How Goldman Sachs killed Penn Central
By William D. Cohan
Published: Sunday, March 25, 2012
Goldman Sachs has been in and out of trouble throughout its 143 years chiefly because it chose to put its own interests before those of its clients. And one example is most representative -- the June 1970 bankruptcy of Penn Central Transportation Co., the nation's largest railroad.
At the time, Penn Central operated 20,530 miles of track in 16 states and two Canadian provinces and provided 35 percent of all railroad passenger service in the United States. It also had substantial real estate holdings, including Grand Central Terminal in New York, along with much of the land on Park Avenue between Grand Central and the Waldorf-Astoria hotel.
Nevertheless, Penn Central ended up defaulting on $87 million of its short-term unsecured debt ("commercial paper") and Goldman was at the epicenter of its financial difficulties.
In 1968, after years of being shut out of doing business with many of the nation's railroads -- in large part because it was a Jewish-owned firm -- Goldman won the opportunity to underwrite Penn Central's commercial paper, widely seen as among the safest short-term investments.
For large fees, Goldman sold the paper to its clients, including big companies such as American Express and Disney, and smaller ones such as Welch's Foods, the grape-juice maker, and Younkers, a Des Moines retailer. Welch's and Younkers, particularly, counted on the fact that Goldman told them that the Penn Central paper was safe and could be easily redeemed. Welch's invested $1 million -- some of it payroll cash -- and Younkers invested $500,000, both at Goldman's recommendation.
After Penn Central filed for bankruptcy, an SEC investigation discovered that Goldman continued to sell the railroad's debt to its clients at 100 cents on the dollar -- even though, by the end of 1969, the firm knew that Penn Central's finances were deteriorating rapidly.
Not only was Goldman privy to Penn Central's internal numbers, it also heard repeatedly from the railroad's executives that it was rapidly running out of cash.
And according to the SEC, while Goldman did not share the bad news with its customers and continued to sell them the increasingly squirrelly Penn Central commercial paper, it did use public and nonpublic information to protect itself and its partners from having any of the paper on their books when the music stopped.
Back then, Goldman was a private partnership with only its partners' capital at risk, not that of outside investors, like today.
By the beginning of February 1970, Goldman had $10 million worth of Penn Central's commercial paper on its balance sheet, about 20 percent of Goldman's $50 million in capital. Losing 20 percent of its capital would be devastating and would jeopardize Goldman's ability to stay in business.
Goldman's partners decided that they could not take that risk. On Feb. 5, 1970, the very day the firm received Penn Central's latest dismal numbers, it demanded that the railroad buy back Goldman's $10 million inventory of its commercial paper at 100 cents on the dollar, even though it was worth far less at that point.
None of Goldman's customers were made a similar offer, nor did the firm tell them that it had taken care of itself while leaving them to suffer the vicissitudes of Penn Central's rapidly deteriorating fortunes.
The SEC sued Goldman civilly as a result of its behavior in selling Penn Central's commercial paper, and the lawsuit was quickly settled, with the firm neither denying nor admitting guilt.
After Penn Central filed for bankruptcy, Goldman faced an existential threat as client after client sued the firm for selling them the questionable commercial paper. It settled many of these lawsuits for pennies on the dollar.
But several suits went to trial, including one brought collectively by Welch's, Younkers and C.R. Anthony, another Midwestern retailer. In their complaint, they charged Goldman with "fraud, deception, concealment, suppression and false pretense" in the sale of the commercial paper to them.
Incredibly, Goldman thought it could win the lawsuits and allowed them to go to trial, where much of the firm's dirty laundry was aired. In the end, it lost the suit brought by the three companies and paid the plaintiffs 100 cents on the dollar, plus interest.
More important, the firm's partners were petrified that with more than $80 million in potential claims against it and only $50 million in partners' capital, continued lawsuits could put Goldman out of business, taking everything the partners had earned over the years with it.
In the end, the firm squeaked through the crisis, thanks to a combination of good luck and an assortment of insurance payments and settlements. It also held on to the Penn Central commercial paper it took back from its clients through the company's bankruptcy until it regained its value.
Presidents of both parties have been blinded by the Goldman mystique, appointing Treasury secretaries with Goldman pedigrees, to say nothing of various White House chiefs of staff and officials throughout the federal government.
The shocking thing about many Goldman Sachs employees is that they actually think the firm intends to live by the 14 principles that former partner John Whitehead, now 90 years old, sketched out on a yellow pad of paper one Sunday afternoon a generation ago.
Whitehead said he wanted to emphasize what made Goldman a "distinctive" and "unique place to work" without "sounding too schmaltzy."
Principle No. 1: "Our clients' interests always come first. Our experience shows that if we serve our clients well, our own success will follow."
But some Goldman executives, perhaps more cynical, have seemed to understand well that the truth about the firm does not resemble its public relations material. As for putting clients first, former Goldman partner Pete Briger used to say around the trading desk, "Yeah, and when we do, make no mistake about it, it's a business decision."
William D. Cohan is author of "Money and Power: How Goldman Sachs Came to Rule the World."
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