Authors: William D. Cohan
——
D
ESPITE THE MISDIRECTION
provided in the
Times
article, the Goldman partners were immensely fearful of what the potential consequences of the growing
Penn Central lawsuits might be. “
There was real fear that the liability for the Penn Central could put the firm under …,” Rubin explained. “People were really deeply worried that the firm and their net worths were going to be gone. They were surprised by the dangers lurking in the firm’s
commercial paper business. They weren’t traumatized, but they were deeply worried. Deeply worried.” Rubin elaborated in his book: “
As a private partnership, we faced unlimited liability, and some people worried whether the firm would survive.”
In his memoir, Whitehead echoed Rubin’s concerns. “It was scary for all of us, because the total claims at one point exceeded the firm’s capital, and the partners would be personally liable for the remainder in the unlikely event that all the suits went against us.” To try to provide some comfort,
Sullivan & Cromwell wrote a letter to Levy that it didn’t think the payments that Goldman would likely have to make to Penn Central’s commercial paper creditors would “impair” Goldman’s capital. “
Gus carried it in his jacket pocket as a kind of talisman,” Rubin wrote.
A comprehensive, eight-hundred-page report by the U.S. Securities and Exchange Commission, released in August 1972, made clear what Levy, Rubin, and their partners were so worried about. According to the report, not only had Goldman puts its own interests before those of its clients, but it had also continued to sell Penn Central’s commercial paper to investors after learning that the company was in dire financial straits. The allegations were devastating, especially for a firm anxious to portray itself as in the vanguard of Wall Street. “Goldman Sachs continued to sell [Penn Central’s] commercial paper after [it] had received information about the financial condition of the [company,] which should have raised serious questions as to the safety of an investment in the company’s commercial paper, and Goldman, Sachs did not disclose such information to its customers,” according to the report. “The information which Goldman, Sachs received should have put [it] on notice that a thorough examination of the financial condition of [Penn Central] would seem appropriate in order that [it], and through [it, its] customers would be apprised of the current position of [Penn Central]. Despite these warning signs, Goldman, Sachs made no meaningful investigation. Such an examination would have disclosed that the financial condition of the company was more serious than had been revealed to the public.”
From the time the Interstate Commerce Commission, or ICC, authorized Penn Central to sell its commercial paper to investors, in July 1968, to the company’s bankruptcy nearly two years later, Goldman had
been the sole underwriter of the company’s commercial paper. By the end of 1969, Goldman had sold $200 million of Penn Central’s commercial paper. By the first half of 1970, the $200 million outstanding had been reduced to $83 million, held by seventy-two Goldman customers who had purchased the paper between November 1969 and May 1970. “As commercial paper is universally believed to be a very low-risk security, these customers were shocked to learn, prior to the maturity date of their paper, that the [Penn Central] had filed a petition in bankruptcy [court],” according to the SEC report. “Penn Central has repaid none of this indebtedness, and there is little likelihood of repayment.”
Goldman’s relationship with Penn Central originated with Levy’s twenty-two-year friendship with
David C. Bevan, Penn Central’s longtime chief financial officer. By March 1968, months before the ICC approved Penn Central’s application to issue commercial paper and after a round of meetings among Bevan, Levy, and Wilson, Goldman’s head of commercial paper, Penn Central decided to hire Goldman to sell its commercial paper to investors.
According to Wilson, Goldman “followed its usual procedures for taking on a new issuer” but, apparently, these procedures did not include preparing any written reports about Penn Central’s creditworthiness, according to the SEC.
Jack Vogel, head of Goldman’s commercial paper credit department, told the SEC that Goldman got one new commercial paper client a week and issued paper for some 250 separate companies. Vogel had a staff of four people to help him decide the creditworthiness of these companies and to help him review their prospects on an ongoing basis.
Within weeks of the ICC’s decision to allow Penn Central to issue commercial paper, Goldman was busy flogging $100 million of it. Between September 1969 and May 1970, though, the SEC contended that Goldman “gained possession of material adverse information, some from public sources and some from nonpublic sources indicating a continuing deterioration of the financial condition of the [railroad]. Goldman, Sachs did not communicate this information to its commercial paper customers, nor did it undertake a thorough investigation of the company. If Goldman, Sachs had heeded these warnings and undertaken a reevaluation of the company, it would have learned that its condition was substantially worse than had been publicly reported.”
From public information available in November 1969, Goldman should have known that Penn Central, the railroad (as opposed to the holding company, with other assets in it like Grand Central,
Madison Square Garden, and a private-jet leasing business), had lost $40.2 million
during the first nine months of 1969, $26.4 million more than the railroad lost in 1968. Also in November, Penn Central decided not to pay its quarterly dividend, often a sign of impending financial trouble. In his testimony at the time before the ICC, Penn Central’s outside counsel explained the company was “having a very difficult time effecting the merger” of the two railroads. (“[M]anagement was very upset by this statement,” the SEC reported.) “[T]his did not cause Goldman, Sachs to re-examine the financial condition of the company whose paper Goldman, Sachs was selling as prime rated
commercial paper,” the SEC found.
Goldman’s Wilson had concerns about Penn Central. On September 3, 1969, he requested a meeting with the company’s senior executives in the finance division. “[I]t had been a long time since we had gotten together to talk about the company,” he wrote in an internal memo. “We have a lot of questions to ask about the merger, cash flow, and their long term financing plans.” On September 19, Wilson and his Goldman colleagues met with
Jonathan O’Herron, Penn Central’s vice president of finance. O’Herron told Wilson that Penn Central’s cash position in the first quarter of 1970 would be “very tight” and asked Goldman to sell “as much commercial paper as possible through April or longer.” At that moment, lawyers would later argue, “Goldman Sachs was in possession of material, adverse non-public information about Penn Central which it failed to disclose.” On October 22, O’Herron told Wilson that Penn Central would “show a small loss” in its third quarter but that the fourth quarter would improve and the company would be “in the black.”
A week later, the ICC agreed to allow Penn Central to increase its commercial paper outstanding to $200 million, from $150 million. But the regulatory agency noted its concern that the company had a “deficit working capital situation” and seemed to be increasingly reliant on short-term financing—the commercial paper—to try to refinance long-term debt or to make capital expenditures. “The exhaustion of short-term credit to refinance maturing long-term debt or to finance long-term capital expenditures could expose a carrier to a serious crisis in the event of an economic squeeze, at which time a carrier may require short-term financing for traditional use,” the ICC observed. “We are, therefore, concerned about the use of short-term financing for long-term purposes and feel that where necessary it should be resorted to cautiously.”
According to the SEC, Goldman “never did explore in any depth” the topics Wilson said he wanted to investigate in his September memo, and the red flags raised by O’Herron and by the ICC “raised serious questions
about the soundness” of Penn Central and “the safety of investing in its
commercial paper.” The observations “indicated that the company was experiencing a liquidity crisis and that it might find it extremely difficult in the future to meet its cash needs, thus jeopardizing commercial paper holders,” according to the SEC. “A thorough study of the subject would have disclosed how much more damaging the information about the liquidity of the company and its ability to pay off commercial paper holders was.” But Goldman did not “conduct any further investigation” and “made no disclosure of” the information “while continuing to actively promote the company’s commercial paper. Customers were not told that the company expected to be in a tight cash position in the near future; were not told about the ICC order or the information about the deficit working capital situation or the fact that the company’s commercial paper proceeds were being used for long-term financing.”
But, according to the SEC, while Goldman did not share the bad news with its customers and continued to sell the increasingly squirrelly Penn Central commercial paper to them, it did use the public and nonpublic information to protect
itself
and its partners from having any of the paper on its own books. At the September 19 meeting, Wilson asked O’Herron to have Penn Central arrange for additional backup lines of credit from its banks to support the company’s commercial paper program. In other words, Goldman wanted Penn Central to have another source of liquidity—banks—to borrow money from to make sure that its outstanding commercial paper, then around $200 million, could be paid off as it came due in the coming months. At that moment, Penn Central had already borrowed $250 million of its $300 million line of credit with a bank group, and O’Herron told Wilson the company intended to borrow the last $50 million to have in reserve to pay off the commercial paper if needed. Wilson asked O’Herron to get
another
$50 million as a backup for the commercial paper program. Even though Wilson did not like O’Herron’s answer, O’Herron told him the company would not do it: “Penn Central already had a line of credit.”
Throughout the first quarter of 1970, Goldman kept pushing Penn Central to increase its line of credit with its banks. “The management of the company was very reluctant to ask the banks for more line credit,” the SEC found. “Although Goldman, Sachs never inquired too deeply into the reasons for the company’s reluctance, it should have been apparent that the company had exhausted all credit.” In his testimony to the SEC, Wilson conceded that such information “was information that investors would have considered important” but, according to the SEC, Goldman never disclosed it to its commercial paper customers. On February 5,
1970, O’Herron told Wilson that the company “could not raise any additional lines of credit,” according to the SEC, which observed that “the inability of the company” to get the additional financing “as with other relevant information” was “not disclosed to customers.”
February 5 turned out to be a busy day. Rather than the profit that Penn Central had earlier projected that the railroad would earn in the fourth quarter of 1969, the company announced that the railroad had lost $16 million, and lost $56 million for the full year. Wilson called O’Herron to set up a meeting to discuss the unexpected loss. The next day, Levy and Wilson met with Bevan and O’Herron. The company, Bevan explained, needed another $170 million for capital expenditures, which, combined with the expected loss, would bring its financing needs for the year to around $226 million. Bevan told Levy and Wilson that Penn Central had a variety of ideas about how to raise this additional financing, through a combination of a bridge loan, a Euro-dollar loan, and other financings. Levy and Wilson did not ask Bevan for the specifics of how he intended to raise this needed money. “I had complete confidence in Mr. Bevan’s integrity,” Levy told the SEC, “that he could do what he said he could do.”
Goldman did not ask Bevan or O’Herron to provide any documentary evidence of Penn Central’s financial situation for the coming year. “We had no reason to doubt him at that time,” Wilson later said of Bevan, “and we were satisfied with the answers to the questions we asked in these areas.” Vogel, the Goldman credit analyst, later told the SEC that the information obtained through these meetings “reassured” Goldman’s executives that “the situation was one that was explainable, normal, and not of any problem.”
Part of the reason why investors kept buying the Penn Central
commercial paper that Goldman kept selling during this rocky financial period was that the rating agency—the National Credit Office—tasked with rating Penn Central’s commercial paper kept giving the paper its “prime” rating, the highest available. After the fourth-quarter loss was announced on February 5, though,
Allan Rogers, at National Credit Office, called Vogel at Goldman “to express concern over the sharply reduced earnings” at Penn Central. Vogel told Rogers that despite the earnings news Goldman was continuing to sell Penn Central’s commercial paper, that Goldman felt Penn Central had enough ancillary assets that could be sold, and that he “was certain that something could be worked out should it ever become necessary.” According to a memo Vogel wrote that day, “as a result of my comments,” Rogers agreed to keep Penn Central as “a prime name,” which it did until June 1. Wilson informed Levy that the National Credit Office, or NCO, would be keeping
Penn Central as a prime name “as long as Goldman, Sachs was going to continue to handle the company’s c/p [commercial paper].”
The circular nature of the relationship between Goldman and NCO—that NCO was continuing to rate Penn Central’s paper as prime because Goldman was continuing to sell it and Goldman was continuing to sell it because NCO was rating it prime—infuriated the SEC. “As a result of this conversation with Rogers, Goldman, Sachs became aware of facts which undermined the value of the prime rating given by NCO to the company’s paper and the independent nature of that determination,” the agency observed. “Thus, from this point on it appears that NCO was not the thorough, independent rating service that Goldman, Sachs has represented to customers that it was. In addition, from this point on, Goldman, Sachs was aware that the ‘prime’ rating was based to a great extent on the fact that Goldman, Sachs was continuing to offer it.” The SEC found the idea preposterous that Goldman would take comfort from asset sales worth multiples of the commercial paper outstanding—“which fact Goldman, Sachs had never investigated,” the agency wrote—since “looking to liquidation as a means of determining credit-worthiness” meant that the “railroad clearly was no candidate for the ‘prime’ rating.” Needless to say, the SEC continued, “Goldman, Sachs never disclosed to any customers any of these matters.”