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.”
But the firm did take care of itself. “[O]n the very same day [it] learned of the first quarter losses, [it] contacted the company and got a commitment from the company to buy back $10 million of its commercial paper from Goldman, Sachs’ inventory,” the SEC wrote. Furthermore, from then on, Goldman “insisted” than any future commercial paper sales be sold on a “tap” arrangement, where Goldman would no longer underwrite the paper but rather agree to sell it only after it had found buyers in advance, “an arrangement involving no risk for Goldman, Sachs.” Goldman had no exposure to Penn Central at the time of its bankruptcy but failed to share that fact with its customers or that the conditions under which it would sell the paper had changed. “Most customers believed that Goldman, Sachs maintained an inventory in all commercial paper which [it] offered for sale,” according to the SEC report. “Many who purchased the company’s paper after February 5, 1970, looked to the fact that Goldman, Sachs had an inventory of the company’s paper as assurance that Goldman, Sachs felt the paper to be credit worthy.” Pollack, the plaintiffs’ attorney, remembered being appalled that Goldman had sold its Penn Central commercial paper back to the company at the same time Goldman continued to sell the paper to investors. “They did not view their inventory of Penn Central’s commercial paper as something they owned as a security,” he said. “They did not think they had an obligation to disclose their sales.” He added, “While $10 million may seem like a rounding error, it was twenty percent of their capital at the time.”
On March 23, O’Herron told Wilson that Penn Central’s first quarter would “look terrible,” but Goldman chose not to probe O’Herron about just how bad things were looking. Had Goldman done any research, it would have quickly discovered that Penn Central believed that it would have a $60 million loss in the first quarter. Apparently, instead of trying to figure out what was going wrong at Penn Central, Goldman was focused on selling another $17.3 million of the company’s commercial paper to eighteen of its customers. “None of these customers were told about these expected terrible results for the first quarter,” the SEC reported. On April 14, O’Herron reiterated his earlier view and told Wilson that Penn Central’s first quarter would be “lousy” and the losses “staggering.” The company’s cash position, he said, was “in very serious shape.”
Based on O’Herron’s latest comments, Wilson told Levy that he no longer thought Goldman should offer Penn Central’s commercial paper to its customers “until the current situation could be clarified.” But in a meeting, Bevan downplayed the problems, and O’Herron apologized “for the casual nature of his remarks made earlier in the day.” Bevan said the company would soon file for a new $100 million debt offering that he expected to complete “in early May.” Bevan asked Wilson, Levy, and Goldman Sachs to continue to offer Penn Central’s commercial paper for sale in the marketplace. According to the SEC, Bevan’s comments assured Goldman that “there was no emergency at the Penn Central Transportation Company.” The next day, Levy told O’Herron that Goldman would continue to deal the company’s commercial paper.
Unfortunately for Goldman’s commercial paper customers, “Bevan’s statements at this meeting bore no resemblance to the reality of the situation,” according to the SEC. During the eight days between the meeting with O’Herron and Bevan and the public announcement of the company’s first-quarter losses, Goldman sold $300,000 of Penn Central’s commercial paper to one customer. “This customer was told nothing of the first-quarter results,” the SEC said.
Between April 22 and May 15, Goldman kept selling the Penn Central paper. On May 1, American Express bought $5 million of the commercial paper, a deal that would be the subject of the November 1970 lawsuit between the two firms. According to the SEC, American Express “had been reluctant to purchase the company’s paper” but Jack Vogel explained there were “adequate assets to back up” Penn Central’s commercial paper “in order to persuade it to change its mind.”
By mid-May “it was clearly impossible to sell any more of the company’s paper,” according to the SEC, and by “mutual agreement” Goldman and Penn Central decided to stop trying. One of the reasons Penn Central filed for bankruptcy in June 1970 was “its inability to roll over its commercial paper,” which amounted to $117 million. Between November 1969 and May 1970, Goldman sold $83 million of Penn Central’s commercial paper, none of which was repaid after the bankruptcy filing. According to the SEC, “Goldman, Sachs failed to disclose that [it] had reduced and [was] eliminating [its] inventory of the company’s paper, that NCO had been induced to maintain the prime rating and that the company’s paper was meeting strong resistance from customers.”
A small college in Pennsylvania was one such Goldman customer, in late March 1970. The college already had invested $400,000 in Penn Central’s commercial paper, and Goldman was hoping to sell it another $300,000 on March 30. When the school’s treasurer asked the Goldman representative about Penn Central’s latest financial performance, he was told the company had consolidated revenue of $2.3 billion compared to $2.1 billion the previous year and earnings of $4.4 million compared to nearly $87 million the year before. He was also told “there was no need for concern” because Penn Central had $6.5 billion in ass
ets. “With some hesitancy,” the college treasurer agreed to purchase another $300,000 of the Penn Central commercial paper for the school. Four days later, he received a letter of confirmation and the latest financial data about Penn Central. “I was dismayed to learn the information conveyed over the phone” was for the year ended 1968, not 1969.
Goldman’s explanation for why it did what it did at the time sounds eerily familiar to the one it would give forty or so years later in the wake of the financial crisis of 2007 and 2008. First, the firm told the SEC, commercial paper sales were not profitable. While Goldman had sold an average of $4.7 billion of the product per year, its profits from doing so were only $435,000. Second, Goldman claimed the customers “were sophisticated investors” who were buying the stuff in $100,000 lots and “were capable of making their own investment decisions and did not have to rely on Goldman, Sachs’ opinion.” Furthermore, the firm “viewed itself as merely a conduit” selling the paper and “made no recommendations as to the quality” of it “or the credit-worthiness of the issuers.” Goldman “merely” informed customers of “what paper was available and the customer would decide which paper it wished to purchase.” Despite believing it had no obligation to assess the “credit-worthiness” of the issuers, Goldman did tell the SEC that it believed Penn Central “always” had “sufficient assets which could be liquidated should the need arise, which provided sufficient protection for commercial paper holders.” Ultimately, Goldman argued, since Penn Central was a public company, required to file its financial statements with the SEC, there was plenty of information available to investors about Penn Central’s financial condition. But Pollack said Goldman’s argument amounted to a bunch of bunk. “Our clients were very much in need of [the information] and Goldman Sachs had represented the [Penn Central] commercial paper to be a cash equivalent,” he said.
The release of the SEC’s lengthy investigation into the collapse of Penn Central was big news, of course, but very little of the coverage focused on Goldman’s role in selling the commercial paper that, in the end, could not be refinanced. Instead, the major newspapers focused on the juicier stories about how some fifteen top executives of Penn Central—including both Bevan and O’Herron—had, prior to the bankruptcy, sold about 70 percent of the stock they had received at the time of the merger a few years earlier. The stock sales, according to William J. Casey, then the chairman of the SEC, “were deemed to raise the most serious questions as whether [they] had been based on material inside information.… These officers had apparent access to information concerning the state of Penn Central’s affairs which was reaching the public only with a serious amount of distortion.”
On August 15, the Times editorialized about Casey’s report and took Goldman to task. “Aware that new securities issues might expose the company to closer inspection by the financial community”—because new securities had to be registered with the SEC, while commercial paper did not—“Penn Central officers sought to keep afloat by borrowing and reborrowing hundreds of millions of dollars through the issuance of short-term commercial paper, exempt from government supervision. The marketing of this paper was handled by Goldman, Sachs & Co., which later insisted to the S.E.C. that it was ‘merely a dealer and not an underwriter,’ and therefore had no duties of disclosure to those who bought Penn Central paper.”
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THIS WAS THE worst kind of publicity for Goldman—and a headache for Novotny—especially with a rash of civil lawsuits pending that, if lost, could wipe out the firm’s capital and the firm itself. The SEC’s comprehensive report was not only devastating in the serious questions it raised about Goldman’s behavior but also provided a potential legal road map for other litigants against the firm. There was also the growing risk that the SEC itself would sue the firm as a number of the newspaper stories were implying.
Novotny went to work. He arranged for Levy to be interviewed by Gilbert Kaplan, the founder and longtime editor of Institutional Investor magazine, for a long question-and-answer piece in the November 1973 issue of the magazine. “Gus Levy answers 132 questions about his firm, his business—and himself,” read the headline. Fortunately for Goldman, not one of the 132 questions was about the mess at Penn Central or about Levy’s and Goldman’s role in it, or about any of the lawsuits swirling around the firm. Instead, readers were treated to a rare dish of Levy’s humility and modesty. Asked about Goldman’s vigorous competition with Salomon Brothers in block trading, Levy professed not to care. “They can’t say they are No. 1 and we can’t say we’re No. 1 and I don’t know a way to get the facts.” As for his anger when someone at Goldman missed a block trade, Levy said, “I’m human. Obviously, if I hear X firm has done ten blocks and we’ve done only one in a day, it upsets me. So I go to our guys and suggest we try harder. But my real concern is Goldman, Sachs’ profitability, rather than how much business we do.”
Indeed, William “Billy” Salomon, one of the founders of Salomon Brothers, remembered once having lunch with Levy in a place where they could watch the broad tape from their table, and when Levy saw that a big block of three hundred thousand shares of stock had traded and Goldman wasn’t the trader, he leapt up from the table and told Salomon he had to make a call. “Billy, I’ll be gone for a few minutes,” Levy told him. Levy went and called the seller of the stock, whom he knew, and berated him on the phone. “How could you give that trade to Bear Stearns!” he thundered. “I sold you that stock.” “Sure enough,” Salomon recalled, “Gus would get the next trade. But very few people at the time would have the audacity to even think of doing that. But Gus had no compunctions. And he hated to lose a trade.” Salomon said people on Wall Street used to call Levy “the Octopus” because “he wanted to do every trade that was ever made on Wall Street.”
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LEVY WAS RIGHT to be concerned about the firm’s profits in 1973, since there were none—an especially painful development since 1972 had been the best year the firm had ever had. The profits in 1972 “caused people to have a very positive feeling,” Bob Rubin remembered. “They felt good. And then all of a sudden 1973 came and the market peak-to-trough was down forty-two percent and we really suffered.” Roy Smith recalled, “[T]here was no money for bonuses in 1973.” Rubin remembered the problem in 1973 was that the trading positions the firm had taken in its equities division—both in block trading and in arbitrage—went against the firm through the course of the year, with the firm losing money nearly every month. The collapse of the stock market also dried up much of the firm’s investment banking business.
The next year was equally difficult. Goldman actually announced publicly that profits “rose” for 1974—without disclosing any actual data—but that they were less than the “unusually profitable” period from 1970 to 1972. Partners ended up taking money from their own pockets to pay employees’ small bonuses. “This was hard on employees, who then, as now, received most of their income from bonuses, but few people left and hardly anyone was laid off,” Smith observed. “Everyone weathered the storm with internal (and external) cost-cutting, and hoped for the best. But it was hard to be optimistic.”
No doubt employee morale was taxed by the news, in April 1974, that the SEC was considering filing “fraud charges”—as a result of Penn Central’s collapse—against both Bevan, the former chief financial officer, and Goldman. On May 2, the SEC dropped its bomb. In a civil suit filed in federal district court in Philadelphia, the agency charged two former Penn Central executives and three former directors with “making false and misleading statements about the carrier’s financial condition to the S.E.C., to stockholders and to the investing public.” Goldman avoided being cited in the SEC’s complaint filed in Philadelphia, but the SEC filed a separate complaint on May 2 against Goldman in a Manhattan federal court. In it, the SEC alleged that from August 1968 to May 1970, in selling Penn Central’s commercial paper, Goldman “has employed and is employing devices, schemes and artifices to defraud” and “has obtained and is obtaini
ng money and property by means of untrue statements of material facts and omissions” and “has engaged in transactions, acts, practices and courses of business which have operated and are operating as a fraud and deceit upon purchasers of securities.” Furthermore, the SEC contended, Goldman made “false and misleading statements of material facts and omitted to state material facts … concerning, among other things the financial condition of” Penn Central, the “financial prospects” of Penn Central, and “the risks of nonrepayment of the commercial paper of” Penn Central. The SEC sought a “permanent injunction restraining and enjoining” Goldman, and its employees, from continuing this deceptive behavior.
As was once typical, on the same day the SEC filed its complaint against Goldman, the two sides signed a consent decree, negotiated on Goldman’s behalf by Michael Maney, a former CIA officer turned attorney at Sullivan & Cromwell. In it, the firm—“without admitting or denying any of the allegations” in the SEC’s complaint—agreed to be “permanently restrained and enjoined” from continuing to sell Penn Central’s commercial paper and to implement, within sixty days, a new policy at the firm regarding the marketing and sale of commercial paper. Henceforth, Goldman would be required to do what it should have done in the first place: to wit, to perform due diligence about the financial efficacy of the issuer of the commercial paper so that Goldman would have “reasonable ground” to expect the obligation would be repaid when it came due and to disseminate that information on an ongoing basis to customers who bought the commercial paper Goldman sold. This “new” policy was required to be shared with the people in the commercial paper department and with partners of the firm. Goldman paid no fine as part of the agreement.
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