On January 6, 1969, Wilson replied to Hill pointing out "that the terms contemplate that the optional redemption price must 'immediately' be adjusted whenever N. & W. issued any additional shares of stock other than so-called "excluded shares." "It is furthermore required that upon any such required immediate adjustment the corporation is obligated 'forthwith' to file a formal statement of the adjustment with the escrow agent and give prompt written notice by mail to all holders of record of the preferred stock. It would appear that Pennsylvania Co. is rather seriously in default in these obligations.

On January 15, 1969, Wilson wrote to David F. Anderson of the law firm of Potter, Anderson & Corroon of Wilmington, Del.. the general counsel of Pennco, stating that he felt that the optional redemption price should be adjusted and asking Anderson for his thoughts. On January 20, 1969, Anderson replied to Wilson stating that he agreed with him, "[h]owever, I do not have an expertise in interpreting this provision of the merger agreement, and your judgment is as good as mine."

On January 22, 1969, C. L. Rugart, Jr., the secretary-treasurer and comptroller of Pennco, sent a memorandum to Gerstnecker who at the time was a financial officer of Penn Central but was neither an officer nor director of Pennco. The memorandum stated that Chemical Bank was holding 39 shares for conversion and that other preferred holders were considering converting. Advice was requested concerning revision of the conversion ratio. Rugart also cited the provision which states that if N. & W. takes any action with respect to its capital stock which is not adequately covered by the express provisions on dilution and which might materially dilute the right of any holder of preferred stock, the board of directors of Penneo must appoint a firm of independent certified public accountants to get an opinion as to the adjustment.

During the latter part of January, Wilson, at the suggestion of Gerstnecker, forwarded to Robert Rosenman of the law firm of Cravath, Swaine & Moore, documents relating to the several transactions. Rosenman was asked to form tentative conclusions to be given informally. Sometime prior to February 18, 1969, Wilson and Rosenman conversed. On February 18, 1969, Wilson wrote a memorandum to Gerstnecker stating that the preliminary view of the Cravath firm was that the transactions did constitute the events of dilution requiring an alteration of the conversion ratio and the deposit of additional N. & W. stock with the escrow agent. The memorandum stated that Wilson had told Rosenman that Gerstnecker felt no dilution had occurred. In response, Rosenman had indicated that a change in their preliminary opinion would require additional facts, assuming that such facts existed. The memorandum closed with a request to Gerstnecker to consider the urgency of the situation.

On April 3, 1969, Wilson wrote separate memorandums to Rugart, Edward Kaier, general counsel of Penn Central, and Cole, assistant to Saunders. In the memoranda Wilson indicated that nothing had been done since his February 18, 1969, memorandum and that while he realized that Gerstnecker did not agree with his opinion Wilson felt that very serious consequences could result if the company continued to be derelict in its duties to the stockholders. Cole testified that he recalled receiving Wilson's memorandum and having had some discussions with Wilson on the matter. Cole also stated that he

never discussed the area of dilution with Saunders and that he was not aware of whether Saunders was familiar with the area of not.

On May 5, 1969, Wilson wrote a memorandum to the files concerning a conversation with Rugart on May 1, 1969, in which Wilson was informed that Chemical Bank had asked what the reason was for the delay in converting 39 shares. Wilson told Rugart that he could approve only two courses of action: either (1) convert and inform the stockholder that a change in ratio was being worked out; or (2) convert without giving the shareholder any notice, and send the additional shares in a week to ten days. Wilson stated that he could not approve any course of action which complied with the redemption request on the old basis without any intention to get in touch with the stockholder in the future or to take any required action to change the ratio. On May 5, 1969, Wilson was informed that the alternative adopted was the one he had not approved of. Wilson was involved in no further communication until after the bankruptcy.

In testimony Gerstnecker stated that he was aware that there was a question of dilution, and that he and Bevan had conferred about the matter. He recalled that both Wilson and Taylor had indicated. to him that a dilution had occurred, but that he had felt that the question was one that should be resolved by the legal department.161 He also stated that he did not attempt to interpret the sections of 1964 agreement or to indicate his views concerning the intent of the agreement but that he was aware that Cravath, Swaine & Moore had indicated that dilution had occurred and that there was no reason for him to think that there was not a dilution. He stated that if he or Bevan had been told of the need for action, some action would have been taken. Gerstnecker, however, acknowledged having received and read Wilson's memorandum which emphasized the duty specified in the agreement to notify shareholders immediately. Despite this requirement of immediate action, nothing was done during the period of a year and a half until the bankruptcy. The matter was never brought to the attention of the Pennco board.

It is clear that Bevan and Gerstnecker knew that dilution had occurred and knew that Pennco had an obligation immediately to notify shareholders upon such occurrence. Their failure even to raise the issue with the board or to take any of the required steps such as notifying the shareholders resulted from their unwillingness to have to face the problem of finding N. & W. shares. All of Pennco's N. & W. stock had been pledged or escrowed or otherwise restricted. Pennco probably would have been required to purchase the N.&W. stock in the market for cash and management was unwilling to face another cash drain in light of the other financial problems being encountered. Their failure to resolve the problem also contributed to the inaccuracy of statements concerning Pennco's assets. Although the amount of money involved was relatively small, management refused to take even minimal steps to meet its obligations to shareholders.

161 His recollection differs from that of Taylor. Taylor recalled that he was summoned by Gerstnecker and Bevan and told that they were of the opinion that no dilution had occurred despite the opinion of Wilson and others. Taylor stated that with this in mind he looked into the matter and concurred. He did not put his views in writing and never spoke with Wilson despite his possession of Wilson's memorandums and despite the fact that Wilson's office was next to his.

I-D. PUBLIC OFFERINGS

INTRODUCTION

The only public offerings by the Penn Central following the merger of the two railroads were a $50 million Pennco debenture issue in December 1969 and a $100 million Pennco debenture offering in the spring of 1970.162 163 164 The latter offering was never sold. There was no requirement that the offerings be registered with the Securities and Exchange Commission because the issuing company, Pennco, was under the jurisdiction of the Interstate Commerce Commission. The Interstate Commerce Commission rules require that companies under its jurisdiction make applications to the ICC for permission to increase their debt obligations. The purpose is to determine whether an increase in debt is justified in the public interest.165 There were no rules, however, on the use or composition of any selling literature disseminated to the public. 166

Normally, companies under ICC jurisdiction prepare and distribute an offering circular in the general format of a prospectus for a registered offering because the civil liability provisions of the Federal securities laws concerning disclosure apply to selling literature used by these companies. Despite the absence of a requirement that offerings be filed with, and subject to review by, the SEC the threat of civil liability forces issuers and underwriters to be cautious in their use of sales literature.

FIFTY MILLION DOLLAR DEBENTURE OFFERING

The $50 million Pennco debenture offering was made on December 16, 1969. The underwriters were First Boston Corp. & Glore, Forgan, Wm. R. Staats, Inc. The debentures were exchangeable for shares of the common stock of Norfolk & Western Ry. Co.167 The N. & W. shares owned by Pennco had been its most valuable asset both in underlying value and production of cash income. Because of the exchange feature, these debentures kept their value even after the bankruptcy of the railroad. The underwriters have cited this exchange value as one of the reasons why the circular contains no information about the Transportation Co. or the holding company. The information in the circular is limited to the Pennsylvania Co. and Norfolk & Western.

162 The Transportation Co. did issue commercial paper which was made available to public investors but no offering circular was used or was required by the ICC.

163 Both offerings were made for the stated purpose of supplying funds for the Transportation Co. 164 Penneo made a $35 million private placement of collateral trust bonds in July, 1969. The proceeds were supplied to the parent company.

165 The Penn Central had to seek and obtain ICC approval to increase debt under the revolving credit agreement and the commercial paper authorization as well as for these public offerings.

166 The Federal securities laws require issuers (except exempted issuers, such as those regulated by the ICC) to file with the Securities and Exchange Commission a registration statement containing specific types of information. There are additional rules governing the distribution of selling literature to the public.

167 Exchangeable from Nov. 1, 1970, to Apr. 15, 1979, at the rate of 12.2 shares of N. & W. for each $1,000 debenture (ie. at a price of $81.97 per share of N. & W.).

Despite the fact that investors have been protected by the exchangeability provision, the circular presents a misleading picture of Pennco, particularly in connection with Great Southwest. The assets are described in the introduction as constituting $922 million in market value on December 10, 1969. Of this $922 million the Great Southwest stock comprised $435,400,000.168 The market value of Pennco's GSC holding was as large as it was because of failure to disclose the true state of affairs at GSC. The overvaluation was known to Glore, Forgan because it had been the designated underwriter on a GSC offering in October 1969, which had to be abandoned because of the adverse disclosure that would have been required. 169

The circular contained other failures to fully disclose the affairs of Pennco. The apparent dilution of N. & W. stock which had occurred in 1968 was described at the end of the previous section of this report.170

This would require Pennco to free N. & W. stock from pledge or to purchase more on the open market. No mention of this additional burden was made in the circular and Pennco never informed the Pennco preferred shareholders of this apparent dilution.

The circular mentions a proposed sale of 2 million shares of Pennco's GSC stock to three senior officers of GSC for $20 million in cash and $16 million in notes. This was a frivolous proposal which was was never completed 17 and created a false impression as to the possible receipt of cash and as to the value of GSC stock. The circular failed to disclose a simultaneous proposal, which was actually carried out, to have Pennco accept GSC stock from GSC in exchange for the cancellation of a debt exceeding $20 million owed by GSC to Pennco, principally for cash advances which had been made to GSC by Pennco. 172 Disclosure of the exchange might have alerted investors to the cash drain from the railroad to the real estate subsidiaries.

16 Almost all of Pennco's assets were stocks and bonds. The following is a list of stocks and bonds owned by Pennco at Dec. 10, 1969: (From the Pennco circular, footnotes omitted, p. 7.)

Penn Central avoided disclosing these and other adverse facts about the railroad, Pennco, or GSC in the $50 million circular. As described below, it was not quite so fortunate in the next public offering.

ONE HUNDRED MILLION DOLLAR DEBENTURE OFFERING

In 1970, the last vehicle that might be used for an attempt at a major financing was the Pennsylvania Co. The Pennsylvania Co. itself had inherent drawbacks as a financing vehicle at this time and the drawbacks were becoming ever more serious. Debt instruments, including that $50 million December 1969 debenture offering, contained convenants restricting the amount of debt that could be incurred by the Pennsylvania Co. in relation to the assets. 173 The borrowings of Pennco had already increased by $85 million in 1969. At the same time the market price of Great Southwest shares, Pennco's principal asset in terms of market price, was steadily declining in late 1969 and early 1970. Penn Central management realized that the decline would continue as the deteriorating condition of Great Southwest was gradually being perceived by investors. The Penn Central, however, had no choice about using Pennco as a financing vehicle because money was needed and there were no other means of obtaining that money.

On February 2, 1970, O'Herron called N. Gregory Doescher of First Boston Corp. to inquire about the possibility of a debenture issue for Pennsylvania Co. which would include warrants for Penn Central Co. stock and Great Southwest stock owned by Pennsylvania Co. The fact that this proposal was coming less than 2 months after Pennco had completed a similar offering was a clear indication of the serious cash drain and the limited financing possibilities. Despite this warning, the underwriters began preparations for the offering.

WARRANTS FOR GREAT SOUTHWEST AND PENN CENTRAL STOCK

One complication was encountered immediately. Penn Central management had proposed the use of Great Southwest warrants despite the fact that Great Southwest had been forced to abandon a public offering in late 1969 because of the adverse disclosure which would have been required in a registration statement. Glore Forgan, which had been the proposed manager of the abandoned Great Southwest offering, knew of the reasons for the abandonment. First Boston, the lead manager on the Pennco offerings, did not know about the abandoned Great Southwest offering.174 Doescher realized, however, that the GSC warrants and the holding company warrants were needed as "sweetners" because of the prevailing high interest rate and the fact that the Pennsylvania Co. debentures would be less than premium grade. Doescher understood that these factors might have required an interest rate so high that it would be self-defeating in that investors would be frightened away by an offering that had to pay such high

rates.

Penn Central had hoped to avoid the disclosure problems by delaying registration of the warrants until their exercise date on July 1,1971.175

173 The common stock of Pennsylvania Co. itself was pledged as security to the revolving credit. 174 First Boston and Glore Forgan were the original comanagers of the $100,000,000 Pennco debenture as they had been on the $50,000,000 offering. Salomon Bros. was added at the request of Penn Central.

175 A note written by Doescher dated Feb. 12, 1970 states: "Concept feasible, delay exercise of warrants until July 1, 1971; [debenture] circular now; delay registration statements until warrants become exercisable."