Mr. O'Herron, in the event that additional capital must be raised, what assets would be available for this purpose? Also, please tell us how the funds from the sale of commercial paper notes are being used.

This information, and any other comments that you care to make would be very helpful in our analysis.

Unfortunately for NCO, O'Herron never responded to this inquiry even though Merker sent a followup letter on May 18, 1970.

On April 22, 1970, Penn Central announced a first-quarter loss of $17.229 million compared with consolidated net income of $4.601 million for first quarter 1969. The Transportation Co. had a first quarter loss of $62.7 million compared with a loss of $12.8 million in 1969. And it was obvious that even these substantial losses were not reflective of the underlying situation since they included the impact. of large reported profits on two transactions.

During the period from April 23 to May 18, 1970, NCO discussed the Penn Central situation but did not ever consider lowering the company's rating from prime, nor did they take any further action. In fact, the primary topic of discussions during this period was the failure of Penn Central to reply to the letter of April 23.

Moreover, NCO was not aware that the last sale of the Transportation Co.'s commercial paper occurred on May 1, 1970; that Goldman, Sachs ceased to offer the company's commercial paper on May 20, 1970; and that as of April 23, 1970, Goldman, Sachs required its sales personnel to inform prospective customers of the Penn Central earnings announcement of April 22, 1970.

NCO was unaware that the May 12, 1970, offering circular for the Pennco $100 million debenture offering contained the following statement at page 4:

At May 8, 1970, railroad had outstanding $152.1 million of commercial paper pursuant to orders of the Interstate Commerce Commission authorizing up to $200 million of such paper. To the extent that commercial paper outstanding has been less than $200 million, railroad has borrowed under a $50 million bank line of credit. As additional backing for its commercial paper railroad has available $50 million under the credit agreement referred to under introduction. Between April 21, 1970 (the day preceding the announcement of the operating results of railroad for the 3 months ended March 31, 1970) and May 8, 1970, maturities and payments of commercial paper exceeded sales of commercial paper by $41.3 million. Of the commercial paper outstanding at May 8, 1970, approximately $75 million matures prior to June 30, 1970, and the balance at various dates to December 16, 1970.

Although this was a preliminary offering circular, it should have been available to NCO pursuant to their subscription agreement with Penn Central. NCO, however, did not become aware of the fact that the company's redemptions of commercial paper were exceeding sales until the appearance of a Wall Street Journal acticle on May 27, 1970. On May 15, 1970, Standard & Poor's downgraded the bond rating of the Pensylvania Company and its proposed $100 million debenture offering. On May 18, 1970, Merker spoke with Jack Vogel of Goldman, Sachs. According to Vogel, Merker asked him if he still felt the same way about Penn Central in view of Standard & Poor's rating change. Volgel replied affirmatively and Merker accepted his explanation for the change.

8

On May 28, 1970, Merker spoke with Jack Vogel about Penn Central. Vogel after stating that the Transportation Company had bank

7 See discussion at page 54.

Merker, however was unable to recall that the conversation took place and the content of same.

credit still available to redeem commercial paper, also suggested that Merker check the May 12th offering circular.

Merker did obtain a copy and on June 1, 1970, after internal discussions at NCO between Merker, Schenk & Rogers, Merker called O'Herron asking for more information. O'Herron declined to provide same and this, coupled with the fact that the $100 million offering was aborted, prompted NCO to reserve Penn Central's rating pending further information. Effectively this meant that NCO while not refusing to rate the Transportation Company's commercial paper, was not assigning a rating for a limited period as well as downgrading it from prime.

After discussing this action with Vogel and O'Herron, NCO then issued a press release regarding this action. A mere 3 weeks later, Penn Central filed for reorganization.

PART IV

IV. PENPHIL COMPANY (PENPHIL)

INTRODUCTION

Penphil, a private investment company whose stockholders include David Bevan (D. Bevan), other members of the Pennsylvania Railroad Co.'s (PRR) financial department, and officers of companies in which it made investments, purchased securities at a cost of over $2.2 million between 1962 and 1968. Charles J. Hodge (Hodge) and D. Bevan controlled Penphil.

Penphil was closely related to the PRR. Most of the funds for Penphil's investments came from loans made by Chemical Bank. At the time these loans were made D. Bevan was the chief financial officer of the PRR (and later the Penn Central) which had substantial banking relationships with the Chemical Bank. D. Bevan was also in charge of the investments of the PRR and its employee funds. In nearly all instances, the PRR and its employee funds invested in companies in which Penphil was to make or had made investments.' The possible conflicts of interest arising from Penphil's investments were never disclosed to the PRR board of directors.

Penphil also engaged in the practice of inviting officers and directors of companies in which Penphil invested to become members of Penphil. This put Penphil in the position of having an avenue of access to information concerning the day-to-day operations of the companies.

In July 1962, D. Bevan and Hodge, a partner in Glore Forgan-who was to become instrumental in PRR's diversification program of the mid-1960's-organized Penphil for the purpose of buying and selling securities of companies about which Penphil had intimate knowledge because of close business relationships between Penphil shareholders and the companies.2

In connection with these purchases D. Bevan, Glore Forgan, and Hodge arranged for the Chemical Bank, New York, to extend a line of credit to Penphil. Because of D. Bevan's position at the PRR, the Chemical Bank was willing to make these loans to Penphil at the prime rate without compensating balances and with the securities purchased as the only collateral. Prior to 1966, the Chemical Bank loaned Penphil more than 95 percent of the cost of its investments in stocks, most of which were traded over-the-counter. Overall, the Chemical Bank, between 1962-1968, loaned Penphil over $1.7 million to buy securities at a cost of more than $2.2 million. The loan balance was at times as much as $1.2 million.3

In the latter parts of this section no distinction is drawn between the investments made by the company and by the employee funds. Both are referred to as PRR or Penn Central investments hereinafter, unless otherwise specified.

A table giving background information on Penphil shareholders has been attached as Exhibit 1.

* See discussion infra at p. 307 et seq.

SUMMARY OF TRANSACTIONS

In July 1962, Penphil made its first purchases of securities when, on the recommendation of Hodge, a Kaneb Pipe Line Co. (Kaneb) director and a member of its executive committee, Penphil bought Kaneb stock at a cost of $115,925. The July purchases were made with knowledge of nonpublic information regarding a substantial increase in Kaneb's earnings during the first third of 1962 and earnings per share estimates for the year. Penphil purchased additional Kaneb stock at a cost of $40,000 in February 1963. At that point Hodge had information about Kaneb's 10-year estimates of favorable revenues, earnings and cash flow. During 1962 and 1963, the PRR and various Penphil stockholders also purchased Kaneb stock. These purchases were made when each had nonpublic information concerning major pipeline expansion plans and significant increased earnings of the company. As of April 20, 1972, Penphil still held its shares and had an unrealized profit of $926,000.

Penphil's next purchase was 10,000 shares of Great Southwest Corp.-GSC-common stock in July 1963. Hodge, a GSC director, had nonpublic information about a dramatic and unexpected improvement in GSC fiscal 1963 earnings which were expected to double 1962 earnings. In March 1964, D. Bevan personally purchased GSC shares while in possession of information not publicly available that the PRR was considering acquiring 80 percent of GSC's outstanding stock. In November and December 1965, Penphil, D. Bevan, and Hodge sold their shares of GSC to the PRR at substantial profits. Penphil's profit was $212,500.

In August 1963, Penphil, on Hodge's recommendation, made purchases of the common stock of Tropical Gas Co., Inc. (Tropical) Hodge, also a Tropical director, was intimately aware of the company's affairs.

In May 1964, Penphil bought Continental Mortgage Investors (CMI) shares for $196,800. Prior to this purchase Penphil had obtained significant confidential information from CMI's investment banker. This information came from a partner of that firm who was also a Penphil stockholder. This information concerned CMI's confidential plans for $10 million of long-term debt financing and its cancellation of plans for further equity financing; both announcements, when publicly made, were expected to have the desired effect of removing the lid on the price of CMI stock. Penphil still holds these shares and as of June 2, 1971, had an unrealized profit of more than $1 million. From May 29 to June 2, 1967, nine Penphil stockholders and the PRR bought an aggregate of 5,539 shares of Symington Wayne Corp. (Symington Wayne). On June 27, 1967, Penphil bought 1,000 Symington Wayne shares. These purchases were made with knowledge of private merger discussions Symington Wayne was conducting with two competing companies.

The terms being proposed were very favorable to Symington Wayne and its shareholders in that if either offer was accepted it would cause Symington Wayne shares to immediately increase in price. The subsequent public disclosure of these negotiations resulted in the stock selling at an immediate and substantial premium. By the end of January 1968, Penphil, seven of its stockholders and the RPR sold their Symington Wayne shares at substantial profits.

In late 1965, D. Bevan, Hodge, and Benjamin F. Sawin (Sawin) a Penphil stockholder and its bank expert, made plans for Penphil to invest in a chain of Florida banks. They determined to do this through initial investments in two banks in Boca Raton, Fla. controlled by Thomas F. Fleming, Jr. (Fleming). Penphil used personnel and assets of Arvida Corp. (Arvida) a newly acquired subsidiary of the PRR, to meet with and obtain an agreement from Fleming that he would arrange for stockholders of these banks to sell Penphil some of their bank stock which, at the time, was tightly held. At least Penphil's initial purchases of this bank stock were made at a time when some of its members were in possession of nonpublic information concerning significant business developments in the Boca Raton area and private plans of the bank to sell stock to its stockholders at $6 below market. Penphil has an unrealized profit on these purchases of more than $742,000.

Finally, in June 1968, Penphil bought 5,000 shares of National Homes Corp. (National) common stock on the recommendation of Lawrence M. Stevens, a Penphil stockholder who was the manager of the Philadelphia office of Hornblower and Weeks-Hemphill, Noyes. During that same month three Penphil stockholders bought an aggregate of 2,200 National shares. National is the only instance where it appears Penphil invested without having any inside relationship with the target company. It is significant that Hodge opposed this investment, saying that the stock should not be held blindly.

As a result of its investments Penphil has made a profit of $226,895.51 from securities bought and sold, and, as of June 1971, had an unrealized gain of $3,026,476.40 from securities held. Penphil has not had a loss on any of its investments with the single exception of a $40,000 note which it purchased from Holiday International Tours. The latter investment was associated with the EJA situation discussed elsewhere in this report.

BACKGROUND-PENPHIL

In the summer of 1962, D. Bevan and Hodge were the principal organizers and promoters of Penphil, a closely held corporation which was designed to engage in the business of purchasing, holding, and selling securities for its own account. On July 19, 1962, the day after its first securities purchase, Penphil was incorporated in Pennsylvania by Thomas Bevan, an attorney who was David Bevan's brother. Prior to Penphil's incorporation, 13 personal friends of David Bevan and Charles Hodge were invited by them to be stockholders. All were substantial businessmen, many being officers or directors of publicly held companies. Immediately upon its incorporation, Penphil issued 3,000 shares of its common stock by selling 200 shares to each of the 13 friends as well as Charles Hodge and David Bevan for a total capitalization of $15,000. It was planned that Penphil's capital structure would be thin with substantially all of the funds needed for its business to come from bank loans.

Between July 1962 and the present, Hodge and Bevan invited and arranged for 15 additional people to become shareholders of Penphil. Ten of these persons purchased their shares either directly from Penphil or from one of the original shareholders. Five persons became shareholders when a corporation of which they were stockholders, Florphil Co., was merged into Penphil. Florphil had been incorporated to give