Grant and McTiernan replied that we "could not hope to get away with it. This reserve account will be closely audited by our own CPAS and the ICC." S. T. S. tried to insist that all they could do in the last. analysis would be to criticize us and this did not bother him. He dropped the matter for the time being.

On April 30, S.T.S. and I flew to Pittsburgh together. On the way out, S. T. S. said Mr. Perlman said I had been 100 percent cooperative with him and Perlman was very pleased. On the way back S. T. S. advised me he had talked to Dick Mellon, whom he stopped in to see on the same trip, and told him I was doing a fine job in every way. Monday, May 20, 1968

I had a call from Charlie Hill advising me that Tom Meehan, Director, Auditing, was very upset and would probably quit and that he had a date at 10 a.m. with S. T. S. The news came as no surprise as I previously had a number of talks with him as he was very upset by the fact that Walter Grant had made him report to the Budget Manager, whereas before the merger he reported directly to W. S. Cook and me. Also, he had been given various warrings about not being aggressive in his auditing plus a number of other things that had a very bad cumulative effect on him.

As a result of these various conversations, prior to our board meeting in April I had a long talk with S. T. S., explained the situation to him, and told him if we were going to keep Meehan he would have to report to someone at a higher level and I had never known any place where the auditor reported at such a low level. This is particularly important in our case since Meehan has uncovered very substantial areas of fraud. S. T. S. agreed with me and stated he would have it handled through one or two of the Directors making a suggestion at board. meeting. I thought it would come up in April or May but it never materialized.

On Monday, after receiving a call from Hill, I got ahold of Mechan and tried to calm him down. He said there had never been any problems as long as he had reported to W. S. Cook and me, but things were unsatisfactory now and he had gone too far to reverse himself and stay. He thought that by the way he had been deliberately undercut by his new superiors that he had lost his effectiveness and he thought our Auditing Department was disintegrating very rapidly. Later in the day, Basil Cole on S. T. S. staff, advised me that S. T. S. had been unable to persuade Meehan to stay but had remarked if he had an opportunity to get into this earlier he was sure he could have persuaded him to stay.

Tuesday, May 21, 1968-Budget Meeting

As usual S.T.S. complained about the per diem account and how excessive it was. He then suggested that in order to improve earnings that we deliberately underaccrue it. When told by Charlie Hill that he thought it was probably already underaccrued, S. T. S. said that that did not make any difference. It had been underaccrued before and it was not necessary to become a "Christian" all at once. Wednesday, May 22, 1968

Today, while W. R. G. and I were in New York, W. R. G. received an urgent call from Verlander stating that he had been instructed by McCrone, Treasurer in New York, to cancel a lease that the Financial Department had authorized by the Board of Directors in

volving some racks for piggyback cars. McCrone also said that he should order some additional racks and pay for them in cash and not finance. He said these instructions had come from Walter Grant. On my advice W. R. G. advised Verlander to take no action until he had an opportunity to investigate what was going on.

Thursday morning Walter Grant denied to W. R. G. that he told McCrone to have the lease canceled but still insisted that the racks should be bought for cash by Dispatch Shops, a subsidiary of the former N.Y.C. W. R. G. pointed out that we had a very serious cash situation and that these racks were ideal for investment credit financing and that he thought one way or another Dispatch Shops money should be conserved.

Late Wednesday afternoon I had a meeting with S. T. S. and informed him what had transpired up to that date re interference by Grant. All he said in reply was work it out yourself.

Recently, when I received rumors that Bruce Relyea, Budget Manager of the Pennsylvania before the merger and now Assistant Budget Manager was planning to leave I called him in to talk to him to see if I could persuade him to stay in any way. He advised me that morale on the Pennsylvania side was very bad in the accounting budget area, that although he considered McTiernan, Budget Manager, a very bright person he thought he was not only lazy but only willing to take the course of least resistance. He said McTiernan was not interested in developing true cost throughout the railroad but was satisfied with something far less than what was potentially possible and desirable. He thought he would be wasting his time in staying. He also advised me that certain of the Regional Comptrollers, formerly of the Pennsylvania, were looking for jobs because they thought we were going to lapse into the former N.Y.C. bookkeeping approach rather than a modern scientific accounting approach that had prevailed on the Pennsylvania prior to the merger.

EXHIBIT 1B-3

PENN CENTRAL-QUARTERLY RESULTS (PUBLICLY REPORTED ORDINARY INCOME)

Note: Transportation Company earnings also reflect Subsidiaries,significant items to the extent received as dividends and
tax payment.

1 Included in above results.

I-C. FINANCES

CASH FLOW VERSUS "EARNINGS"

The formal bankruptcy of the Penn Central finally occurred in June 1970 after the company was unable to obtain an immediate Government guarantee for a $225 million loan. The company had simply run out of cash and ways of raising cash. To many reasonably informed investors this terminal cash crisis came as a surprise because Penn Central's earnings, while becoming progressively worse, had not seemed to indicate such a critical cash shortage. The results for the transportation company only (the company containing the railroad) were poorer than the consolidated results, but they did not appear to be terminally critical, particularly considering the size of the company.117

The reported earnings, however bad, did not reflect the truly disastrous performance of the company, particularly with respect to the critical cash flows. The earnings were inflated by transactions and accounting practices which produced reported earnings but little or no cash.118 Additionally, the earnings were presented in a format which tended to conceal the source and the trend of the losses.119 While the moderately adverse earnings figures were being presented to the public, a cash drain of staggering proportions was occurring in Penn Central. The following is a chart of the cash flow at Penn Central, including the railroad but excluding cash flows within individual subsidiaries: 120

115 See Income Management section of this report for further explanation. 119 Management has argued that accounting practices required for reporting to the ICC mandated this presentation. Even if ICC accounting were required for ICC regulation purposes, management was not prevented from supplying additional earnings information to the public.

120 These figures do not include expenditures for equipment which is customarily financed by conditional sales agreements or equipment trust certificates which require little or no cash outlay by the company. Under these financings, the loans are directly secured by the equipment being acquired.

(84)

The public was unaware of the magnitude of the cash drain. This cash drain was particularly important information about the condition of the company and the direction in which it was headed. The drain cut through the optimistic statements and the inflated earnings because it was a reality which could not be denied even by management. The cash drain also indicated at a very early date that Penn Central was a likely prospect for bankruptcy. Penn Central's ability to borrow was very limited despite its huge corporate size. It could not raise money through long-term debt because most of its property was already encumbered by debt and Penn Central's poor earnings would assure poor reception for long-term debt in the financial markets. Penn Central could meet its cash drain only by short-term borrowing or by a liquidation of assets and these two courses were restricted in their own right. There were few assets that could be liquidated. The real estate holdings in New York City, formerly owned by the New York Central, were heavily mortgaged and would not produce much cash upon sale. The other likely area for salable assets would be the Pennsylvania company, but many of these assets were pledged, and some, like Great Southwest Corp. and Macco Corp., were not what they appeared to be on the surface.

Faced with these problems and the poor image that would be created by trying to liquidate, Penn Central decided to use some of these assets indirectly by pledging them as collateral for short-term loans. The short-term borrowing had severe limitations, however. The money market was tight and interest rates were high even for a large "blue chip" such as Penn Central. Then, too, the pledging of assets in connection with borrowings, such as the revolving credit,