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[COMMITTEE PRINT]

THE PENN CENTRAL FAILURE AND THE
ROLE OF FINANCIAL INSTITUTIONS
PAKT I

EFFECTS OF PENN CENTRAL'S DIVERSIFICATION
PROGRAM ON THE RAILROAD'S CASH
POSITION

STAFF REPORT OF THE
COMMITTEE ON BANKING AND CURRENCY
HOUSE OF REPRESENTATIVES
91st Congress, Second Session

NOVEMBER 2, 1970

Printed for the use of the Committee on Banking and Currency
U.S. GOVERNMENT PRINTING OFFICE
51-903

WASHINGTON : 1970

For sale by the Superintendent of Documents, U.S. Government Printing Office
Washington, D .C. 20402 - Price 10 cents




COMMITTEE ON BANKING AND CURRENCY
W R I G H T PATMAN, Texas, Chairman
WILLIAM B. WIDNALL, New Jersey
F L O R E N C E P. DWYER, New Jersey
SEYMOUR H A L P E R N , New York
W. E. (BILL) BROCK, Tennessee
A L B E R T W. JOHNSON, Pennsylvania
J. WILLIAM STANTON, Ohio
C H E S T E R L. MIZE, Kansas
BENJAMIN B. B L A C K B U R N , Georgia
G A R R Y BROWN, Michigan
LAWRENCE G. WILLIAMS, Pennsylvania
CHALMERS P. WYLIE, Ohio
M A R G A R E T M. H E C K L E R , Massachusetts
WILLIAM O. COWGER, Kentucky
P H I L I P M. C R A N E , Illinois
J O H N H. ROUSSELOT, California

WILLIAM A. B A R R E T T , Pennsylvania
L E O N O R K. (MRS. JOHN B.) SULLIVAN,
Missouri
H E N R Y S. REUSS, Wisconsin
THOMAS L. ASHLEY, Ohio
WILLIAM S. MOORHEAD, Pennsylvania
R O B E R T G. S T E P H E N S , JR., Georgia
F E R N A N D J. ST GERMAIN, Rhode Island
H E N R Y B. GONZALEZ, Texas
JOSEPH G. MINISH, New Jersey
R I C H A R D T. HANNA, California
TOM S. G E T T Y S , South Carolina
F R A N K ANNUNZIO, Illinois
THOMAS M. R E E S , California
N I C K GALIFIANAKIS, North Carolina
TOM BEVILL, Alabama
C H A R L E S H. G R I F F I N , Mississippi
JAMES M. H A N L E Y , New York
F R A N K J. BRASCO, New York
BILL C H A P P E L L , J R . , Florida
MICHAEL J. H A R R I N G T O N , Massachusetts




PAUL NELSON, Clerk and Staff Director
CURTIS A. PRINS, Chief Investigator
B E N E T D . GELLMAN, Counsel
JAMES F . DOHERTY, Counsel

JOSEPH C. LEWIS, Professional Staff Member
ORMAN S. FINK, Minority Staff Member
«X>

LETTER OF TRANSMITTAL
NOVEMBER 2,

1970.

To Members of the Committee on Banking and Currency:
Transmitted herewith for use by the Banking and Currency Committee and the Congress is Part I of the staff report on The Penn
Central Failure and the Role of Financial Institutions. Part I deals with
a fundamental issue involved in the recent history of the Penn Central
and one of its principal predecessors, the Pennsylvania Railroad:
The Effects of the Penn Central1 s Diversification Program on the Pailroad'}s Cash Position.
Former top officials of the Penn Central have consistently claimed
to the Congress and the public that the diversification program begun
in 1963 was a tremendous success. A careful examination of the diversification program reveals, however3 that this program, rather than
financially supporting the railroad's operations, proved to be a very
serious drain on the railroad's financial resources amounting to at
least $175 million and contributed significantly to the Penn Central's
ultimate financial collapse. I t is of more than passing interest to
place this $175 million up against the $200 million loan guarantee
requested by the railroad from the government in June, 1970.
In addition, the use of credit lines by the Penn Central to finance
this diversification program, principally in real estate development,
proved a serious problem in attempting to secure additional bank
financing when the liquidity crisis hit the railroad in the spring of
1970. This diversification program was largely supported by bank
loans from major Eastern banking institutions that were also the
principal sources of the railroad's financing.
As mentioned above, as well as discussed with the Committee at the
executive session of September 15, 1970, the material transmitted
herewith is but one of several aspects of the collapse of the Penn
Central Transportation Company that is being investigated by the
staff. Other parts of the investigation will deal in detail with such
matters as specific aspects of diversification; possible conflict of interest
situations involving officers and directors of Penn Central in their
personal financial transactions; and the relationship between commercial banks and other financial institutions, and Penn Central and
its subsidiaries prior to the collapse of the Penn Central. These
additional parts of the staff report will be forthcoming in the next
several weeks.
The views and conclusions found in this report do not necessarily
express the views of the Committee or any of its individual Members.
W R I G H T PATMAN, Chairman.




(in)

THE P E N N CENTRAL FAILURE A N D THE ROLE OF
FINANCIAL INSTITUTIONS
PART I
EFFECTS OF P E N N CENTRAL'S DIVERSIFICATION PROGRAM ON THE
RAILROAD'S

CASH

POSITION

HISTORICAL ASPECTS OF PENN CENTRAL'S DIVERSIFICATION

PROGRAM

For many years, the Penn Central corporate complex has consisted
of many companies either owned or controlled by the Pennsylvania
Railroad Company (subsequently renamed the Penn Central Transportation Company following the merger with the New York Central
Railroad in February 1968). These companies, prior to 1963, consisted
entirely of other railroads or companies engaged in railroad-related
activities. Up to that point in time, ownership of non-railroad-related
companies by the Pennsylvania Railroad was nonexistent.
This program of ownership or control of other railroads and railroadrelated companies has proven to be very successful over the years.
These companies, primarily through the payment of dividends, have
provided and continue to provide significant sums of cash to the
parent Railroad.
Beginning in 1963, the Railroad embarked on a diversification program completely different from its previous acquisition program. For
the first time, the Railroad began to acquire control of non-railroad
companies. Within the next few years, the Railroad made four major
acquisitions under its new diversification program: (1) Buckeye Pipe
Line Company; (2) Great Southwest Corporation; (3) Arvida Corporation; and (4) Macco Corporation. The latter three companies are
all real estate investment and development companies.
The companies were all acquired through the Pennsylvania Company, the Railroad's 100-percent-owned subsidiary holding company.
In the case of each acquisition, large sums of cash were needed to
acquire sufficient stock to gain control of the companies. 1
By the end of calendar year 1965, the acquisition of the four
companies was substantially completed. I n total, the Pennsylvania
Railroad, primarily through the Pennsylvania Company, invested a
total of about $144 million of cash in these four companies. Much
of the cash used in the diversification program was obtained through
bank loans.
EFFECT OF DIVERSIFICATION PROGRAM

With the ultimate collapse and placement in reorganization of the
Penn Central Transportation Company, many aspects of the Railroad's activities have been subjected to close scrutiny by various
1
To acquire 100 percent ownership of Buckeye, a combination of stock purchases and issuance of Pennsylvania Company preferred stock in exchange for Buckeye common stock was used. The preferred stock
issued by the Pennsylvania Company to the stockholders of Buckeye requires annual cash dividend payments by the Pennsylvania Company.




(i)

2
sources. Much of this attention has been focused on the Railroad's
diversification program and the effect of the subject program on
Railroad operations.
Many questions have been raised concerning the diversification
program. Some of the more significant questions include:
1. Should the Railroad have embarked upon this diversification program?
2. Was this the best possible use of the $144 million in cash?
3. Could this $144 million have been used more productively
by investment in the Railroad in order to enhance the profitability of the Railroad, in such projects as (1) upgrading of
railroad beds, (2) overhauling and refurbishing of railroad
equipment, (3) purchase of new, modern equipment, etc.?
4. Did use of the $144 million in cash on diversification represent a serious cash drain from the Railroad that significantly
contributed to its ultimate collapse, since the Pennsylvania
Company could have given the cash directly to the Railroad
through dividend payments and loans?
5. Did the use of bank loans to finance part of the cost of the
diversification program dry up lines of bank credit that could
have been used to assist the Railroad during its period of tight
cash needs prior to its collapse?
6. Could the Railroad have avoided or at least delayed financial
collapse, if the cash and bank loans used for diversification had
been applied, instead, to meeting the cash needs of the Railroad?
POSITION OF PENN CENTRAL OFFICIALS

Penn Central officials, in public statements and in appearances
before Congressional Committees, have emphatically maintained that
cash generated by the four companies acquired during the diversification program helped to provide the money necessary to keep the
Railroad running in the face of significant operating deficits. The
position of these officials is probably best typified by statements
made by David C. Bevan in his appearance before the Senate
Commerce Committee on August 6, 1970. Mr. Bevan, the former
Chief Financial Officer for the Railroad and one of the architects of
the diversification program, stated:
In summary I believe our financial management over the years has been good.
Even with all the adverse circumstances I have outlined, we were able to produce
the money necessary for the operating people to keep the railroad running in the
face of deficits and that was no small job.
I might add that it would not have been possible without the income made
available through our new diversification program.
Our first acquisition was Buckeye Pipe Line in 1964, followed by Great Southwest, also in 1964, and Arvida and Macco in 1965. . . . All in all, from the Pennsylvania Railroad side, we invested a total of approximately $144 million of cash in
this diversification program, of which only about three-quarters of a million
dollars came from the Transportation Company. The sj^stem realized a return of
$146 million from these investments from the date of acquisition through 1969,
approximately five years in all. Those dividends and income from other nonrailroad properties, have served to blunt the losses from passenger service and
have provided the margin necessary for continued operation of the Railroad. In
other words, our investment in non-railroad companies yielded a much better
return than the railroad itself, which would have been in much more serious
trouble without the benefits of diversification." [Emphasis supplied.]




3
ANALYSIS

OF MR. BEVAN S

STATEMENTS

A reading of the above-quoted excerpts from Mr. Bevan's statements before the Senate Commerce Committee leaves two initial
impressions.
(1) That the diversification program begun in 1963 was a
resounding success, with the Penn Central corporate complex
realizing a return of more than 100 percent on its investment in
a little over five years; and
(2) That significant amounts of cash flowed up from these
four subsidiaries to the Railroad to help keep the Railroad afloat
during the period of time it was encountering enormous operating
deficits.
A detailed analysis of Mr. Bevan's cited figure of $146 million
return on investments from the diversification program points out
some very interesting facts. Mr. Bevan's "return of $146 million"
is comprised of the following:
Type of return:
Dividends
Tax allocation
Interest
Undistributed earnings

Millions
$37. 8
8. 0
2. 9
115. 2

Total
163. 9
Less: Dividends paid by Pennsylvania Co. on preferred stock issued
in exchange for Buckeye common stock
17. 9
Net return on investment

146. 0

The most important factor concerning Mr. Bevan's figures is that
only the dividends of $37.8 million paid by the subsidiaries represent
actual cash flowing up from the subsidiaries towards the Railroad.
Part of the "tax allocation" and all of the "interest" was paid through
the issuance of stock to the Pennsylvania Company by the subsidiary
involved, not with cash. The remainder of the tax allocation is still
unpaid and outstanding.
"Undistributed earnings", while ostensibly impressive for accounting purposes, do not represent any cash flow unless they are eventually
paid out in the form of cash dividends. To date, none of the $115.2
million in undistributed earnings has been paid out in dividends to the
Railroad and, based on the cash position of the subsidiaries, there is
no indication that this will occur anytime in the immediate future.
Therefore, if one limits the use of Mr. Bevan's figures to those
representing actual cash flow, we find that only $19.9 million in cash
flowed up towards the Railroad during the subject five years on a
cash investment of $144 million, hardly an impressive return. This is
computed as follows:
Millions

Cash dividends paid by subsidiaries
$37. 8
Less: Dividends paid by Pennsylvania Company on preferred stock issued
in exchange for Buckeye common stock
17. 9
Net cash flow up towards Railroad

19. 9

Further analysis of the cash dividends paid by the four subsidiaries
points out the following interesting facts. Of the $37.8 million in
cash dividends paid by the four subsidiaries, about $33.5 million came
from the Buckeye Pipe Line Company. Buckeye was the first acquisi


4
tion under the diversification program, and the only one of the four
companies acquired that does not engage in real estate investment
and development. I n fact, Buckeye's activities are so closely related
to the transportation business in which the Railroad is engaged that
Buckeye operates as a common carrier under the jurisdiction of the
Interstate Commerce Commission.
Elimination of Buckeye's cash dividend payments from the above
calculation leaves the total cash flow up to the Railroad from the
three real estate subsidiaries at about $4.3 million over a five-year
period. When compared to the Railroad's total cash investment in
these three companies—about $114 million—the return cash flow
from the three real estate subsidiaries is very unimpressive. I n fact
it would appear that the Railroad might have realized a greater rate
of return by simply investing this money in improving the Railroad,
rather than venturing into real estate development.
In sum, based on the cash flow figures, the diversification program
was anything but the resounding success various Penn Central
officials have described it to be. For the five-year period referred to
by Mr. Bevan, the total cash flow up towards the Railroad from the
four subsidiaries averaged less than $4 million a year. I t is apparent,
using Mr. Bevan's own figures, that the diversification program did
not provide large sums of cash for the Railroad during its tight cash
position in the years immediately preceding its collapse, despite his
claims to the contrary.
Another interesting point is Mr. Bevan's statement that, of the
$144 million invested in the diversification program, only "threequarters of a million dollars came from the Transportation Company."
While this statement may be technically accurate, it does not take
into account the nature of the relationship between the Railroad and
the Pennsylvania Company. Since the Pennsylvania Company is 100
percent owned by the Railroad, it can make its cash resources directly
available to the Railroad through dividend payments and loans. Thus,
the cash resources of the Pennsylvania Company are, in fact, potentially the cash resources of the Railroad.
The $144 million expended by the Pennsylvania Company on diversification involved the use of funds that ultimately could have been
made available to the Railroad. Accordingly, it is clear that the diversification program, in effect, represented a very substantial cash drain
on the Railroad.
INVESTIGATION

BY

STAFF

OF

HOUSE COMMITTEE
CURRENCY

ON

BANKING

AND

As part of its investigation into the collapse of the Penn Central
Transportation Company, the staff of the House Committee on Banking and Currency has examined the diversification program and its
effect on the cash position and cash needs of the Railroad. The Committee staff limited this part of its investigation to the cash flow aspects
of diversification—a comparison of the cash flow down from the Railroad and Pennsylvania Company into the four subsidiaries with the
cash flow up from the four subsidiaries towards the Railroad. 2
2
The investigation did not concern itself with profit and loss statements, undistributed earnings, or
accounting techniques for calculating rates of return on investments. Rather, it concerned itself with the
fundamental question:What effect did the diversification program have on the cash position of the Railroad?




5
The examination discloses that the diversification program had
serious negative effects, both direct and indirect, on the cash positions
of the Railroad. As discussed below in more detail, it has been found
that (1) the total cash investment in the diversification program was a
serious cash drain on the Railroad and far exceeded the $144 million
direct cost of acquiring the four subsidiaries, and (2) the diversification
program may have seriously affected the lines of bank credit available
to the Railroad.
TOTAL COST OF D I V E R S I F I C A T I O N

PROGRAM

Analysis of figures supplied to the Committee by the Railroad show
that the total direct cash investment in the four subsidiaries was
approximately $144 million, as follows:
DIRECT CASH INVESTMENT IN COMPANY

Company acquired
Buckeye Pipe Line Co.._
Great Southwest Corp
Macco Corp
ArvidaCorp
Total

Parent Railroad
..
""

""

Pennsylvania Co.

Total

0
$738,150
0
0

$30,042,869
51,225,637
39,450,702
22,046,893

$30,042,869
51,963,787
39,450,702
22,046,893

_.

143,504,251

However, the figures supplied by the Railroad do not give consideration to the costs of financing the diversification program. At
the time the Railroad embarked upon the diversification program, it
had outstanding debt of several hundred million dollars. For example,
had the $144 million used for diversification been applied to reducing
this outstanding debt, the Railroad's interest costs for financing its
outstanding debt would have been reduced proportionately.
The decision to diversify meant that the Railroad was deprived of
the potential use of $144 million in cash at a time when it was heavily
in debt. To compensate for this loss, it must be assumed that the
Railroad borrowed sufficient funds to replace the funds lost through
diversification. While no detailed effort has been made to calculate
the exact interest costs incurred by the Railroad as a result of having
to finance the replacement of funds lost to it through diversification,
preliminary calculations indicate the cost exceeds $51 million. 3
Based on these calculations, it is estimated that the total cash
cost of the diversification program is at least $195 million—direct
cash investment of $144 million, plus interest costs of at least $51
million incurred in financing the diversification program.
Using this conservative figure—$195 million—as the cash cost
of the diversification program, it appears that the diversification
program resulted in a net cash drain from the Railroad of approximately $175 million, calculated as follows:
3
Interest cost calculations were based on the net cash outlays for each year. Interest rates used were the
average rates charged the Railroad in each year for equipment financing. Interest was computed on a simple
interest basis. Computing the interest on a compound basis would have significantly increased the interest
costs incurred in financing the diversification program.




6
Cash Flow Down From Railroad:
Millions
Direct cash investment in companies
$144. 0
Dividends paid by Pennsylvania Co. on preferred stock issued in
exchange for Buckeye common stock
18. 0
Interest costs of financing diversification program
51.0
Total
Less: Cash flow up to railroad: Cash dividends paid by subsidiaries

213. 0
38. 0

Net cash drain to Railroad

175. 0

Based on the above figures, it is quite evident, on a cash flow basis,
that the diversification program was extremely detrimental to the cash
position of the Railroad. The Committee staff believes that the net
cash drain from the Railroad of at least $175 million at a time when
the Railroad was faced with a critical cash shortage, significantly contributed to the ultimate collapse of the Railroad. The significance of
this sum is even more evident when compared with the abortive
proposal in June of this year to have the Government guarantee a
$200 million loan to the Railroad to meet critical cash needs.
OTHER NEGATIVE EFFECTS OF THE DIVERSIFICATION PROGRAM

Examination also discloses that the diversification program had
other negative effects on the cash position of the Railroad, particularly
as relates to the drying-up of bank lines of credit potentially available
to the Railroad.
As stated previously, much of the cash used in the diversification
program was obtained through bank loans. I n addition, the Railroad
had to finance sufficient sums of cash to compensate for the cash drain
resulting from the diversification program. In these instances, the
diversification program was drying up lines of credit that potentially
could have been available to the Railroad during its period of tight
cash needs prior to its collapse.
The committee staff also found that the diversification program
indirectly affected the Railroad's potential lines of credit. Subsequent
to their acquisition by the Railroad, the real estate subsidiaries embarked on major expansion programs. I n financing these expansion
programs, the subsidiaries drew upon the same sources of credit,
including bank loans, that the Railroad used to finance its cash needs.
For example, several large eastern banks, which previously had
supplied the Railroad with credit for many years, became heavily
involved in financing the activities of the real estate subsidiaries acquired by the Railroad. Thus, the subsidiaries were competing with
the railroad for the same limited sources of credit at a time when the
Railroad was having trouble obtaining needed financing. (See table,
page 7.)
A subsequent part of this report, to be issued at a later date, will
deal in more detail with the banks' involvement in the Railroad's
diversification program.




EXAMPLES OF LOANS BY EASTERN BANKS TO REAL ESTATE SUBSIDIARIES OF PENN CENTRAL
Company Receiving Loan
Great Southwest Corporation
Arvida Corporation
Great Southwest Corporation
Arvida Corporation
Arvida Corporation
Great Southwest Corporation




Date of Loan
Dec.
June
Dec.
Dec.
Apr.
June

Bank Making Loan

1,1969 Provident National Bank
13,1969 First National City Bank
18,1969 Provident National Bank
11,1968 Chase Manhattan Bank
11,1969 Chemical Bank of New York
30,1969 Provident National Bank

O

Amount of Loan
$3,000,000
5,400,000
5,000,000
4,350,000
2,500,000
1,000,000


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102