission released a statement endorsing the establishment of audit committees composed of independent directors. The staff report points up the critical importance of the whole subject of the responsibility of directors, the greater utilization of public and independent directors, the professionalization of their function, providing staff support for directors and judging their performance not on the basis of hindsight but on the basis of the reasonableness of their judgments in the circumstances and at the time it was exercised.

The report also examines the way three major banks handled their obligation under the securities laws to assure that nonpublic information obtained in the course of commercial lending is not used by the trust department in its investment decisions. These institutions recognized this obligation and set up procedures, with varying degrees of adequacy, to meet it. The report points up the possibilities of conflicting responsibilities where such inside information is available to operating divisions of the institutions and the need for adequate procedures to prevent misuse of such information where this situation exists.

Lastly, the report goes into the circumstances surrounding sales of Penn Central securities by management officials during this period in connection with the question whether sales by some individuals occurred while they were privy to material adverse inside information concerning the company. If this occurred, it might involve violations of existing law, and accordingly, I express no view at this time on the question. In addition, the report's analysis of the activities of a private investment fund composed primarily of principal corporate officials and their financial advisers raises questions of possible conflicts of interest and misues of inside information and suggests the need for consideration of additional controls in this area.

The report represents the culmination of a lengthy and exhaustive inquiry by our staff. I hope it will be a catalyst for considering significant improvements and reforms in the securities field. In this letter of transmittal, I have tried to indicate some recent improvements in our rules which are relevant to the problems brought out by this report and to suggest other measures that should be considered. Respectfully yours,

WILLIAM J. CASEY, Chairman.

CONTENTS

Foreword...

Letter of transmittal..

Introduction.

Summary

Chronology of events.

Part I..

I-A. Railroad difficulties: Merger and operating problems..

Premerger period: History -

Premerger period: Merger expectations-

Premerger period: Planning -

Postmerger period: Service problems.

Earnings record.-

Introduction.

Merger savings and costs.

The ICC study-

Reported earnings.

Summary---

I-B. Income management-

The maximization policy-

Pressures on the accounting department to allow the reporting of

higher income

The November confrontations-

The "spongy” areas.-

The merger reserve.

Other devices to increase railroad earnings-

Nonrailroad operations.

Real estate activities.-

The search for investment income..

Early 1970—The last gasp-

Accounting treatment.

Madison Square Garden Corp-

Trucking company dividends.

Washington Terminal Co-----

Lehigh Valley Railroad Co----

Merger reserve: Separation of mail and baggage handlers.

Executive Jet Aviation --

The $10 million Liechtenstein account.

The role of the independent auditor.

I-C. Finances.

Cash flow versus "earnings”

Some causes of the cash loss.

Operations losses..

Dividends..

Interest costs

Cash relationship---

Management's vantage point--

(1) Cash situation at time of merger (Feb. 1968).

(2) Immediate crisis (mid to end 1968).

(3) Crisis grows (end 1968 to fall 1969)

(4) Last efforts (fall 1969-June 1970).

Postscript: A case study--

I-D. Public offerings -

Introduction

Fifty million dollar debenture offering-

One hundred million dollar debenture offering-

Warrants for Great Southwest and Penn Central stock..

Discovery of underwriters of Penn Central's critical problems.

Part 1-Continued

I-E. Great Southwest Corp--

Introduction.--

Great Southwest Corp-

Great Southwest and Penn Central.

Profit maximization.

Some other methods.

Tax allocation agreement.

Officer employment contracts...

Abandonment of proposed offering of Great Southwest stock.

Failure of alternative efforts to sell Great Southwest stock

Exchange of Great Southwest stock for debt owed to Pennco.

Great Southwest financing after abandonment of the public

offering-

Futile attempts at an earnings encore- 1970.

I-F. Role of directors.

Introduction: Responsibilities and fundamental problems..

Premerger period

Postmerger period..

Financial problems and a first challenge to dividend policy -

Investigation of Bevan abandoned...

Fall 1969: Gorman/Gengras—A beginning request for informa-

tion..

Robert Odell on Great Southwest and management.

The final months..

I-G. Disclosure..

General

Railroad operations: The merger.

Earnings---

Railroad earnings..

Nonrailroad earnings..

Disclosures relating to 1968 earnings

Disclosures relating to 1969 earnings.

Disclosures relating to 1970 earnings.

Cash flow and financing --

The professional analyst.

Summary and conclusions-

Part II...

II-A. Sale of Penn Central stock by institutions.

Introduction...

Chase Manhattan Bank, N.A..

Morgan Guaranty Trust Co.---

Continental Illinois National Bank & Trust Co..

Alleghany Corp. and Investors Diversified Services, Inc.-

II-B. Trading by officers and directors

Introduction.--.

Officers-Finance-

Officers-Real estate and taxes..

Officers-Operations and labor.

General corporate officers.-

Chronology of officer sales discussed in report.

Part III..

III-A. Sale of commercial paper.

Introduction.

Commercial paper..

The market for commercial paper---

Penn Central Transportation Co.'s commercial paper..-

Other financial relationships between Goldman, Sachs, and the

Transportation Company -

Methods employed by Goldman, Sachs to sell the Company's

commercial paper to customers.

Summary--

Goldman, Sach's position on the sales of the Company's com-

mercial paper.-
III-B. Role of National Credit Office in rating the commercial paper

of Penn Central.

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