Item 1. Business
General
The North Carolina Railroad Company (the "Registrant") was incorporated in 1849 in the State of North Carolina. The Registrant owns approximately 317 miles of continuous railroad line running from Charlotte, North Carolina to Morehead City, North Carolina. The Registrant has one office located at 234 Fayetteville Street Mall, Raleigh, North Carolina (27602) and three full time employees.
Background of Railroad Leases
The Registrant conducted railroad operations beginning in 1856. In 1871, the Registrant leased substantially all of its assets to the Richmond & Danville Railroad Company, a predecessor of Southern Railway Company, for a term of thirty years. In 1895, the Registrant leased substantially all of its assets to Southern Railway Company, now known as Norfolk Southern Railway Company ("NSR"), for ninety-nine years (the "1895 Lease"). In 1989, the Registrant acquired the Atlantic and North Carolina Railroad Company, the assets of which were subject to a lease dating to 1939 with the Atlantic & East Carolina Railway Company ("AECR"), a wholly-owned subsidiary of Norfolk Southern Railway Company (the "1939 Lease"). NSR and AECR are hereinafter referred to as "Norfolk Southern." Information about the 1895 and 1939 Leases has been disclosed by the Registrant in prior quarterly and annual reports to the Securities and Exchange Commission ("Commission").
The terms of the 1895 Lease and 1939 Lease provided for expiration on January 1, 1995 and December 31, 1994, respectively, and did not require either the Registrant or Norfolk Southern to renew the leases. However, Norfolk Southern's operation of the Registrant's railroad line may not be discontinued unless discontinuance is authorized by the Surface Transportation Board of the United States Department of Transportation ("STB"), the successor agency to the Interstate Commerce Commission ("ICC"). Neither the Registrant nor Norfolk Southern have sought regulatory authority for discontinuance of service by Norfolk Southern (see "Regulatory Matters," below), and Norfolk Southern is continuing to operate the Registrant's railroad line under the circumstances described below.
During the fourth quarter of 1994, the Registrant and Norfolk Southern reached tentative agreement on the primary terms of a long term agreement to extend the 1895 and 1939 Leases. However, a definitive agreement had not been reached as of the expiration dates of the 1895 and 1939 Leases at the end of 1994, and the Registrant and Norfolk Southern entered into a temporary
arrangement to continue the rental and other terms of the 1895 and 1939 Leases beginning in 1995. During 1995, Norfolk Southern continued to make rental payments under the terms of the 1895 and 1939 Leases.
Lease Extension Agreement
On August 10, 1995, the Board of Directors of the Registrant approved a Lease Extension Agreement in the form attached as an exhibit hereto (the "Lease Extension"). The Lease Extension extends the terms of the 1895 Lease and the 1939 Lease, and its effectiveness is retroactive to January 1, 1995. On August 24, 1995, the Board of Directors of NSR and the Board of Directors of AECR approved the Lease Extension.
Conditions to effectiveness of the Lease Extension were as follows: (i) approval or exemption from approval from the ICC or any successor entity, (ii) obtaining all required governmental and corporate approvals and (iii) the expiration or termination of any existing court-ordered injunctions. The Board of Directors of the Registrant, pursuant to North Carolina law, voted to condition approval of the Lease Extension upon a majority of the votes cast at the meeting in person or by proxy held by shareholders other than the State of North Carolina. In a decision effective December 22, 1995, the ICC exempted the Lease Extension from the prior approval requirements of the Interstate Commerce Act. On December 22, 1995, the Governor and Council of State of the State of North Carolina approved the Lease Extension Agreement pursuant to North Carolina law. On December 15, 1995, the shareholders of the Registrant voted to approve the Lease Extension. However, a shareholder has commenced a legal action challenging the validity of shareholder approval. See Item 4, Submission of Matters to Vote of Security Holders, regarding shareholder approval of the Lease Extension. Other shareholder derivative litigation seeking to enjoin the Lease Extension is also pending. See Item 3, Legal Proceedings, for a description of the actions.
The Lease Extension, which has been executed by the Registrant and Norfolk Southern, is being held in escrow by a third party pursuant to an escrow agreement. The escrow agreement provides for the Escrow Agent to retain the original execution copies of the Lease Extension until the Escrow Agent receives satisfactory evidence that either (i) all remaining approvals of the Lease Extension have been received, or (ii) the remaining approvals cannot be obtained. If neither of these events occurs by March 31, 1997, the escrow agreement makes provision for further disposition or destruction of the original execution copies of the Lease Extension. As a result of the shareholder action challenging the validity of shareholder approval, neither the Registrant nor Norfolk Southern has made demand to the Escrow Agent to release the Lease Extension documents, and the Registrant has not indicated to Norfolk
Southern that it considers the Lease Extension to be effective.
Notwithstanding Norfolk Southern's knowledge of the shareholder derivative actions challenging approval of the Lease Extension and the Registrant's failure to confirm the effectiveness of the Lease Extension, on December 28, 1995 Norfolk Southern paid the Registrant approximately $7.8 million, which, along with other amounts paid by Norfolk Southern in 1995, is the amount that would have been owed to the Registrant under the terms of the Lease Extension had the Lease Extension become retroactively effective as of January 1, 1995. During 1996 to date, Norfolk Southern has continued to make monthly payments to the Registrant in amounts that would be due if the Lease Extension is effective. The Registrant has not returned such payments to Norfolk Southern, but has not indicated to Norfolk Southern that the Lease Extension is effective. If the December 15, 1995 approval by the shareholders of the Registrant of the Lease Extension is determined to be invalid, it is the intention of the Registrant to retain any payments made by Norfolk Southern to the Registrant as payment for use of the assets of the Registrant since the beginning of 1995 or for other claims the Registrant may have under the 1895 and 1939 Leases. The Registrant may also seek payment of additional amounts for use of the Registrant's assets by Norfolk Southern and other claims. The Registrant does not know what position Norfolk Southern would take with respect to payments made to the Registrant, but Norfolk Southern's position could include a claim against the Registrant seeking recovery of such payments from the Registrant. In such event, the Registrant intends both to aggressively defend any legal action Norfolk Southern may bring and to assert other claims of the Registrant against Norfolk Southern. See "Alternatives to Lease Extension" below regarding alternatives in the event shareholder approval of the Lease Extension is invalidated or if the Lease Extension is enjoined.
The Lease Extension provides for Norfolk Southern to make a one-time settlement payment of $5 million, plus interest, to the Registrant in exchange for the Registrant's release of Norfolk Southern from certain contractual obligations relating to certain personal property upon expiration of the 1895 Lease and 1939 Lease. The Registrant and Norfolk Southern entered into an agreement dated August 10, 1995, whereby the settlement payment was made in early December 1995 in order to facilitate the Registrant seeking Real Estate Investment Trust ("REIT") status at the earliest practicable date. The Registrant is seeking a ruling from the Internal Revenue Service as to the effect of the payment with respect to the timing of the Registrant's REIT election, but the Registrant has not yet received such ruling. The Lease Extension does not waive or otherwise affect any claims of the Registrant to railroad yards or other such property or facilities, but provides that such claims are postponed until the termination of the Lease Extension and any renewal pursuant to its terms.
Set forth below is a summary of some of the material terms of the Lease Extension, which summary should be read in conjunction with the complete terms of the Lease Extension.
(1) The base annual rental under the Lease Extension is eight million dollars ($8,000,000) for the period from January 1, 1995 through December 31, 1995.
(2) Annual base rent for 1996 and each year thereafter will be adjusted each year to account for inflation during the preceding calendar year according to the implicit price deflator for the gross domestic product (IPD- GDP). In no event, however, will the base annual rental for any calendar year be less than eight million dollars ($8,000,000). The base rent adjustment in any year cannot exceed the sum of: (i) four (4%) percent of the base rent for the preceding year, plus (ii) seventy-five (75%) percent of the IPD-GDP in excess of four (4%) percent. There is a one-year delay in application of the IPD-GDP. For example, adjustment of 1995 rental payments to determine 1996 rental payments is based upon the IPD-GDP for 1994.
(3) The Leases are extended for an initial term of thirty (30) years, through December 31, 2024 and are extendable for an additional twenty (20) years at the option of Norfolk Southern. Exercise of the twenty- year extension option requires that Norfolk Southern pay to the Registrant an option fee equal to the lesser of (i) twenty-five (25%) percent of the base rent in effect during the year prior to Norfolk Southern giving notice to exercise its extension option or (ii) $5 million. If the extension option is exercised by Norfolk Southern, the Registrant expects to recognize the renewal fee ratably over the 20-year lease renewal term.
(4) 317 miles of railroad property (including the railroad right of way and certain improvements to yard areas and other structures situated adjacent to, under or along the lines) located between Morehead City and Charlotte, North Carolina, are covered by the Lease Extension. The Registrant has the right, however, to have certain properties outside the right of way not used in operating a railroad released from the 1895 and 1939 Leases. Norfolk Southern's rental payments will not be reduced if the Registrant exercises this right. The Registrant intends to exercise its right to have released from the Leases those properties it determines have income-generating potential in excess of projected expenses. The Registrant estimates these properties currently are producing less than $100,000 of annual lease income. The Registrant will determine which properties it will seek to have released after
evaluating potential environmental liability and other relevant factors.
(5) Norfolk Southern is required to pay to the Registrant seventy-five (75%) of any revenues (in excess of de minimis amounts) obtained by Norfolk Southern for longitudinal leases and licenses granted by Norfolk Southern to third parties for certain fiber optic and other uses.
(6) The Lease Extension contains extensive provisions governing the rights and obligations of the parties for various environmental liabilities and expenses.
(7) Norfolk Southern is required to pay the expenses to maintain and operate the leased railroad lines and facilities, to fulfill all railroad common carrier duties pertaining to the leased railroad lines and to indemnify the Registrant from certain liability claims by third parties.
Except as modified or supplemented by the Lease Extension, the terms of the 1895 and 1939 Leases continue in full force and effect.
Norfolk Southern beneficially owns 113,855 shares of the common stock of the Registrant, which represents an ownership interest of 2.7% of the Registrant.
Real Estate Investment Trust Election
On August 10, 1995, the Board of Directors of the Registrant voted to cause the Registrant to elect REIT status for income tax purposes, in connection with the Lease Extension. If the Registrant qualifies for taxation as a REIT, it generally will not be subject to federal corporate income taxes on that portion of its ordinary income or capital gain that is currently distributed to its shareholders. The REIT provisions of the Internal Revenue Code ("I.R.C.") generally allow a REIT to deduct distributions paid to its stockholders. The Registrant received an opinion of counsel that the Registrant can qualify as a REIT based upon the effectiveness and terms of the Lease Extension. However, the Registrant is seeking a ruling from the Internal Revenue Service ("I.R.S.") as to the effect of the $5 million one-time settlement payment with respect to the timing of the Registrant's REIT election, but the Registrant has not yet received such ruling. In addition, certain shareholder litigation could enjoin, delay, or otherwise affect the effectiveness of the Lease Extension, the terms of the Lease Extension, or the timing or amount of shareholder distributions. In that event, the litigation may delay or even cause the Registrant to be unable to qualify for REIT status, which would substantially decrease the after-tax net income available for
distribution to shareholders of the Registrant. See Item 3, Legal Proceedings, for a description of the shareholder litigation.
In order to be taxed as a REIT, the Registrant is required to distribute dividends (other than capital gain dividends) to its stockholders in an amount at least equal to (a) the sum of (i) 95% of the Registrant's "REIT taxable income" (computed without regard to the dividends-paid deduction and the Registrant's capital gain) and (ii) 95% of the net income, if any, from foreclosure property in excess of the special tax on income from foreclosure property, minus (b) the sum of certain items of non-cash income. Such distributions must be paid in the taxable year to which they relate, or in the following taxable year if declared before the Registrant timely files its Federal income tax return for such year and if paid on or before the first regular dividend payment after such declaration. Even if the Registrant satisfies the foregoing distribution requirements, to the extent that the Registrant should fail to distribute during each calendar year at least the sum of (a) 85% of its ordinary income for that year, (b) 95% of its capital gain net income for that year and (c) any undistributed taxable income from prior periods, the Registrant would be subject to a 4% excise tax on the excess of such required distribution over the amounts actually distributed. Under certain circumstances, the Registrant may be able to rectify a failure to meet the distribution requirements for a year by paying "deficiency dividends" to shareholders in a later year, which may be included in the Registrant's deduction for dividends paid for the earlier year. Thus, the Registrant may be able to avoid being taxed on amounts distributed as deficiency dividends. The Registrant will, however, be required to pay interest based upon the amount of any deduction taken for deficiency dividends.
Due to the uncertainty over the effectiveness of the Lease Extension caused by the shareholder derivative actions challenging the validity of shareholder approval of the Lease Extension, the Registrant has determined to delay a decision as to whether to elect REIT status for its 1995 taxable year until the earlier of the date the uncertainty has been resolved or the latest date by which the Registrant may make an election to be taxed as a REIT for 1995. The Registrant believes it may be able to qualify for 1995. If the Lease Extension is invalidated, the Registrant does not know whether its income, if any, for 1996 and later years will qualify the Registrant for REIT status for taxable years after 1995. The I.R.C. provides that if a taxpayer's REIT election is terminated by its failure to satisfy the qualification requirements, the taxpayer may not make a new election to be taxed as a REIT prior to the fifth taxable year after disqualification, unless the taxpayer fits within certain narrow exceptions. Distributions to shareholders in any year in which the Registrant fails to qualify as a REIT will not be deductible by the Registrant nor will they be required to be
made. Accordingly, the Registrant will evaluate the tax benefits to be gained by electing REIT tax status for 1995 compared to the possible detriment to the Registrant if the Registrant is disqualified from REIT tax status for four subsequent taxable years. The provisions of the I.R.C. and related regulations governing the federal income tax treatment of REIT's are highly technical and complex. There can be no assurance that the Registrant can qualify for REIT status for 1995 or later years. (See Note B to the financial statements regarding pro forma information in the event the Registrant qualifies for REIT status for 1995.)
To ensure that the decision about electing REIT tax status for 1995 is made with the most reliable information available under the circumstances, the Registrant has filed applications for an extension of the time to file its tax returns for tax year 1995 until September 15, 1996. On or before that date, the Registrant will evaluate all relevant factors in determining whether to make a REIT election for its 1995 taxable year. Such factors will include, for example, the status of the shareholder derivative actions, any discussions with Norfolk Southern about the Lease Extension, alternatives to the Lease Extension, advice from the Registrant's professional advisers about the feasibility of qualifying for REIT tax status if the Lease Extension does not become effective, and the tax consequences of the Registrant electing REIT status for 1995, but failing to qualify as a REIT for 1996, 1997 or later years.
If the Registrant makes a REIT election for its 1995 taxable year, by delaying certain distributions of 1995 income past January 31, 1996, the Registrant would incur a Federal excise tax liability of approximately $315,000 for 1995. If the Registrant does not elect REIT tax status for 1995, the Registrant would incur an additional 1995 income tax liability of approximately $3 million, in addition to income tax liability of approximately $2 million attributable primarily to taxes on the $5 million property settlement payment. Under the original terms of the 1895 Lease, which pursuant to a temporary arrangement between the Registrant and Norfolk Southern are applicable to Norfolk Southern's continued operation after the end of 1994, all taxes, including income taxes of the Registrant attributable to the Lease, were the responsibility of Norfolk Southern as lessee. It is unclear at this time, however, how such a temporary arrangement would be interpreted by the courts with respect to tax liability reimbursement.
Alternatives to the Lease Extension Agreement
In light of the uncertainty about the status of the Lease Extension and the need to make an informed decision regarding electing REIT tax status for 1995 and later years, the Registrant is evaluating its strategic goals and the alternatives available
to achieve such goals. Alternatives under consideration by the Registrant include resubmitting the Lease Extension for approval by the shareholders of the Registrant, seeking to negotiate with Norfolk Southern terms more favorable to the Registrant than those afforded by the Lease Extension submitted to the shareholders in December 1995, litigation against Norfolk Southern, leasing all or part of its properties to one or more independent railroad operators, or operating all or part of its properties as an independent railroad. Prior to approval of the Lease Extension, the Registrant evaluated many of the foregoing alternatives. For example, the Registrant and its financial advisors attempted to interest alternative lessees/operators in its railroad properties. Such efforts did not produce a satisfactory alternative to the Lease Extension.
The Registrant has not determined whether to pursue any of these alternatives, but depending upon future circumstances the Registrant may decide to pursue one or more or a combination of such alternatives. The Registrant also may solicit shareholders opinions about these or other alternatives. Over the past several years, certain shareholders have met with representatives of the State of North Carolina ("State") to discuss a sale or reorganization of the Registrant and the Registrant has been advised by the State that a buy-out or reorganization is being evaluated along with other options, but the Registrant is not aware of the seriousness of such discussions or whether the State will decide to pursue such a transaction. Although certain State officials have discussed in public a buy-out of the other shareholders as being in the interest of the State, other officials have also indicated that it may be in the State's interest to sell all or part of its stock. The Registrant is not aware of any decision by the State to buy-out the other shareholders and is not aware of what legislative or other government approvals would be required for such a transaction.
Under the Lease Extension discussed above, Norfolk Southern would continue to assume maintenance, capital improvement, and common carrier obligations with respect to the leased properties, as is the case under the 1895 and 1939 Leases. The Registrant has been advised by its ICC/STB counsel that it may have a residual common carrier duty if Norfolk Southern were to discontinue railroad service. If the Registrant were to operate the railroad lines itself, the Registrant anticipates that it would have to incur substantial capital expenditures. See Item 7, Registrant's Discussion and Analysis of Financial Condition and Results of Operation, below.
If the Registrant operates its railroad lines, it would not be eligible to seek qualification as a REIT for income tax purposes, but instead would be treated as an operating railroad for income tax purposes, in which event ordinary corporate income tax treatment would apply to the Registrant. See "Real Estate Investment Trust Election" above regarding a failure of the
Registrant to qualify for REIT status for 1995 or later years.
It is possible that Norfolk Southern would seek to discontinue its responsibility as a common carrier to operate all or part of the Registrant's lines and/or to re-route certain railroad traffic that does not either originate or terminate on the Registrant's lines (known as "overhead traffic") to other Norfolk Southern controlled lines. The Registrant does not have complete or reliable information about the overhead traffic because Norfolk Southern refused to disclose overhead traffic data to the Registrant, but the Registrant believes that a substantial majority of the traffic on its lines is overhead traffic according to analyses of ICC carload waybill sample information for 1994 and prior years. A portion of the property leased by the Registrant, the segment between Greensboro, North Carolina and Charlotte, North Carolina, forms part of a major system route for Norfolk Southern.
The Registrant believes the volume and type of overhead traffic diverted by Norfolk Southern would be the most significant factor in determining the revenues of the Registrant or any other operator of the Registrant's railroad lines. Many of the factors affecting routing of overhead traffic would be beyond the control of the Registrant. Other factors that would likely affect the profitability of operating the railroad include whether the operator would lose traffic to trucking companies or other competitors, the percentage of revenues required for operation (railway operating ratio), the revenues the operator would receive for traffic moving to and from connecting railroads, including Norfolk Southern, and revenues and expenses associated with operations of National Rail Passenger Corporation ("Amtrak"), which operations are governed in part by federal law.
Other Leases
Under a lease dated December 31, 1968 (the "1968 Lease"), the Registrant and Norfolk Southern renegotiated a portion of the 1895 Lease. Three parcels of land located in Charlotte, North Carolina were released from the 1895 Lease and became subject to the 1968 Lease. This lease expires on December 31, 2067, and provides for an annual rental of $81,319 until 2018, when the rent becomes six percent (6%) annually of the current value of the leased land as determined by the parties.
In 1862, the Registrant entered into an agreement with the Chatham Railroad Company ("Chatham"), a predecessor of CSX Transportation Inc. ("CSXT"), for parallel construction and operation of a railroad track by Chatham within the Registrant's right of way between Raleigh and Cary, North Carolina, a distance of approximately eight miles (hereinafter referred to as the "1862 agreement"). The 1862 agreement made no provision for rental to be paid to the Registrant by Chatham. CSXT succeeded to the interests of
Chatham and the railroad track and facilities subject to the agreement are currently operated by CSXT as a part of its branch line between Henderson and Hamlet, North Carolina. The Registrant is currently negotiating with CSXT for renewal and modification of the 1862 agreement.
In addition to the leases and agreements described above, the Registrant leases several small parcels of property producing approximately $700 of lease revenues monthly.
Regulatory Matters
Railroads and other transportation companies are subject to state and federal regulations administered by agencies such as the STB (successor agency to the ICC), United States Department of Transportation ("DOT"), Federal Railroad Administration, state departments of transportation and state utilities commissions. During the past thirteen years, regulatory agencies have exhibited a trend toward less regulation of transportation industries. Effective January 1, 1996, under the ICC Termination Act of 1995 ("ICCTA"), federal jurisdiction over the economic regulation of railroads was modified and transferred by Congress to the STB, a department within DOT. The ICCTA also gave the STB exclusive jurisdiction over the economic regulation of railroads and preempted remedies under state law. The Registrant is evaluating the effect of the ICCTA upon the Registrant, including the extent to which the prior law was retained, modified, or repealed.
Railroads are affected not only by the regulation of the railroad industry, but by regulation of other modes of transportation, which can change the cost structures of competitive modes of transportation. For example, proposals to have regulations changed to increase the size and weight limits of certain trucks are submitted to Congress from time to time. If permitted, such increases could have a material adverse effect upon railroads by decreasing the cost of shipping goods by truck. The Registrant monitors the regulation of railroads and competing modes of transportation on a regular basis, primarily through railroad industry publications.
Other Matters - Environmental
The Registrant and its lessees are responsible for compliance with state, federal, local or other provisions relating to discharge of materials or the protection of the environment. State and federal environmental provisions may impose joint and several liability upon the Registrant and its lessees and sublessees for environmental damage or clean up (or associated costs) of any real properties owned by the Registrant and adjoining properties if the source of any problem is the property of the Registrant. The Registrant believes that damage
or clean up (or the associated costs) would be the responsibility of the lessees and any sublessees or other parties who may have created any actionable environmental condition. The Lease Extension contains extensive provisions governing the rights and obligations of the parties for various environmental liabilities and expenses. If the Lease Extension is invalidated or enjoined, the Registrant may determine it is in its interest to initiate substantial environmental assessments of its properties and commence environmental litigation against Norfolk Southern and its sublessees or other parties who may have created or who are responsible for any actionable environmental conditions. If such parties are not able to meet their responsibilities, under certain statutes, regulations, and rules, the Registrant could ultimately be held responsible. See Item 7, Legal Proceedings, regarding the Peele site environmental matter.
Item 2.

Item 2. Properties
The principal asset of the Registrant is 317 miles of railroad property, averaging less than 200 feet in width, between Morehead City, North Carolina, and Charlotte, North Carolina. Some of the property is owned in fee, and the majority of the road extends over rights of way and perpetual easements purchased or granted in the 19th century. The line extends from Morehead City in an arc across North Carolina westward through New Bern, Kinston, Goldsboro, Selma, Raleigh, Research Triangle Park (unincorporated), Durham, Mebane, Burlington, Greensboro, High Point, Lexington, Salisbury, Kannapolis, and Charlotte. The route between Greensboro and Charlotte is a primary line of Norfolk Southern's north-south freight route between Washington, D.C. and Atlanta, Georgia. The Registrant's line intersects CSXT railroad lines at Selma, Goldsboro, Raleigh, Durham, and Charlotte, North Carolina.
The Registrant's tracks on the Greensboro to Charlotte segment have been upgraded since original construction so that today the track is laid with 132-lb. continuous welded rail with alternating double and single track. Speeds of up to 79 miles per hour may be maintained over substantial portions of the line, and centralized traffic control exists for the entire stretch. On the Greensboro to Goldsboro segment, the line is constructed with both welded and jointed rail of varying weights. No signal system is in use on this segment. Speeds of up to 50 miles per hour (higher for passenger trains) may be maintained over substantial portions of this segment. The road segment from Goldsboro to Morehead City is unsignalled, single-trackage with continuous welded and jointed rail of 85- to 132-lb. weight. Several short segments of the line are operated jointly with railroads other than the Registrant's lessees. The Registrant's line between New Bern and Morehead City currently provides Norfolk Southern's only access to the port at Morehead City. At
the current time, Amtrak operates passenger trains on the Registrant's railroad line between Selma and Charlotte, North Carolina.
The Registrant also owns approximately 208 acres of land divided into 24 parcels (non-operating property) that mostly adjoin its rail corridor. Among these parcels are the three in Mecklenburg County which are located in the downtown Charlotte business district and subject to the 1968 Lease with Norfolk Southern. Some of the properties have improvements, the ownership of which depends on the terms of the arrangements with the sublessees of the properties. Pursuant to the Lease Extension, the Registrant has the right to have certain properties outside the right of way not used in operating a railroad released to the Registrant from the Lease Extension. Norfolk Southern's rental payments will not be reduced if the Registrant exercises this right. The Registrant intends to exercise its right to have released from the Leases those properties it determines have income-generating potential in excess of projected expenses. The Registrant estimates these properties currently are producing less than $100,000 of annual lease income. The Registrant will determine which properties it will seek to have released to it after evaluating potential environmental liability and other relevant factors.
Item 3.

Item 3. Legal Proceedings
Except as described below, there are no legal proceedings pending to which the Registrant is a party that are material to the operation of the Registrant.
Peele Site
During the fourth quarter of 1989, the Registrant was notified by the North Carolina Department of Environment, Health, and Natural Resources ("DEHNR") that DEHNR had been notified of a possible abandoned pesticide disposal site on property owned by the Registrant in Johnston County, North Carolina. Information about the site has been disclosed by the Registrant in prior quarterly and annual reports to the Securities and Exchange Commission. Since 1991, the site had been included in the DEHNR Inactive Hazardous Waste Sites Priority List. The sites on the Priority List are ranked in decreasing order of danger to the public health and environment based on a ranking system administered by DEHNR. In February 1996, the site ranked 122 out of a total of 183 sites on the Priority List.
In January, 1994, DEHNR initiated a lawsuit against the Registrant and other parties seeking reimbursement of $84,354 in response costs incurred by DEHNR and remediation of the site. On February 1, 1995, the Court granted partial summary judgement
holding all of the defendants, including the Registrant, jointly and severally liable. The Court has not yet ruled on apportionment of liability or cost sharing among the defendants. According to a preliminary study conducted by the Registrant, the estimated costs of remediation range between $500,000 to in excess of $2,000,000. The Registrant will vigorously defend the action by DEHNR, and will aggressively pursue any other parties who may be liable for any remediation, removal, or clean-up. The ultimate costs of any remediation, removal, or clean-up are not known. However, if such costs are not paid by other parties, the financial position of the Registrant could be materially adversely affected.
Shareholder Litigation
Four shareholder derivative actions were filed in the United States District Court for the Eastern District of North Carolina during December 1994 and January and February 1995 by shareholders of the Registrant. Information about the actions has been disclosed in prior quarterly and annual reports to the Securities and Exchange Commission. On March 30, 1995, the court consolidated the actions into one proceeding. The Registrant, along with the co-defendants, filed motions to dismiss or stay the actions. On October 18, 1995, the court denied the motions to dismiss, granted the motions to stay the proceeding until such time as the shareholders voted on the Lease Extension, and granted a motion by the plaintiffs for leave to supplement their pleadings. On February 26, 1996, the court again stayed the proceeding until after the court rules on whether a quorum of private shareholders was present at the December 15, 1995 shareholder meeting of the Registrant.
On December 21, 1995, a shareholder derivative legal action was filed in Federal District Court in the Eastern District of North Carolina, Rucker v. North Carolina Railroad Company, et al., Case No. 5-95-CV-1054-BO(2). The action seeks to enjoin the Lease Extension or invalidate the December 15, 1995 shareholders meeting held to approve the Lease Extension on the basis of a lack of a quorum of shareholders other than the State of North Carolina, and makes other allegations against the defendants, including alleged proxy rule violations. The court has not enjoined the Lease Extension. The bylaws of the Registrant provide that, in order to constitute a quorum for a shareholders' meeting, a majority of the shares of stock of the Registrant held by shareholders other than the State of North Carolina, must be represented, in person or by proxy, at the meeting. The plaintiff also sought a temporary restraining order seeking permission to review the proxy records of the shareholder meeting, which access was granted by the court. On February 26, 1996 the court granted a motion by the Registrant to accelerate discovery on the issue whether a quorum of private shareholders was present at the December 15, 1995 shareholder meeting, and
stayed discovery with respect to all other issues. See Item 1, Business, regarding the possible effects of the shareholder litigation on the Registrant's ability to qualify for REIT status, and Item 4, Submission of Matters to a Vote of Security Holders regarding the shareholder meeting. The Registrant is considering bringing a counterclaim or separate legal action against certain shareholders of the Registrant for proxy rules violations.
The Registrant is defending the aspects of the shareholder suits relating to the shareholder meeting, the effectiveness of the Lease Extension, and attempts to enjoin the Lease Extension. The directors and officers named as defendants in the suits, represented by separate counsel, are defending damage claims brought against the directors and officers. The bylaws of the Registrant provide that its directors and officers shall have the right to be indemnified by the Registrant, to the fullest extent permitted by law, against liabilities and expenses arising out of their status as Directors. To the extent the directors' and officers' conduct meets the standard of conduct for indemnification set forth by the North Carolina Business Corporation Act ("NCBCA"), as described below, they will be so indemnified by the Registrant in connection with the shareholder derivative actions described herein. The Registrant will oppose the actions brought by the plaintiffs to the extent the actions seek to enjoin any lease arrangement or seek recovery against the Registrant or seek any remedy against the best interests of Registrant or its shareholders.
Under the NCBCA, a corporation is permitted to indemnify a director or officer who conducted himself in good faith and reasonably believed: (i) in the case of conduct in his official capacity with the corporation, that his conduct was in the best interest of the corporation and (ii) in all other cases, that his conduct was at least not opposed to the corporation's best interest. In the case of any criminal proceeding, the director or officer must not have had any reasonable cause to believe his conduct was unlawful. In any proceeding by or in the right of a corporation (such as the shareholder derivative actions described herein), a corporation may not voluntarily indemnify a director or officer if the director or officer is adjudged liable to the corporation. In addition, a corporation may not indemnify a director or officer if the director or officer is adjudged liable on the basis that personal benefit was improperly received by him. Where a proceeding is by or in the right of a corporation, indemnification of a director or officer is limited to reasonable expenses if the proceeding is concluded without a final adjudication on the issue of liability. The NCBCA permits an advance for expenses incurred by a director or officer in defending a proceeding. The expenses may be paid by a corporation in advance of the final disposition of the legal action, upon receipt of an undertaking by or on behalf of the
director or officer to repay such amounts unless it is ultimately determined that he is entitled to be indemnified by the corporation against such expenses. The directors and officers of the Registrant who have executed such undertaking are receiving advances for expenses incurred in defending the actions brought against them in connection with the Lease Extension. Additionally, the NCBCA provides that a corporation may purchase and maintain insurance on behalf of a director or officer of the corporation against any liability asserted against or incurred by him in that capacity or arising from his status as a director or officer. The Registrant has an insurance policy that covers the Registrant against the indemnification liability of the Registrant to its directors and officers. The policy has a aggregate limit of $5 million and a $75,000 retention per occurrence. The Registrant's liability exposure to its directors and officers will, therefore, not be material, unless (i) the directors or officers satisfy the requirements for being indemnified as described above and (ii) the indemnified liabilities and expenses exceed the Registrant's insurance coverage. The Registrant is unable to determine this early in the legal proceedings whether either of the foregoing conditions will occur.
Charlotte Convention Center Litigation
On December 10, 1991, the Registrant initiated a lawsuit in the Mecklenburg County, North Carolina, Superior Court regarding its railroad corridor through downtown Charlotte. The Registrant alleged that both the City of Charlotte and Norfolk Southern have breached contract obligations and obligations based on real property rights to the Registrant. The litigation has been disclosed by the Registrant in prior quarterly and annual reports to the Securities and Exchange Commission. On December 7, 1993, the North Carolina Court of Appeals ruled against the defendants' appeal and against the Registrant's cross-appeal. Norfolk Southern then petitioned the Supreme Court of North Carolina to review the decision of the North Carolina Court of Appeals, which petition was denied. Norfolk Southern then petitioned the United States Supreme Court for review. On June 12, 1995, the United States Supreme Court denied the petition, and the lawsuit will continue in Superior Court, Mecklenburg County, North Carolina. The Registrant is engaging in negotiations to settle the litigation, but there can be no assurance of any settlement or the terms of any such settlement.
Item 4.

Item 4. Submission of Matters to a Vote of Security Holders
The Registrant's annual meeting of shareholders was held on December 15, 1995. The bylaws of the Registrant provide that a majority of the outstanding shares of the Registrant entitled to vote, represented in person or by proxy, constitutes a quorum at
a meeting of shareholders, provided, that a majority of the shares held by shareholders other than the State of North Carolina (the "private" shares) are represented at the meeting, in person or by proxy. At the meeting, the Registrant submitted the Lease Extension to the shareholders of the Registrant for approval pursuant to North Carolina law. See Item 3, Legal Proceedings, regarding shareholder litigation over whether a quorum of shareholders was present at the shareholder meeting. In connection with shareholder litigation challenging the quorum, and the tabulation by the Registrant's stock transfer agent, the Registrant retained a professional inspector of elections to audit the tabulation of the number of shares present at the meeting in person or by proxy and the votes cast at the meeting by shareholders other than the State of North Carolina. The tables below reflect the final quorum tabulation and voting results.
Pursuant to the charter of the Registrant, the State of North Carolina elects a total of ten directors and the remaining shareholders elect a total of five directors. Directors are elected to three-year staggered terms.
(a) Quorum ("private" shares)
Number of "Private" Shares required to be represented: 538,149 Number of "Private" Shares represented: 539,169
The quorum margin, according to the Registrant's audited tabulation described above, is 1,020 shares. The plaintiff in the quorum litigation has challenged proxy votes exceeding 30,000 shares. Until a final determination is made by the court, there can be no assurance that the Registrant's tabulations are legally valid. The Registrant cannot predict if or when a final determination will be made by the court or when any appeals of any court ruling may be exhausted.
(b) Votes Cast Abstain/ Broker For Against Withheld Non Votes --------- --------- -------- ---------- 1. Approval of the Lease Extension Agreement
By the "Private" 374,453 30,451 2,555* 131,460 Shareholders:
By the State of 3,207,173 North Carolina:
(*) an additional 250 shares were represented at the meeting in person and not voted.
2. Election of Directors
By the "Private" Shareholders:
P. C. Barwick, Jr. 516,947 -0- 21,972
By the State of North Carolina:
Marvin D. Gentry 3,207,173 -0- -0- Robert W. Griffin 3,207,173 -0- -0- William H. Kincheloe 3,207,173 -0- -0- John S. Russell 3,207,173 -0- -0-
3. Appointment of Independent Public Accountants
Ratification of the Selection of Ernst & Young LLP 3,729,346 11,728 6,018
PART II
Item 5.

Item 5. Market for Registrant's Common Equity and Related Stock- holder Matters
(a) Market Information
Common shares of the Registrant are currently traded in the over-the-counter market. Quarterly high and low bids are as follows for fiscal years 1994 and 1995:
1995 1994 Low High Low High 1st 1st 24 1/4 26 35 35 2nd 2nd 25 1/2 30 1/2 37 1/2 40 1/2 3rd 3rd 26 35 36 39 4th 4th 25 30 24 3/4 38
These over-the-counter market quotations reflect interdealer prices, without retail markup, markdown or commission, and may not necessarily represent market transactions.
(b) Holders
There were approximately 752 holders of common shares of the Registrant of record as of March 4, 1996.
(c) Dividends
In 1995, no dividends were declared. In 1994 and 1993, the Registrant declared regular cash dividends of $.03 per share, or $128,504. The amount and timing of future dividends will depend upon the requirements for shareholder distributions if the Registrant elects REIT status for income tax purposes, the shareholder litigation, and the future profitability of the Registrant. See Item 3, Legal Proceedings, regarding certain shareholder litigation seeking to enjoin the Lease Extension. The Registrant expects to continue to have substantial uncertainty with respect to the shareholder litigation and the effect of the litigation upon the Registrant's qualification for REIT status for 1995 and future periods. See "Real Estate Investment Trust Election" under Item 1, Business, above, regarding the relationship between tax matters and dividend policy, and Note C to the financial statements.
Item 6.

Item 6. Selected Financial Data
The following selected financial data are derived from the financial statements of the Registrant. The data should be read in conjunction with the financial statements, related notes and other financial information included herein.
Selected Financial Data At December 31 or For the Year Ended December 31 ----------------------------------------------------------
See notes to financial statements.
STATEMENTS OF INCOME
NORTH CAROLINA RAILROAD COMPANY
See notes to financial statements.
STATEMENTS OF SHAREHOLDERS' EQUITY
NORTH CAROLINA RAILROAD COMPANY
See notes to financial statements.
STATEMENTS OF CASH FLOWS
NORTH CAROLINA RAILROAD COMPANY
See notes to financial statements.
NOTES TO FINANCIAL STATEMENTS
NORTH CAROLINA RAILROAD COMPANY
December 31, 1995
NOTE A--SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION: The North Carolina Railroad Company (the "Company"), owns approximately 317 miles of continuous railroad line extending from Charlotte, North Carolina to Morehead City, North Carolina. On August 10, 1995, the Board of Directors of the Company approved a Lease Extension Agreement ("Lease Extension") with Norfolk Southern to extend two prior leases of substantially all of the Company's property. (See Note C.)
PROPERTIES: Buildings and equipment are reported at cost. Depreciation is computed on the straight-line method over the estimated useful lives of the assets. Buildings are depreciated over thirty years and equipment is depreciated over three to five years.
Properties in the roadway and land account are carried at an amount which approximates the 1916 valuation by the Interstate Commerce Commission. These properties are not depreciated because they represent fully depreciated roadway or non- depreciable land. However, a rehabilitation project of $200,000 was amortized over a five-year period during the 1940's.
REVENUE RECOGNITION: Revenue is reflected in the statements of income when earned in accordance with the Company's lease arrangements on the accrual method. (See Note C.)
INCOME TAXES: Prior to 1995, income tax expense was disproportionate to income before income taxes because the lessee of certain of the properties, pursuant to the terms of the 1895 Lease, was responsible for all income taxes attributable to the lease arrangement. The Company considered the lessee's share of the amortization of roadway costs to be a permanent difference and no deferred taxes were provided thereon.
Under the Lease Extension, all income taxes become the responsibility of the Company as of January 1, 1995. The 1995 income tax provision does not take into account the Company's possible Real Estate Investment Trust ("REIT") election for 1995 or Norfolk Southern's potential liability for the Company's taxes should the Lease Extension not be effective. (See Note B and Note D.)
CASH AND CASH EQUIVALENTS: Cash and cash equivalents include investments in commercial paper, U. S. Treasury Bills, and
certificates of deposit with original maturities of three months or less. Cash deposits are placed with high credit quality financial institutions. At times, deposits exceed amounts insured by the Federal Deposit Insurance Corporation.
SHORT-TERM INVESTMENTS: Short-term investments include investments in high quality commercial paper and U. S. Treasury Bills with maturities within one year of the balance sheet date. These investments are held-to-maturity and are carried at cost, which approximates market.
LEASE/TRANSACTION COSTS: Certain lease negotiation costs have been capitalized and will be amortized over the life of the lease agreement.
USE OF ESTIMATES: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
RESTRICTED ASSETS: Under terms of its lease agreement with AECR, the Company had maintained a restricted cash account. All restrictions expired on December 31, 1994, and the assets became the unrestricted property of the Company. (See Note C.)
FASB STATEMENT NO. 121: In March 1995, the Financial Accounting Standards Board ("FASB") issued Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long- Lived Assets to be Disposed of," which requires impairment losses to be recorded on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by these assets are less than the assets' carrying amount. Statement 121 also addresses the accounting for long-lived assets that are expected to be disposed of. The Company will adopt Statement No. 121 in the first quarter of 1996 and, based on current circumstances, does not believe the effect of adoption will be material.
NOTE B--REAL ESTATE INVESTMENT TRUST
On August 10, 1995, the Board of Directors of the Company voted to cause the Company to elect REIT status for income tax purposes, in connection with the Lease Extension. (See Note C.) The REIT provisions of the Internal Revenue Code ("I.R.C.") generally allow a REIT to deduct distributions paid to its stockholders. The Company received an opinion of counsel that the Company can qualify as a REIT based upon the effectiveness and terms of the Lease Extension. However, certain shareholder litigation could enjoin, delay, or otherwise affect the effectiveness of the Lease Extension, the terms of the Lease
Extension, or the timing or amount of shareholder distributions. The Company is also seeking a ruling from the Internal Revenue Service as to the effect of a one-time $5 million settlement payment with respect to the timing of the Company's REIT election, but the Company has not yet received such ruling. (See Note F.) There can be no assurance that the Company can qualify for REIT status for 1995 or later years.
If the Company qualifies for and elects to become a REIT for the year ended December 31, 1995, lease revenue, income before income taxes, income taxes, net income, and earnings per share on a pro-forma basis would be as follows:
The pro forma effect of REIT election for 1995 would be $.61 per share.
NOTE C--LEASES ON ROADWAY AND LAND
In 1895, the Company leased substantially all of its assets to Southern Railway Company, now known as Norfolk Southern Railway Company ("NSR"), for ninety-nine years (the "1895 Lease"). In 1989, the Company acquired the Atlantic and North Carolina Railroad Company, the assets of which were subject to a lease dating to 1939 with the Atlantic & East Carolina Railway Company ("AECR"), a wholly-owned subsidiary of Norfolk Southern Railway Company (the "1939 Lease"). NSR and AECR are hereinafter referred to as "Norfolk Southern". The terms of the 1895 Lease and 1939 Lease provided for expiration on January 1, 1995 and December 31, 1994, respectively, and did not require either the Company or Norfolk Southern to renew the leases.
On August 10, 1995, the Board of Directors of the Company approved a Lease Extension Agreement to extend the terms of the 1895 Lease and the 1939 Lease, with its effectiveness retroactive to January 1, 1995. However, a shareholder has commenced a legal action challenging the validity of shareholder approval. Other shareholder derivative litigation seeking to enjoin the Lease Extension is also pending. The base annual rental under the Lease Extension is eight million dollars ($8,000,000) for the period from January 1, 1995 through December 31, 1995. Annual base rent for 1996 and each year thereafter will be adjusted each year to account for inflation during the preceding calendar year according to the implicit price deflator for the gross domestic product (IPD-GDP). In no event, however, will the base annual
rental for any calendar year be less than eight million dollars ($8,000,000). The base rent adjustment in any year cannot exceed the sum of: (i) four (4%) percent of the base rent for the preceding year, plus (ii) seventy-five (75%) percent of the IPD- GDP in excess of four (4%) percent. There is a one-year delay in application of the IPD-GDP. For example, adjustment of 1995 rental payments to determine 1996 rental payments is based upon the IPD-GDP for 1994. The 1895 and 1939 Leases are extended for an initial term of thirty (30) years, through December 31, 2024 and are extendable for an additional twenty (20) years at the option of Norfolk Southern.
A third lease to Norfolk Southern (the "1968 Lease") expires on December 31, 2067, and provides for an annual rental of $81,319 through December 2017 for certain properties in Charlotte, North Carolina. Beginning on January 1, 2018, 6% of the appraised value of the property will be the annual rental for the remaining term of the 1968 Lease. Under the terms of the 1968 Lease, all taxes connected with the property, except income taxes, are paid by the lessee. The 1968 Lease would not be affected by the Lease Extension.
NOTE D--INCOME TAXES
Effective January 1, 1993, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by FASB Statement No. 109, "Accounting for Income Taxes." As permitted under the new rules, prior years' financial statements were not restated. The cumulative effect of adopting Statement No. 109 as of January 1, 1993 was a reduction of income of $140,902.
Significant components of the provision for income taxes attributable to continuing operations are as follows:
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.
Significant components of the Company's deferred tax liability as of December 31 are as follows:
The Company may be eligible for REIT status for 1995, which would substantially reduce the Company's income tax expense for 1995 by approximately $2.6 million, or $.61 per share. (See Note B).
NOTE E--COMMITMENTS AND CONTINGENCIES
During the fourth quarter of 1989, the Company was notified by the North Carolina Department of Environment, Health, and Natural Resources ("DEHNR") of a possible abandoned pesticide disposal site on property owned by the Company in Johnston County, North Carolina. It is believed that the site was used by a predecessor owner to burn and/or bury surplus pesticides from the predecessor's business, which was not located at the site. In January, 1994, DEHNR initiated a lawsuit against the Company and other parties seeking reimbursement of $84,354 in response costs incurred by DEHNR and remediation of the site. On February 1, 1995, the Court granted partial summary judgment holding all of the defendants, including the Company, jointly and severally liable for the site. The Court has not yet ruled on apportionment of liability or cost sharing among the defendants. According to a preliminary study conducted by the Company, the estimated costs of remediation range between $500,000 to in excess of $2,000,000. The Company will vigorously defend the action brought by DEHNR and will aggressively pursue any other parties who may be liable for any remediation, removal, or clean- up. The ultimate costs of any remediation, removal, or clean-up are not known. However, if such costs are not paid by other parties, the financial position of the Company could be materially adversely affected.
Four shareholder derivative actions were filed in the United States District Court for the Eastern District of North Carolina during December 1994 and January and February 1995 by shareholders of the Company. The complaints name the directors of the Company as defendants and the Company as "nominal defendant." Two of the actions seek to enjoin a purported lease between the Company and Norfolk Southern and seek to recover for the Company unspecified damages and other relief from the directors. Two other actions seek similar relief and also name the State of North Carolina, the Governor of North Carolina, and Norfolk Southern as defendants. On December 21, 1995, a shareholder derivative legal action was filed. The action seeks to enjoin the Lease Extension or invalidate the December 15, 1995 shareholders meeting held to approve the Lease Extension on the basis of a lack of a quorum of shareholders other than the State of North Carolina, and makes other allegations against the
defendants, including alleged proxy rule violations. The Company is defending the aspects of the shareholder suits relating to the shareholder meeting, the effectiveness of the Lease Extension, and attempts to enjoin the Lease Extension. The directors and officers named as defendants in the suits, represented by separate counsel, are defending damage claims brought against the directors and officers. The Company's officers and directors are indemnified in the bylaws of the Company for certain claims and liabilities alleged in the actions, including the defense costs and expenses. The Company notified its directors and officers insurance carrier of claims as a result of the actions, which claims have been acknowledged by the insurance carrier. The directors and officers insurance policy has an aggregate limit of $5,000,000 and a $75,000 retention per occurrence.
On December 10, 1991, the Company initiated a lawsuit in the Mecklenburg County, North Carolina Superior Court regarding its railroad corridor through downtown Charlotte. The Company alleged that both the City of Charlotte and Norfolk Southern have breached contract obligations and obligations based on real property rights to the Company. The litigation has been disclosed by the Company in prior quarterly and annual reports to the Securities and Exchange Commission. On December 7, 1993, the North Carolina Court of Appeals ruled against the defendants' appeal and against the Company's cross-appeal. Norfolk Southern then petitioned the Supreme Court of North Carolina to review the decision of the North Carolina Court of Appeals, which petition was denied. Norfolk Southern then petitioned the United States Supreme Court for review. On June 12, 1995, the United States Supreme Court denied the petition, and the lawsuit will continue in Superior Court, Mecklenburg County, North Carolina. The Company is engaging in negotiations to settle the litigation, but there can be no assurance of any settlement or the terms of any such settlement.
NOTE F--SETTLEMENT INCOME
On December 1, 1995, Norfolk Southern made a one-time settlement payment of $5 million, plus interest, to the Company, as provided in the Lease Extension, in exchange for the Company's release of Norfolk Southern from certain contractual obligations relating to certain personal property upon expiration of the 1895 Lease and 1939 Lease. The Company and Norfolk Southern entered into an agreement dated August 10, 1995, whereby the settlement payment was made in early December 1995 in order to facilitate the Company seeking REIT status at the earliest practicable date. The Company is seeking a ruling from the Internal Revenue Service as to the effect of the payment with respect to the timing of the Company's REIT election, but the Company has not yet received such ruling. In the event the Lease Extension is invalidated, the Company is entitled to retain the payment and interest for application against any future rental or other amounts due from Norfolk Southern.