I-F. ROLE OF DIRECTORS

INTRODUCTION: RESPONSIBILITIES AND FUNDAMENTAL PROBLEMS

In light of the critically adverse developments, the lack of adequate disclosure and the dubious conduct of senior management as described in the other sections of this report, a question arises as to the role of the directors. It should first be noted that it is generally agreed that directors are not responsible for directing the day-to-day operations of the company and they are not insurers of the performance of management. It should also be noted that outside directors are undoubtedly at some disadvantage in terms of monitoring and appropriately directing a company and its management. Most directors have other demanding full-time jobs so that the time and energy that can be devoted to a company's affairs is limited. Directors often must rely on the company staff officers for information and evaluation. Directors rarely have their own staffs to assist them and they usually receive only relatively modest stipends for being on the board.

Outside directors are, however, ultimately responsible to the shareholders of the company for the proper monitoring of a company's affairs. Among the roles of directors are the selection of competent management and review of the performance and integrity of management including compliance with laws applicable to the corporation. As a practical matter, shareholders can rely only on the outside directors to oversee management and to take corrective action when management abuses its authority. The role of directors in the scheme of corporate affairs is reflected in some of the general legal principles relating to the liabilities of directors:

Selection of officers.-There is no question but that the directors may be personally liable where their appointee is untrustworthy or incompetent, and the directors were negligent in making the appointment.282

Oversight of officers. All the courts doubtless agree that the responsibility of a board of directors, or of an individual director, does not end with the appointment of honest and capable men to be executive officers, and that ordinary care on the part of directors requires reasonable oversight and supervision. 283

In other words, a director cannot escape liability merely by picking out able and apparently trustworthy men to act as president, general manager, and then paying no attention to the acts of such executive officer or officers or to the corporate business.284

Being put on notice. Of course, if a director acquires knowledge which tends to raise a suspicion against executive officers or agents, in connection with their positions, he must follow it up or inform the other directors. 285

282 Fletcher, Cyclopedia of the Law of Private Corporations; 1965 revised volume; vol. 3, p. 688 (§ 1079). 283 Id. p. 674 (§ 1070).

284 Id. p. 685 (§ 1072).

285 Id. p. 687 (§ 1078).

286

Of course, if negligent or wrongful acts of officers are merely isolated acts then it might well be that the directors would not be chargeable with notice thereof, but if the wrongful acts are part of a system which has long been practiced by the wrongdoer, the presumption is that the directors, ordinarily, would have discovered the wrongdoing if they had been reasonably diligent. The Penn Central outside directors maintain that they did not violate their obligations, including their obligations under the securities laws.287 They maintain that they were faced with a difficult situation caused to a large extent by forces outside of the control of management or the board. They cite specifically inadequate tariffs, passenger service losses, inability to abandon lines, and the overemployment of labor. The directors claim that they took what measures that they reasonably could under difficult circumstances. They also emphasize that they received no personal gain from any nondisclosure and that some directors suffered significant losses on their Penn Central holdings. They further maintain that they had no knowing participation and they did not aid or abet any nondisclosure of material facts. It was their belief that all of the company's difficulties were repeatedly made known to the public through statements to Congress, the ICC, and the public.

It appears, however, based on the information in this and other sections that the Penn Central board failed in its obligations. In particular, it failed to see to the integrity of management and it failed to see to the compliance by management with the laws governing the company, including the provisions of the Federal securities laws. The failure of the Penn Central board to effectively monitor management arose from several circumstances. One circumstance was the change in the complexity of corporate matters as a result of the merger and the diversification efforts. The directors of the Pennsylvania Railroad in particular had served on a company with a long and conservative financial and operating history. The railroad performed basic functions in a largely unchanging way.288 In such a situation, a board seat was more a matter of business honor than an active business responsibility. On the New York Central, generally a more dynamic railroad, the majority of directors were overshadowed by the active ownership interest of Robert Young and Allen and Fred Kirby 289 and the active management of Alfred Perlman. Under these conditions, the boards tended to miss the management and financial complexity of the proposed merger. Even after the merger, the directors only slowly awakened to what was happening.

Another circumstance limiting the effectiveness of the board was the limited amount of information it sought or received. In the merged company, directors were furnished only with (1) a volumnious

296 Id. p. 684 (§ 1072).

287 In the course of its investigation, the staff took the testimony of almost every director who was on the board at anytime during the period from the merger to the reorganization. The experience of every director was not identical, of course. For purposes of clarity, however, this portion of the report will describe many of the activities of directors in the context of the board as a whole. Some reference is made to individual directors where such reference is necessary to explain particular developments.

288 For example, until the merger, almost the sole financing vehicle was an uncomplicated and conservative conditional sales agreement for equipment. After the merger, commercial paper and Swiss francs were used. 20 Alleghany Corp. acquired control of the New York Central in 1954. Robert Young was chairman and Allen Kirby was president of Alleghany. Young died in 1958 and Kirby became chairman of Alleghany. From 1961 to 1963 the Murchison brothers struggled with Kirby for control of Alleghany. Kirby, who finally retained control, retired in 1967. His son, Fred Kirby, replaced him. Alleghany's control was diluted in 1966 through an exchange offer of its New York Central stock for Alleghany Corp, stock.

docket of routine capital expenditure authorizations for numerous individual transactions, (2) a treasurer's report giving the current cash balances, and (3) a sheet listing revenues and expenses for the railroad for the period between the board meetings.290 291 The directors had no cash or income forecasts or budgets; they had no guidelines to measure performance; they had no capital budgets; they had no information describing the earnings or cash performance of the subsidiaries. For all this vital information, they were forced to rely on oral presentations by management.

The board meetings were largely formal affairs 292 which were not conducive to discussion or interrogation of management. Some of the directors had little opportunity to consult with other directors outside of the environment of the board meetings.293 In extreme cases, directors were isolated from the company or other directors. Otto Frenzel, located in Indianapolis, spoke with other directors only at board meetings, which, as indicated, allowed only limited communication. Seymour Knox, who was in Latin America and in North Carolina. much of the time from September 1969 to May 1970, attended only one board meeting during this extremely critical period.

The board failed in two principal ways. It failed to establish procedures, including a flow of adequate financial information, to permit the board to understand what was happening and to enable it to exercise some control over the conduct of the senior officers. Secondly, the board failed to respond to specific warnings about the true condition of the company and about the questionable conduct of the most important officers. As a result, the investors were deprived of adequate and accurate information about the condition of the company.

PREMERGER PERIOD

The staff's investigation principally covered the period between the merger and the reorganization because in this period the decline in the affairs of the company was most significant and disclosure was most critical. Nevertheless, an examination of developments leading up to the merger is appropriate, particularly in connection with the role of the directors. During the period from 1963 to July 1968, the price of Penn Central stock rose from around 20 to a high of 84.29 The principal cause of the rise was the prospects for the merged company. Numerous financial analysts were repeating the projections of management: the merger would vastly improve the performance of the railroads and the real estate diversification of the Pennsylvania. Railroad would provide a bountiful growth factor. Neither prospect was founded on fact. This would have been revealed by a more intensive review of the prospects for the merger.295

200 In late 1969 and early 1970, as directors became more concerned, the flow of information increased slightly but events had so vastly changed that the information was equally useless.

31 Even the finance committee received no additional written information.

The board of the merged company had 25 directors. These were joined at board meetings by numerous officers. Some directors testified that the size and the arrangement of the meetings effectively limited discussion between management and the directors.

23 Directors associated with Alleghany Corp. did have a common connection. Kirby, Taylor, Rabe, Hunt, and Routh were all Alleghany directors. The Alleghany directors still on the board in the Spring of 1970 resigned following an ICC ruling on Alleghany's acquisition of Jones Motor Co.

294 Adjusted for the premerger period.

295 The directors state that the planning of that merger and its implementation were the responsibility of management. The directors also noted that the merger proposal was reviewed by the ICC and was litigated in the courts over several years. Governmental approval was obtained, however, on representations made by the railroads. In addition, management tended to encourage investor optimism and to minimize the very serious risks which they knew existed.

As described in the beginning of this report, the proposal of a merger between the PRR and the Central was dropped after the death of Robert Young in 1957. Later, following mergers among the other Eastern roads, Perlman became concerned that the Central would be isolated. When this concern arose in late 1961, the idea of merger between the PRR and the Central was revived and negotiating committees of the boards of both railroads were formed. Isaac Grainger chaired the Central committee consisting of himself, Seymour Knox, and R. Walter Graham, Jr. The PRR committee was chaired by Richard K. Mellon and consisted of Mellon, Jared Ingersoll, and Phillip R. Clark. The responsibility of the committee was limited to setting the general terms of the merger including the exchange rate, the composition of the board, and the staffing of the several top management positions.

The negotiating committees began their work in November 1961. It was necessary for the railroads to complete an arangement within several months because other mergers were before the ICC and the Central had to determine its position before the hearings began. The committees each selected an investment banking house to set the exchange rate. The Central selected Morgan Stanley & Co. and the PRR chose First Boston Corp. These two selected the third, Glore, Forgan & Co. The principal problem facing the negotiating committees was the selection of the top officers. The Central directors felt strongly that Perlman should have responsibility for the operations in light of his performance on the Central. James Symes, chairman of the PRR, wanted to be chief executive officer despite his planned retirement in August 1962. Greenough of the PRR was expected to be Symes' replacement and so the PRR directors wanted Greenough as well as Symes to have a high position in the merged company. An impasse developed. On December 27, 1961, Grainger, Symes, and Perlman met to consider the selection of top management. Upon being pressed about problems in the selection of management Symes said that frankly the PRR directors were having difficulty accepting Perlman. The Central directors, however, were desirous of having Perlman as chief operating officer because of his performance on the Central. A caustic discussion followed during which Symes and Perlman bluntly stated their dissatisfaction with the other's management of his road. To resolve the basic dispute, it was finally proposed that Symes and Perlman would become inactive vice chairmen of the board and that the PRR would name a chief executive officer and the Central would name a president. The merger agreement was signed, and the merger began its course through the ICC and the courts.

The road to final approval was not wholly harmonious between the two railroads, and Perlman occasionally expressed the belief that the negotiating committee had given away too much and that perhaps an alternative merger was possible. Meanwhile Sounders had replaced Symes as chairman of the PRR on October 1, 1963. Saunders was formerly head of the N. & W. and was named chairman of the PRR when the railroad was unable to choose one of its own officers (including Greenough and Bevan) for the position. While discussing merger matters with Saunders in March 1965, Grainger broached the suggestion that the merger agreement be changed so that Perlman could be made president. Saunders, who was not an operating officer himself, agreed.

The negotiating committees became inactive after the signing of the agreement in 1962 and, except for isolated instances, neither that committee nor the board was directly involved in any other matters relating to the merger. The only information about the progress of the merger which the board received was oral reports from management at board meetings. Other than what was given in the oral presentations, the board did not review the savings or costs which were being forecast and they never reviewed the kind of planning being done.

As explained elsewhere in this report, the merger planning was inadequate and fundamentally flawed. The Patchell report which was presented to the ICC was not a plan for the merger nor was it intended to be. It had not attempted to set out savings or costs that would result from the actual operations of the merged railroad. Instead it was a vehicle for presenting some cost and savings figures to gain approval of the merger. The planning for some of the departments, other than the operations department was valueless. The departments of the respective roads did not cooperate and a lot of the planning did not take place until the department heads were named at the time of the merger. In the area of rail operations, where a detailed plan was formulated, the plan was ignored. Apparently no detailed plan was in effect on merger day. Little or no training was given yard crews or connecting lines and shippers.

None of the directors who testified was aware of these problems. The directors were under the impression that all necessary planning had been done and that the merger was being carried out pursuant to this planning. Most of the directors never did learn of the lack of meaningful planning or the relation of poor planning to the chaos which occurred upon the merger of the railroads. They were also unaware that the cost and savings forecasts were not accurate. The directors have emphasized that governmental bodies reviewed the merger and that only management could be expected to be familiar with the details of the planning. It would seem reasonable, however, for the directors to have informed themselves about the underlying theories and the actual planning. According to the testimony of directors, however, no director expressed any concern or reservations about the merger during the premerger period and the board never attempted to verify the representations of management about planning progress or expected savings and costs. Neither board had a committee established for the purpose of reviewing or monitoring the feasibility of, or planning for, the merger.296 The merger of the Central and the PRR was probably one of the most complex and difficult mergers in corporate history and yet it appears that the directors did not make significant efforts to analyze it or evaluate it.

A committee of the board did review one merger related item. Under the terms of the merger agreement, the Central and the PRR were limited to $100 million in additional debt. In March of 1966, the NYC board considered a PRR request to increase their indebtedness above the ceiling. The PRR explained that the debt increase arose out of the acquisition of Great Southwest, Macco, Buckeye, and Arvida. The Central board formed a committee consisting of Grainger, Graham, and Odell to examine the request. Upon the recommendation of the committee, the board approved the increase. The approval recommendation, however, contained some reservations about the real estate investment (these had been raised by Odell):

Independent opinions were exceedingly favorable for the Buckeye property and for the most part favorable for the real estate acquisitions. However, questions were raised over short-term prospects for the Arvida properties, and there were negative views expressed in connection with the California properties. Therefore, the committee cannot give a definitive appraisal of the overall diversification program of the PRR. While there is a feeling that real estate investments at this time would not be the committee's choice, nevertheless, it has confidence in the judgment of its partner in the merger. (Memorandum from Graham, Odell, and Grainger to Central board May 2, 1966).