Karasti 1

Aviation and the Law
Kevin Karasti

The Demise of Eastern Airlines

By 1985 Eastern Airlines had become one of the United States’ largest airlines. They operated in twenty-six countries on three different continents, and were considered one of the four prominent airlines in the U.S. Although for a time they were successful, it wasn’t long after that Eastern Airlines began to run into problems. Eventually Eastern made a decision that would prove to be disastrous for the airlines-- they sold the company to Frank Lorenzo.

Why did Eastern sell to Texas Air? For starters, the 1970's and 80's proved to be a very difficult time for many airline companies. In the late 70’s the Airline Deregulation Act of 1978 was passed. The enactment did provide many new freedoms (freedom to expand their route systems for example), and positive outcomes for airline carriers. One of which was flexibility to develop innovative pricing structures. This flexibility allowed carriers to expand into new markets. Yet with the positive changes of deregulation, came negative consequences for the airlines-- “airfare wars.” Companies now had to compete to remain in the market. They waged airfare wars against their rivals, slashing their own prices to knock off smaller companies. Many airlines struggled tremendously, and had difficulty keeping their doors open. This made many air carriers susceptible to unwanted, hostile takeovers and mergers. In 1985 Eastern was a large airline (three point nine billion in assets, and over four point eight billion in revenues). Eastern was ranked third among all U.S. airlines, followed by United Airlines, and American. However, between 1985 and 1986 Eastern’s performance steadily declined. Eastern Airlines was one of the many airlines struggling to contend with the price wars. The combination of competition, labor unrests, and Eastern’s overwhelming debt (much from the purchasing of Boeing’s 757’s and Airbus’s A-300s) made Eastern very vulnerable during the battle.

Eastern eventually sold it’s majority share holdings to Frank Lorenzo, owner of Texas Airlines.

Lorenzo had previously taken control of Texas International Airlines (TIA) in 1971. Frank used TIA to build a large airline holding company, and systematically acquired Continental Airlines, People’s Express, and Frontier. Lorenzo had built a reputation for being a “Union Buster”-- a title he acquired after Continental made a controversial strategic bankruptcy filing in August of 1983. Continental Airlines continued to operate during their chapter 11 (chapter 11 of the U.S. bankruptcy code defines the rules by which a distressed firms stakeholders renegotiate
Karasti 2

their claims.) for two years. Lorenzo took advantage of the situation, and was able to break down the unions. He then forced employees to take steep pay cuts (as large as fifty percent). Frank Lorenzo, now moved onto Eastern Airlines. Lorenzo was seen as someone who could turn the airline around (as he had done for Continental). His strategy was simple-- to cut costs. Usually the cuts came from the laying off of employees, and cutting wages. No one saw what was coming once he took the helm of Eastern. Almost immediately after its acquisition by Texas Air in February of 1986, Lorenzo started to strip away Eastern’s assets. The following paragraphs are an account of the detrimental stripping of Eastern’s assets by the guiding hand of Frank Lorenzo.

The Reservation System: Lorenzo plugged Eastern right into his so called “machine.” Once the purchase of Eastern by Texas Air was complete, the company wasted no time in stripping Eastern of one of it’s most productive money makers-- it’s computerized reservation system (known as System One Direct Access (SODA). This complex computer system bank gave more than 5,000 travel agents around the country instant access to Eastern’s flights, and fares. In the mid 1980’s the larger carriers came to use systems similar to the SODA reservation system as a means to pull in passengers, and ample profits. When Eastern’s board sold the company to Lorenzo, Merril Lynch (Easterns Investment bankers), estimated that SODA by itself was worth between $200 to $250 million. However, another outside company estimated its worth to be at about $400 million By March 1987, a new subsidiary of Texas Air called System One Holdings Inc. bought SODA, and a related software unit called EAL Automation Systems Inc. A similar system was sold in late 1986 by Trans World Airlines (TWA). TWA sold a half share in its PARS reservation system (which linked 3,600 travel agencies) for $140 million. You would think that the selling of a like system, as a whole reservation system would fetch about double-- or at the minimum match that price, right?

Lorenzo sold SODA to Texas Air for $100 million! Far less then the value both Eastern, and outside sources assessed it to be. What’s more--the icing on the cake-- instead of paying cash, Texas Air gave Eastern a note for the $100 million (that paid interest at well below market value). Now because the note did not come due until 2012 it was probably worth less than $50 million. It gets even worse, Eastern was required to pay to use what had once been it’s own reservation system. System One received a fee for every reservation made on Eastern, plus other fees. Eastern was paying about ten million a month for a system that had once generated substantial income for the company. In the 9 months after Texas Air had purchased the system Eastern paid $90 million for a service it had sold for an amount which when due would only be worth $50 million dollars!
Karasti 3

Bad Bonds:

Texas Air bought a small airlines in late 1986 called People’s Express. Through the purchase, Texas Air picked up $100 million in notes from the nearly bankrupt carrier. These bonds were risky and if sold in the open market they probably would have fetched much less. So Texas Air, sold $30 million of them to Eastern for $25 million even though Texas Air had paid less then $21 million to buy this particular set of notes in the first place. Lorenzo came out of the deal with a $4.4 million dollar profit and Eastern was left $25 million poorer.

Shuttle Operations:

The sale of Eastern’s Washington, New York, and Boston Shuttle operations more or less confirms the previous charges. Lorenzo sold the shuttle operations to Donald
Trump for three hundred sixty five million dollars in 1988. It was said that Trump would use the shuttle to fly gamblers to the gaming mecca in Atlantic city on the weekends. The deal included seventeen Boeing 727 aircraft facilities, and landing positions in New York, Boston, and Washington. The shuttle was considered Eastern’s most important operation because it brought in the most profits. Knowing this, most would question the actions of the owner, who knowingly sells off a companies only profitable operation. Many suspected Mr. Lorenzo‘s actions were intended to dismember the rest of the company, or to possibly merge it with one of his other airlines. Of course Lorenzo denied such allegations, and claimed the sale of the shuttle operations was not his preferred course. Adding that he had only been forced to sell the shuttle operations because he was unable to get wage concession from the unions. Despite frequent denials, industry analysis at the time viewed the sale as a sure sign that the rest of Eastern would now be sold, and most of it soon was. Gate Giveaways:

Eastern sold Continental eleven airport gates at Newark for an eleven million dollar note. Again an outside consulting firm reviewed the deal, and valued the gates at twice as much. Eastern itself valued them at nearly twice as much as well (in an earlier deal Eastern had sold eight of its gates to Charlotte N.C which was a considerably smaller market to Piedmont Aviation for $25 million). Of course this deal was made in cash.

Airplane Sales:

Eastern sold Continental six Borman’s Fancy A-300 jets. Continental paid $162 million for the jets, $67 million of the payment was in the form of a promissory note. Continental, an airline not being ripped apart by its owner, then turned around and sold the very same planes to someone else for $169 million in hard cash. This left Eastern seven million short, and holding another note of questionable value.
Karasti 4
Fuel Company:

Texas Air created a new company called Texas Air Fuel Management Inc. which bought fuel for all it’s airlines, sounds reasonable. Except, Eastern Airlines was charged about a million dollars a month for this service which brought in no apparent benefit to the company. These moves were not just haphazard attempts to raise cash by a hard up management-- they were part of a deliberate and premeditated campaign to break the unions, damage Eastern, and help Continental.

Subsidiaries:

We know that Lorenzo had in fact started to strip assets from Eastern almost as soon as Texas Air gained control of the company. He bought the company with the long term plan of merging it into Continental. Lorenzo’s corporate structure allowed him to use Eastern as his own personal bank in which he could withdrawal money at will. It also allowed him almost unlimited room to shift money among his various entities. In 1988 Lorenzo had taken the countries largest airline, and buried it in about five and a half billion dollars worth of debt. Texas Air being vulnerable to bankruptcy, spawned dozens of subsidiaries. By the end of 1988 the parent company had given birth to about 25 subsidiaries. This allowed Lorenzo to parcel out the enormous debt among his children. This structure meant Lorenzo was always living life on the edge, constantly pulling money from one company to subsidize another. When the system ran smoothly, the money would stream up to Texas Air, which accumulated hundreds of millions of dollars even though it was just a holding company. When crisis developed, as they did consistently with Continental, Texas Air was able to take money from say, Eastern and pump it back into Continental.

Spin-Offs:

Lorenzo’s financial moves were so convoluted that even wall street analysis’s had a tough time figuring out what was going on. The Pilot’s Union, was weary from trying to keep up with Texas Air’s transactions. In January of 1988 the Pilot’s Union hired Touche and Ross Co. (one of the countries largest accounting firms) to help analyze Eastern’s finances.

Lorenzo continued to spin off parts of Eastern by creating new companies to replace those already in place by Eastern. Eastern’s board created a new company called Protective Services Corporation, a small company with only about fifty employees. Although guards were already represented by the machinists union. Lorenzo was an intelligent man, and if he could not break the unions he sought to replace them with new companies. Management served notice that a new labor agreement would have to be negotiated just for these fifty guards, who averaged about $13.50 an hour. Of course new labor contracts would give management an opportunity to slash the guards wages without
Karasti 5

waiting for the entire machinists union to agree to concessions. Through these new companies he would be able to negotiate lower wages and reduced benefits.

Eastern’s officials feared eventually they would try to place all six thousand of it’s baggage handlers, and other fleet service workers into the new company allowing management to further cut wages. Two months later Eastern created the Airport Ground Services Corporations which employed about one hundred union baggage handlers, and maintenance people in Fort Lauderdale. The union’s fears were becoming a reality. Eastern’s Chief operating officer announced that if the new venture was successful, it would spread to other Eastern locations. Within days the Machinists lawyers filed a lawsuit with the U.S. district court in Washington D.C. Almost immediately Judge John H. Pratt issued a temporary restraining order against the spin-off. Lorenzo, unfazed continued to sell of pieces of the airline, and kept up spin-offs throughout 1987 and 1988, Continental usually reaped the rewards. On March 4th, 1989
Eastern’s Machinists went on strike. The Pilots and flight attendants were also unionized and refused to cross the picket line-- crippling Eastern’s ability to operate. Five days later on March 9th 1989 Eastern filed for chapter 11 bankruptcy. While the airline was in chapter 11, the court extended management rights to form a reorganization plan until February 20, 1990. Almost a year after the chapter 11 filling management proposed three plans. None of the plans came to a vote because severe operating losses made it clear that plans were not viable. The bankruptcy allowed Lorenzo to continue operating using non-union employees. In the time Eastern was in chapter 11, and until the time the airline ceased operations, the company raised about one point eight billion dollars through asset sales. Some of the assets sold included routes, gates, planes, engines and spare parts.

The pilots and machinists unions sued Eastern airlines, and its chairman Frank Lorenzo. They alleged that Eastern/ Lorenzo were guilty of fraudulent empire building, misrepresentation, extortion and other criminal means (including asset stripping and asset shifting). These criminal actions not only damaged the carriers employees, but also it’s shareholders. After a creditor brought suit against Eastern Airlines the court appointed Martin Shugrue as temporary trustee over Eastern. Two of Eastern’s major unions (The Airline Pilots association and the International Assn. of Machinists and Aerospace Workers) consistently accused Lorenzo of having planed to chop Eastern into pieces, and sell those pieces off.

The Eastern Airlines stopped flying on January 19th 1991. It had completely run out of money to operate. In the early 1990s, the airline was liquidated. Ending the life of one of America’s greatest airlines. Karasti 6

In total Touche and Ross Accounting estimated that Lorenzo made off with a net sum of at least $750 million in assets. To many, it seemed that Eastern’s fall was the result of unions that would not come to an agreement (ultimately leaving the carries unable to operate), yet if you dig a little deeper you will find the truth behind Eastern’s demise.

Works Cited

Bernstein, Aaron. Grounded: Frank Lorenzo and the Destruction of Eastern Air Lines. New York: Simon & Schuster, 1990.

Leary, William M. Editor. Encyclopedia of American Business History and Biography: The Air Industry. New York: Facts on File, 1992.

Online resources:

“Eastern Airlines,” http://avstop.com/History/HistoryOfAirlines/Eastern.htm
“Eastern Airlines,” http://en.wikipedia.org/wiki/Eastern_Airlines”
“Eastern Airlines,” http://articles.sun-sentinel.com/keyword/eastern-air-lines”
“Eastern Airlines,” http://www.nytimes.com/1989/03/04/us/machinists-strike-eastern-airlines-after-talks-fail.html?pagewanted=all&src=pm”