Petition — Meserve v. Chesapeake & Ohio Railway Co.

| Supreme Court, U. S,

No. 80- JAN 14 198i

ae fe CLERK

Supreme Court of the Uni |

OcrosBer TERM, 1980

ROBERT W. MESERVE anp BENJAMIN H. LACY,

REORGANIZATION TRUSTEES OF THE

BOSTON AND MAINE CORPORATION, DEBTOR, and

THE FIRST NATIONAL BANK OF BOSTON anp

MALCOLM W. HALL,

SUCCESSOR INDENTURE TRUSTEES,

PETITIONERS,

ov

CHESAPEAKE AND OHIO RAILWAY COMPANY, MAINE

CENTRAL RAILROAD COMPANY, PENN CENTRAL

CORPORATION, CANADIAN PACIFIC, and EASTERN

ASSOCIATED COAL CORPORATION, ET AL,

RESPONDENTS.

PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE FIRST CIRCUIT

THE First NATIONAL BANK Ropert W. MESERVE AND

oF BosTON AND BENJAMIN H. Lacy,

MALcoLM W. HALL, Reorganization Trustees

Successor Indenture

Trustees

Counsel: Counsel:

OsEPH H. B. Epwarps CHARLES W. MULCAnY, JR.

INGHAM, Dana & GouLD Hawkes & GoLpINGs

100 Federal Street One Walnut Street

Boston, MA 02110 Boston, MA 02108

(617) 357-9300 (617) 367-2900

Special Counsel:

Rosert M. GarcILL

DONALD F. FARRELL, JR.

CuHoaTe, HALL & STEWART

60 State Street

Boston, MA 02109

(617) 227-5020

Blanchard Press, Inc.. Boston. Mass.—Law Printers

I

Questions Presented

1. In railroad reorganization proceedings, should a priority

under the so-called Six Months Rule be recognized in the absence

of a current debt fund or equitable grounds for re-creating such a

fund? More particularly, if during the period of the reorganiza-

tion proceedings and during the six months prior thereto there is

no net railway operating income and no inequitable diversion of

operating revenues for the benefit of mortgagees, should the cor-

pus of mortgaged property be invaded at the expense of the mort-

gagees to provide priority payments to pre-petition unsecured

creditors?

2. Should a deduction from operating revenues for deprecia-

tion expense be denied in determining the existence of a current

debt fund?

Parties

Petitioners herein are the reorganization trustees of the estate

of the Boston and Maine Corporation, Debtor, and The First Na-

tional Bank of Boston and Malcolm W. Hall, successor indenture

trustees under the indenture pursuant to which the Debtor’s first

mortgage bonds are outstanding. The Respondents are the

Chesapeake and Ohio Railway Company, Baltimore and Ohio

Railway Company, Western Maryland Railway, Maine Central

Railroad Company, Portland Terminal Company, and Eastern

Associated Coal Corporation. i

For purposes of Supreme Court Rule 28.1, it is hereby dis-

closed that: (a) the Reorganization Trustees of the Boston and

Maine Corp., Debtor, as such, own stock in or are otherwise af-

filiated with the following companies: Springfield Terminal

Railway Co., Stony Brook Railroad, Northern Railroad, Ver-

mont and Massachusetts Railroad, Mystic Terminal Co.,

Pullman Co., Pine Tree Corp., Connecticut River Valley Co.,

Inc., Trailer Train Co., North Station Industrial Building, Inc.,

and North Station Hotel Building, Inc.; (b) The Co-petitioner,

The First National Bank of Boston (“The Bank”) is, except for

directors’ qualifying shares, a wholly-owned subsidiary of First

National Boston Corporation (“The Parent”).

Il

The Bank has no direct or indirect material beneficial interest

in this litigation but is acting solely in its fiduciary capacity as

corporate trustee of the First Mortgage Indenture of Boston and

Maine Corporation, and is uncertain whether under this cir-

cumstance Rule 28.1 contemplates that its individual corporate

affiliations be listed. Such affiliations do not attach to the trustees

as such under said mortgage. Those affiliations are as follows:

The Bank

The Bank is a national banking association with its principal

office in Boston, Massachusetts. Except for directors’ qualifying

shares, all of its outstanding stock is held beneficially and of

record by the Parent. The Bank has a number of wholly-owned

subsidiaries one or more of which, in turn, has one or more

wholly-owned subsidiaries. Except as hereinafter stated, all of

the Bank’s subsidiaries are wholly-owned, directly or indirectly

(except in some cases for directors’ qualifying shares).

The Bank’s Parent - First Natiunal Boston Corporation

The Parent is a registered bank holding company with its prin-

cipal office in Boston, Massachusetts. Its outstanding stock is

publicly held and is listed and traded on the New York and

Boston Stock Exchanges. The Parent has a substantial number of

banking and financial subsidiaries many of which subsidiaries

are directly held and many of which are held indirectly through

various subsidiaries. Except as hereinafter mentioned, all of such

subsidiaries of the Parent are wholly-owned directly or indirectly

(except in certain cases for directors’ qualifying shares).

Exceptions Relating to the Bank

The Bank has a wholly-owned subsidiary, Boston Overseas

Financial Corporation, which is a United States Edge Act cor-

poration. This wholly-owned subsidiary has direct ownership in-

terests in a number of financial entities organized under the laws

of, and operating in, various foreign countries. Some of such en-

tities are wholly-owned directly or indirectly. A number of such

entities are partly-owned. Except in the instance mentioned

Il

below, the “outside” ownership interests in such partly-owned

entities are held by one or more banks or other financial institu-

tions organized and operating under the laws of foreign countries

none of which are affiliates of the Bank or the Parent. In some

cases, the outside ownership interests are wholly or partly held by

individuals who are foreign nationals who are not otherwise af-

filiated with the Bank or the Parent.

An indirectly wholly-owned subsidiary of the Bank is a 20%

joint participant in a small Brazilian enterprise, the outstanding

80 % interest in which is owned by a wholly-owned subsidiary of

PHH Group, Inc., a publicly-held domestic corporation whose

stock is traded and listed on a national securities exchange.

The assets of all such entities if considered in the aggregate,

and if considered to be owned by a single subsidiary, would not

constitute such subsidiary to be a significant subsidiary of the

Bank or the Parent.

Exceptions Relating to the Parent

(A) The Parent, through a wholly-owned subsidiary, owns

50% of the outstanding stock of First National Computeristics,

Inc., a Massachusetts corporation, the balance of whose out-

standing stock is owned indirectly by Uniroyal, Inc., which is a

domestic publicly-owned corporation whose common stock is

traded and listed on a national securities exchange.

(B) Until recently, the Parent, through several separate single

purpose indirectly wholly-owned subsidiaries, had been engaged

in a tanker leasing program involving three 265,000 deadweight

ton U.S. flag tankers. In August of 1980, the Parent entered into

an agreement to sell all of its stock in said subsidiaries to Tenafly

VLCC Holdings, Inc., a privately-held company, for notes

guaranteed by Seatrain Lines, Inc., a publicly-held corporation

whose stock is traded and listed on a national securities exchange;

49 % of the stock of said single purpose subsidiaries has been sold

and transferred to Tenafly and the remaining 51% of stock will

be transferred to Tenafly at the conclusion of statutory waiting

periods required under the pre-merger notification provisions of

the Hart-Scott-Rodino Antitrust Improvements Act of 1976.

Vv

TABLE OF CONTENTS

Page

SS OMNIS 6 8 FER VaR Re cies ea Mepen I

NE IO Fig 60s wt <gchs Wy's sudt cS vnedn id Ww' ka 2

Rb AES Fe hed 5 ov OURS Wks GAN TAR NG Swe ok 2

I I aod boas Ltan che's 6504 sik Seca ov lee’ 2

eC CO rik. aw Pata cod cies 3

Reasons for Granting the Writ....................0.. 10

I. The Court of Appeals’ Decision Below Con-

flicts With Decisions of Other Courts of Ap-

ED CSN ERIE bs FE ln ye ek wea 10

A. Fee Gece Catena, 10

ie ee, ee nee 15

C. The Seventh Circult.................. 16

Be Be Pe RI 5s Vidievinswee seas 17

II. The Court of Appeals’ Decision Below Con-

flicts With Prior Decisions of This Court Con-

cerning the Six Months Rule................ 17

III. The Court of Appeals’ Decision Below Con-

flicts With Congressional Policy as Recently

Reflected in the Adoption of the Railroad

Reorganization Provisions of the Bankruptcy

SE FOE OE, Mie ota yk Ws ae Hes em cs 25

IV. The Present Case Offers an Excellent Oppor-

tunity To Eliminate Disagreement Among the

Circuits and Continually Recurring Disputes

Regarding the Applicability of the Six Months

Ws «ore we Sues Os wa ee ee hs ccuN Ve ee 28

IE 5 Uhh Cad eich dine Mi v vin. bcd O4 sae eae 30

Appendix A

Opinion of the Court of Appeals for the First Circuit

ee IN Wh I? oa sc 6s KK we daha A-l

| PREVIOUS PAGE WAS BLANK |

VI

Page

Appendix B

Opinion of the United States District Court for the

District of Massachusetts dated March 12, 1979.... B-1

Order of the United States District Court for the

District of Massachusetts dated March 19, 1979... . B-24

Appendix C

Stipulation With Respect to Petition to Classify

SUN is arn. a dda a bs Baan Se es BD as aes C-1

Trustees’ Answer to Interrogatories.............. C-9

Appendix D

Order of the United States District Court for the

District of Massachusetts dated February 5, 1979... D-1

eo Mere err ere eres D-3

TABLE OF AUTHORITIES

Cases

Burnham v. Bowen, 111 U.S. 776 (1884).............. 4,17

Carbon Fuel Co. v. Chicago, C. & L.R. Co., 202 F.172

PUN: MIs +See bin cccd ou Veh 0 £055 pots oeMa sakes 16

Central R.R. Co. of N.J. v. Manufacturers Hanover

Trust Co., 421 F.2d 604 (3d Cir. 1970).............. 15

Fosdick v. Schall, 99 U.S. 235 (1878).......... 4,5, 8, 17, 18

Gregg v. Metropolitan Trust Co., 197 U.S. 183 (1905). 4, 8,

16, 20, 23

In re Boston and Maine Corp., 468 F.Supp. 996 (D.

ek I Sas chs Rae ew winds Sees 6

In re New York, N.H. & H.R.R. Co., 278 F. Supp. 592

(D. Conn.1967), aff'd, 405 F.2d 50 (2nd Cir. 1968),

cert. denied, 394 U.S. 999 (1969)............ 4,5, 6, 11,

15, 16, 25, 29

VII

Page

In re New York N.H. & H. R.R. Co., 405 F.2d 50 (2d

Cir. 1968), cert. denied, 394 U.S. 999 (1969)......... 10

In re Penn Central Transp. Corp., 458 F.Supp. 1234

ee SS ap Serpe rer op oe mere | tenses 4,5, 6, 16

In re Tennessee Central Ry. Co., 316 F.Supp. 1103

M.D. Tenn. 1970), vacated, 463 F.2d 73 (6th Cir.

1972), cert. denied, 409 U.S. 893 (1972)............. 6

In re Third Ave. Transit Corp., 138 F.Supp. 623 (S.D.

N.Y. 1955), aff'd per curiam, 230 F.2d 425 (2d Cir.

PRS oo KOEN sa iv scab diced Fe keea eS caw. 29

Kneeland v. American Loan Co., 136 U.S. 89 (1890). 4,17, 19

Miltenberger v. Logansport C. & S.W. Ry. Co., 106

Se NG 0G oie 5 on is Weed de daees Seee 8, 14, 20

New England R.R. Co. v. Carnegie Steel Co., 75 F.54

7 Ree a a yee RUM whis Pade Metdes Sue a. eR ee 22

Southern Ry. Co. v. Carnegie Steel Co., 176 U.S. 257

Naik 5 egy Fc hi RS MME PS bv Se Koa cn KE 4,17

Southern Ry. Co. v. Flournoy, 301 F.2d 847 (4th

ee EE 6 0's fl we va co ea 6 Fhe Bess 0k RNS Kee 6, 12, 17

Statutes

Bankruptcy Act §77, 11 U.S.C. 205 (1976).............. 2,3

Bankruptcy Reform Act of 1978, 11 U.S.C. §1171(b)

PN Belo ease eh oie oo ale 2, 3, 27

Bankruptcy Reform Act of 1978, Pub. L. No. 95-598,

ps ee OE. BPO OTE. one vk cccceptbeevedecs 2

Legislative Materials

Report of the Commission on the Bankruptcy Laws of

the United States, H.R. Doc. No. 93-137, 93rd Cong.,

Be TI Gs 66.8 cise be nisin Sas eRooes Sib 27

S. Rep. No. 95-989, 95th Cong., 2d Sess. 136 (1978)..... 27

- H.R. 8200, 95th Cong., Ist Sess. (1977)............... 27

Vill

Commentaries

Page

Comment, 33 Colum. L. Rev. 834 (1933).............. 29

Note, The Present Status of the Six Months Rule, 34

Coben: hav Dia BIO) sass sc Ween cc ee ees: 25

Note, Bankruptcy Law—The Continued Vitality of the

Six Months Rule in Railroad Receiverships, 57 N.C.L.

BBE CE cy SON 6 UR AREY ie Sek eas bs 25

In the

Supreme Court of the United States

Ocroser TERM, 1980

80-

ROBERT W. MESERVE anp BENJAMIN H. LACY,

REORGANIZATION TRUSTEES OF THE

BOSTON AND MAINE CORPORATION, DEBTOR, and

THE FIRST NATIONAL BANK OF BOSTON anp

MALCOLM W. HALL,

SUCCESSOR INDENTURE TRUSTEES,

PETITIONERS,

v.

CHESAPEAKE AND OHIO RAILWAY COMPANY, MAINE

CENTRAL RAILROAD COMPANY, PENN CENTRAL

CORPORATION, CANADIAN PACIFIC, and EASTERN

ASSOCIATED COAL CORPORATION, ET AL,

RESPONDENTS.

PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE FIRST CIRCUIT

Petitioners, who are, respectively, the Trustees in Reorganiza-

tion of the estate of the Boston and Maine Corporation, Debtor

in pending railroad reorganization proceedings, and the Inden-

ture Trustees under the Indenture pursuant to which the

Debtor’s first mortgage bonds are outstanding, respectfully pray

that a writ of certiorari issue to review that part of the judgment and

2

opinion of the United States Court of Appeals for the First Cir-

cuit entered on October 6, 1980 which reversed the District

Court’s Order of March 19, 1979 insofar as the latter classified

creditors without providing for a priority classification under the

so-called Six Months Rule.

Opinion Below

The opinion of the Court of Appeals is reproduced as Appen-

dix A hereto (pp. Al-A47).

Jurisdiction

The judgment of the Court of Appeals was entered on October

6, 1980. By order dated December 29, 1980, this Court granted

an extension of the time within which to file this petition for a

writ of certiorari to and including January 15, 1981. This petition

for a writ of certiorari was filed prior to that date. This Court’s

jurisdiction is invoked pursuant to 28 U.S.C. Section 1254(1).

Statute Involved

Section 77(b) of the Bankruptcy Act, 11 U.S.C. 205(b) (1976)

provides in pertinent part:

For all purposes of this section unsecured claims, which

would have been entitled to priority if a receiver in equity of

the property of the debtor had been appointed by a Federal

court on the day of the approval of the petition, shall be en-

titled to such priority and the holders of such claims shall be

treated as a separate class or classes of creditors.

The foregoing provision is applicable to cases, such as the case

at bar, which were pending under Section 77 of the Bankruptcy

Act on the date of enactment of the Bankruptcy Reform Act of

1978 and in which the trustee had filed a plan of reorganization.

Bankruptcy Reform Act of 1978, Pub. L. No. 95-598, §403(b),

92 Stat. 2549 (1978).'

' Asto other cases, the statutory rule is set forth in section 1171(b) of the

Bankruptcy Code, 11 U.S.C. § 1171(b) (as amended) which provides:

3

Statement of the Case

On March 12, 1970, an involuntary petition pursuant to Section

77 of the Bankruptcy Act (the “Act”), 11 U.S.C. § 205 (1976), was

filed against the debtor Boston and Maine Corporation in the

United States District Court for the District of Massachusetts

(“Reorganization Court”), The involuntary petition for reorganiza-

tion was thereafter approved by the Reorganization Court and the

Reorganization Trustees were appointed as such by Order dated

April 24, 1970.

On or about November 4, 1977 the Trustees filed a petition re-

questing that the Reorganization Court approve the Trustees’ pro-

posed classification of claims pursuant to Section 77(c)(7) of the Act.

The proposed classification was substantially consistent with the

Trustees’ proposed plan of reorganization dated December 12,

1975, and did not provide for any priority based upon the so-called

Six Months Rule (hereinafter referred to as “Rule” or “Six Months

Rule”). Objections to the proposed classification were filed by the

Respondents herein, pre-petition unsecured creditors of the Debtor

Any unsecured claim against the debtor that would have been entitl-

ed to priority if a receiver in equity of the property of the debtor had

been appointed by a Federal court on the date of the order for relief

under this title shall be entitled to such priority in the case under this

chapter.

The preceding provision of the Bankruptcy Code is applicable both to

cases pending under Section 77 of the Bankruptcy Act on the date of enact-

ment of the Bankruptcy Reform Act of 1978 in which the trustee had not

filed a plan of reorganization and to subsequently filed railroad

reorganization cases. Bankruptcy Reform Act of 1978, Pub. L. No.

95-598, §§ 403(a), (b), 92 Stat. 2549 (1978).

Because the Reorganization Trustees filed a plan of reorganization prior

to enactment of the Bankruptcy Reform Act of 1978, this case is governed

by the provisions of the Bankruptcy Act and not the Bankruptcy Code.

There is, however, no substantive difference between the above-quoted

provisions; thus, the issues raised by this Petition are issues that can be

resolved for purposes of future as well as pending railroad reorganization

cases. Additionally, as hereinafter discussed, the Code provision and its

iegislative history provide further reason for the grant of the writ.

4

who claimed, inter alia, entitlement to priority under the Six

Months Rule. The points at issue before both the Reorganization

Court and the Court of Appeals with respect to the Six Months

Rule were the same threshold questions presented on this Peti-

tion. While the scope and prerequisites to application of the Rule

are at issue on this Petition, it is generally agreed that if ap-

plicable, the Rule provides a priority ranking junior to post-

petition administration expense claims but senior to the claims of

the railroad’s lien creditors and mortgage bond holders* for

those pre-petition unsecured claims against the Debtor which

represent a current operating expense of the railroad necessarily

incurred® within six months prior to the filing of the reorganiza-

tion petition’ and which arise from the provision of goods or ren-

dition of services in reliance on the railroad’s current earnings

and not in reliance on the railroad’s general credit® (claims

meeting such requirements are hereinafter referred to as “Six-

Months claims”).

Factual questions as to whether a particular creditor's claim met

these specific requirements of the Rule were deferred pending

resolution of the fundamental question of whether a Six Months pri-

ority could be recognized or applied at all in the absence of acurrent

debt fund or equitable grounds for re-creating such a fund and

whether such a fund or grounds existed in this case.

Based on decisions of this Court which have articulated the ra-

tionale and delineated the parameters of the Rule as it developed in

railroad equity receiverships predating Section 77 proceedings,°

"Inte Penn Central Transp. Corp., 458 F Supp. 1234, 1321 am D. Pa.

1978

. eee Bowen, 11 U.S. 776, 780 (1884).

‘ Southern Ry. Co. v. Carnegie Steel Co., 176 U.S. 257, 292 (1900).

5 Id. at 285. Inre Penn Central Transp. Corp., 458 F.Supp. 1234, 1321,

(E.D. Pa. 1978); In re New York, N.H. & H. R.R. Co., 278 F.Supp. 592,

596-98 (D. Conn. 1967), aff'd, 405 F.2d 50 (2d Cir. 1968), cert. denied,

394 U.S. 999 (1969).

® Gregg v. Metropolitan Trust Co., 197 U.S. 183 (1905); Southern Ry.

v. Carnegie Steel Co., 176 U.S. 257 (1900); Kneeland v. American Loan

Co., 136 U.S. 89(1890); Burnham v. Bower., 111 U.S. 776 (1884); Fosdick

v. Schall, 99 U.S. 235 (1878).

5

and based on decisions of the Courts in the Second and Third

Circuits’ which have applied that learning, it was, and is, the

Petitioners’ position that the Six Months Rule is a rule of

equitable restitution which establishes » priority for creditors

holding 5: Months claims only to the ex*ent that there exists for

the relevant period what has come to be valled a “current debt

fund”® consisting of net railway operating income remaining

after payment or provision for all operating expenses, including

depreciation expense, and/or operating revenues inequitably

diverted to or for the benefit of mortgagees. The Rule is premised

on an implied agreement of railroad mortgagees that current ex-

penses of the road are to be paid out of operating revenues before

the mortgagees’ interest in those revenues attaches.’ Hence,

when operating revenues exceed expenses, that excess must be

paid to the unpaid pre-petition current expense creditors prior to

its payment to mortgagees. If operating revenues have been

diverted from current expense creditors to pay mortgagees, the

corpus of mortgaged property may be invaded to the extent of

the diversion if sufficient surplus current revenues do not exist to

to pay those creditors.’ Therefore, in the absence of surplus

earnings any recognition of a priority for Six Months claims

necessarily results in the invasion of the mortgaged property. To

recognize a priority un“er the Rule in other than the above-

named circumstances would impair the rights of mortgagees

without warrant and provide one group of pre-petition

unsecured creditors a preferential payment not available to other

pre-petition unsecured creditors.

In light of the substantial losses of the Debtor prior to the filing

of the reorganization petition and of the estate subsequent

7 In re Penn Central Transp. Corp., 458 F.Supp. 1234 (E.D. Pa.

1978); In re New York, N.H. & H.R.R. Co., 278 F.Supp. 592 (D.

Conn. 1967), aff'd, 405 F.2d 50 (2d Cir. 1968), cert. denied, 394 U.S.

999 (1969).

® Fosdick v. Schall, 99 U.S. 235, 252 (1878).

° Id.

10 Id. at 254.

6

thereto, recognition of a priority under the Rule would require

the Trustees to divert several million dollars from the corpus of

mortgaged property to satisfy Six Months claims. (C 4).

Relying on two cases"! which had been uniformly discredited

until the Court of Appeals opinion which is the subject of this

Petition, it was, and is, the Respondents’ position that all that

was required to establish priority under the Rule was the provi-

sion of necessary goods and services within the six months im-

mediately preceding the filing of the reorganization petition in

reliance on the railroad’s current revenues.

As to whether the facts of this case established the existence of

a current debt fund or grounds for re-creating such a fund, the

Reorganization Trustees answered interrogatories propounded

by certain Respondents and stipulated as fact relevant data. The

aforesaid Answers and Stipulation are reproduced as Appendix C

hereto. Additionally, pursuant to an Order of the Reorganization

Court dated February 5, 1979, the Reorganization Trustees filed

a computation utilizing relevant financial data which indicated

that no diversion for the benefit of mortgagees existed. The

aforesaid Order and Computation are reproduced as Appendix D

hereto.

The Reorganization Court conducted a hearing on the pro-

posed classification and the objections thereto on November 13,

1978. The Court issued its Memorandum of Decision on March

12, 1979, 468 F.Supp. 996 (D. Mass. 1979) and its Order on

March 19, 1979 (reproduced as Appendix B hereto). To the ex-

tent pertinent to the issues presented on this Petitioi, the

Reorganization Court held that a current debt fund must exist or

be re-created to entitle otherwise qualified Six Months claims to a

priority. (B5-6). Essentially following the analysis of Judge

Anderson in the second New Haven reorganization" (other than

1! Southern Ry. Co. v. Flournoy, 301 F.2d 847 (4th Cir. 1972); In re

Tennessee Central Ry. Co., 316 F.Supp. 1103 (M.D. Tenn. 1970),

vacated, 463 F.2d 73 (6th Cir..), cert. denied, 409 U.S. 8993 (1972).

12 In re New York, N.H. & H.R.R. Co., 278 F.Supp. 592 (D. Conn.

1967), aff'd, 405 F.2d 50 (2d Cir. 1968), cert. denied, 394 U.S. 999

(1969) (hereinafter referred to as “New Haven”).

7

his treatment of unmortgaged assets) and Judge Fullam’s analysis

in the Penn Central reorganization’*, the Reorganization Court

held that the current debt fund consisted of surplus current earn-

ings during the course of the reorganization and the six months

prior thereto and income diverted during that period for the

benefit of mortgagees. (B7-10). Surplus current earnings were

defined as the sum of all operating revenues accrued during the

releyant period which were actually received or taken over by

the Trustees less depreciation expense and all other operating ex-

penses paid or payable by the Trustees or which constituted ad-

ministration expenses. (B8). The Reorganization Court further

held that the deduction of depreciation expense does not enhance

the mortgaged assets but is more akin to an expenditure to

preserve the assets and as such is not a diversion. (B13). On the

basis of the foregoing and upon the evidence submitted, the

Reorganization Court concluded that there was no surplus cur-

rent operating revenue during the relevant period to constitute

the required current debt fund (B8-9, 13-14) and that there ex-

isted no net diversion in favor of mortgagees. (B12-13). Accor-

dingly, the Court concluded that no provision should be made

for a separate class of creditors having priority under the Six

Months Rule and subsequently ordered a classification of

creditors which did not provide for such a priority class.

On appeal, the Court of Appeals reversed in part the

Reorganization Court for its failure to provide a separate class of

creditors having priority under the Six Months Rule and remand-

ed the case for further proceedings consistent with that decision.

The Court of Appeals rejected the view that the existence of a

current debt fund or grounds to re-create such fund was prere-

quisite to recognition of a priority under the Rule. Rather, the

Court held that application of the Rule was supported by either

one of two co-existing but distinct principles. (A34-35). The first

principle, which the Court characterized as one of mortgage law

despite its derivation and effect, is one of equitable restitution

8 In re Penn Central Transp. Corp., 458 F.Supp. 1234 (E.D. Pa.

1978) (hereinafter referred to as “Penn Central’).

8

as exemplified in Fosdick v. Schall, 99 U.S. 235 (1878). (A35). A

priority premised on this principle does require the existence of a

current debt fund, determined essentially as indicated in New

Haven and in Penn Central except the Court held that deprecia-

tion expense is not to be deducted from operating income in

determining the amount of the fund. (A42-45). The second

“principle” supporting application of the Rule is one which the

Court of Appeals characterized as a principle of receivership ad-

ministration which it found reflected in this Court’s decision in

Miltenberger v. Logansport C. & S.W. Ry. Co., 106 U.S. 286

(1882). (A35). That principle, premised by the Court of Appeals

on the public interest in the uninterrupted operation of a

railroad, calls for the payment of Six Months claims on the same

basis and from the same operating income as post-petition ex-

penses of administration. (A41). The Court’s equating the pre-

petition current expense creditor with the post-petition ad-

ministration expense creditor appears to imply that the priority

accorded under this “receivership administration principle” may

be satisfied out of the corpus of mortgaged property when there

are insufficient operating revenues to pay all such claims and ad-

ministration expenses, even though there has been no diversion of

operating revenues for the benefit of mortgagees.

The Court of Appeals rejected the contention of the Reorgan-

ization Trustees that Miltenberger simply expressed a “Necessity

of Payment” rule under which a receiver or trustee was justified

in paying pre-petition claims if, and only if, the non-payment of

such claims would threaten the continued operation of the

railroad. (A37-38). The Court of Appeals essentially converted

Miltenberger from a case involving only the necessity of a pay-

ment to a case involving the establishment of priorities. In so do-

ing, the First Circuit Court’s decision is directly contrary to this

Court’s view of Miltenberger as expressed in Gregg v.

Metropolitan Trust Co., 197 U.S. 183 (1905), and indeed

9

restates a prior and similar interpretation of Miltenberger by the

First Circuit Court (see pages 23-27 infra) which was cited and

repudiated by this Court in Gregg. Further, the decision of the

First Circuit Court of Appeals in the case at bar is in conflict with

recent congressional action.

As previously noted, the Court of Appeals held that when a

priority is claimed under the Fosdick rule, a current debt fund

must exist and that the deduction of depreciation expense from

current revenue was an improper deduction in the calculation of

that fund. (A41-44). In arriving at this conclusion, the Court did

acknowledge that depreciation is a “[c]ost...to produce the

revenue of that period” (A43) but failed to explain why such a

cost to produce revenue should not be treated as a deduction

against revenue to the same extent as other costs to produce

revenue, aid further failed to explain why such a deduction

would be inequitable from the perspective of operations

creditors. The Court incorrectly concluded that a deferment of

current operating expenses to depreciation charges would con-

stitute a direct set-aside of revenue for the mortgage bondholders

at the cost of current expense creditors (A44-45), and failed to

state why this is unreasonable in the circumstances. The Court

failed to recognize depreciation as representing the mortgagees’

contribution to the production of current revenues. Further-

more, the Court appears to have assumed that there existed a

fund of cash available for distribution as a consequence of the

deduction of the depreciation charge and that such cash had not

been consumed by operating losses. When, as in the case at bar,

there is a deficit in net railway operating income apart from the

depreciation charge, a priority in favor of current expense

creditors would necessarily have to be paid out of the corpus of

mortgaged property with the result that mortgagees would ine-

quitably suffer not only the loss in the value of their security

reflected by depreciation, but would also suffer the additional

loss of the security used to pay the priority.

10

Reasons for Granting the Writ

I. THe Decision BeLow Conr.icts WitH Decisions OF OTHER

Courts OF APPEALS

The decision by the Court of Appeals for the First Circuit that

a priority for Six Months claims may be recognized regardless of

the existence of a current debt fund and that depreciation ex-

pense is not a proper deduction from current revenue in the

determination of the existence of such a fund is inconsistent with

decisions of other Courts of Appeals.

A. The Second Circuit

In In re New York, N.H. & H. R.R. Co., 405 F.2d 50 (2d Cir.

1968), the Court of Appeals for the Second Circuit affirmed the

District Court’s denial of priority status to unsecured creditors

claiming priority status under the Six Months Rule. The Court

stated:

Whether the six months creditors receive priority depends,

however, on whether there existed a ‘current debt fund’ or

‘current expense fund’ from which payment could have

been made but which was used instead for the benefit of the

bondholders.

405 F.2d at 52.

The court further held that depreciation expense should be

deducted from current revenue in the determination of the ex-

istence of the fund.

We hold that the availability of a current expense fund

under the six-months rule is to be determined by generally

accepted accounting practices, including those prescribed

by the Interstate Commerce Commission, and that under

those practices the current expense fund is to be computed

by deducting operating expenses and depreciation from

operating revenues.

Id.

11

The District Court opinion affirmed by the Court of Appeals

confirms both the restitutional nature of the Six Months Rule and

the necessity of a current debt fund out of which the priority may

be paid. 278 F.Supp. at 598. In discussing the Rule’s rationale,

the District Court rejected the importance of currently furnished

goods and services to the continued operation of the railroad as a

basis for the Rule.

Most cases contain additional rhetoric to the effect that ex-

tensions of credit by those furnishing operating services and

materials have “kept the railroad running.” This continued

operation of the railroad is then said to be a benefit to the

pubic and to the mortgagees as well, because the railroad is

wor i more as a going concern than its liquidation value.

Hence a priority should be granted to the operations

creditors. However, given the railroad reorganization pro-

visions of Section 77 of the Bankruptcy Act (11 U.S.C. Sec-

tion 205), it is simply not true in circumstances like those

facing the New Haven that extensions of credit by suppliers

of operating materials and services keep a railroad from

ceasing to run. Should these suppliers withhold credit and

demand cash, the railroad would not go into liquidation; it

might have to go into reorganization so much the sooner,

but it would keep running until a plan of reorganization

was approved or liquidation was decreed.

Id, at 598 n.10.

The foregoing view is in direct contradiction to much of the

First Circuit’s rationale with respect to its second “principle”

justifying recognition of a priority for Six Months claims. (see

page 8, supra.)

As to the circumstances under which the corpus of mortgaged

property may be invaded to pay the Six Months priority, the

District Court stated:

On the question of invasion of corpus the Supreme Court

has consistently held in every decision on the point that

12

corpus cannot be invaded to satisfy the priority of the opera-

tions creditors except to the extent that the current expense

fund has been “diverted” to the benefit of the mortgagees.

See, e.g., Fosdick v. Schall, 99 U.S. at 254, 25 L.Ed. 339

‘{I]f there has been in reality no diversion, there can be no

restoration; ... the amount of restoration should be made

to depend upon the amount of the diversion.’; St. Louis, A.

d T.H. R.R. Co. v. Cleveland, C., C. & I.R. Co., 125 U.S.

658, 674, 8 S.Ct. 1011, 31 L.Ed. 832 (1888); Gregg v.

Metropolitan Trust Co., supra. This limiting of corpus in-

vasion to the amount of diversion of the fund is entirely con-

sistent wtih (sic) the rationale of the rule. If the current

revenues to which operations creditors are entitled, have

never benefited or been diverted to the mortgagees, the

operations creditors have no right to invade the interests of

the mortgagees. The rule states that mortgagees shall not

take any of the operating revenues until the operations

creditors have been paid; if the mortgagees have never

received any such revenues, they are not bound to restore

any.

Id. at 602-03 (footnotes omitted).

Addressing this Court’s decision in Miltenberger and the subse-

quent interpretation of that decision by the Court of Appeals for

the Fourth Circuit in Southern Ry. Co. v. Flournoy, 301 F.2d

847 (4th Cir. 1972), a decision remarkably akin to that of the

First Circuit in regard to the interpretation and application of

Miltenberger, Judge Anderson stated:

One lower federal court has misread the Supreme Court's

holdings on this point. Southern Railway Company v.

Flournoy, 301 F.2d 847 (4 Cir. 1962). The Flournoy court

confused and merged the six months rule with another

priority developed in equity receiverships: the so-called

“necessity of payment” rule. This rule is completely

unrelated to the six months rule, with different re-

quirements and a different rationale. The necessity of pay-

ment rule was first enunciated in Miltenberger v.

13

Logansport, C. & S.W. Ry. Co., 106 U.S. 286, 1 S.Ct. 140,

27 L.Ed. 117 (1882); there it was held that if payment of a

claim which arose prior to reorganization is necessary for

the continued operation of the railroad during reorganiza-

tion, (e.g., if a previously unpaid creditor occupies a

monopoly position vis-a-vis the railroad during reorganiza-

tion and threatens to withhold his supplies unless paid) then

the trustee is authorized to pay that claim even out of corpus

if necessary. The rationale of the rule is that the interests of

all parties, including the public and the mortgagees, are

best served by the continued operation of the railroad.

Diversion is obviously irrelevant to the necessity of payment

rule as are also such requirements of the six months rule as

reliance on current earnings and accruing of the claim

shortly before reorganization. The Flournoy court inex-

plicably merged the two rules by making necessity of pay-

ment a requirement of the six months rule and eliminating

diversion as a requirement for corpus invasion. This was

directly contrary to Gregg v. Metropolitan Trust Co., 197

U.S. 183, 25 S. Ct. 415, 49 L.Ed. 717 (1905), where the

Supreme Court in an opinion by Justice Holmes un-

equivocally held that necessity of payment rule’s lack of

diversion requirement for corpus invasion was not to be

transposed to the six months rule; the former rule, the Court

held, was based upon the necessity of payment while the

latter rule was based merely on the necessity of the service

or supply furnished. 197 U.S. at 187, 25 S.Ct. 415. See also

Taylor v. Delaware & E. R. Co., 213 F. 622, 624 (2 Cir.

1914).

Id, at 602 n.15.

Hence, it is the clear position of the Courts in the Second Cir-

cuit that before priority under the Rule may be accorded there

must exist a current debt fund or at least such a diversion of

operating revenues for the benefit of mortgagees as justifies re-

creation of the fund. The Second Circuit has unequivocally inter-

14

preted this Court’s decisions as not permitting invasion of mort-

gaged property unless a diversion for the benefit of mortgagees

has occurred. As noted earlier, any recognition of a priority

where no current debt fund exists or can be re-created necessarily

requires the invasion of the mortgagees’ property. Furthermore,

the Courts in the Second Circuit, as do substantially all of the

courts which have considered the question, regard Miltenberger

v. Logansport C. & S.W. Ry. Co., supra, as a decision

establishing a “necessity of payment” rule that is distinct from,

and has absolutely no application to, the Six Months Rule.

Writing for the District Court in New Haven, Judge Anderson

also succinctly elucidated the Second Circuit’s view of deprecia-

tion and the propriety of deducting depreciation expense in the

determination of the existence and amount of a current debt

fund. The surplus earnings required for the current debt fund

was defined as the sum of all operating revenues accrued during

the aforesaid period which were actually received or taken over

by the Trustees, less depreciation and all operating expenses

which had actually been paid or were payable by the Trustees or

which constituted administration expenses. Id. at 599. Deprecia-

tion was characterized in the following terms:

Depreciation. . .does not create additions to assets or acces-

sions to assets already held, but is a reflection of the very

real economic fact that the assets are being consumed or

wasted away in the process of keeping the railroad running

and is actually a measure of the contribution of physical

properties made by the mortgagees for this purpose.

Therefore, to the extent of depreciation, operations

creditors have no equitable claim on operating revenue;

they have no equitable right to be protected from the

phenomenon of depreciation.

Id. at 604.

As previously noted (see page 9, supra) the opinion of the

Court of Appeals for the First Circuit fails to address the fun-

damental equities of the depreciation deduction in terms of the

15

restitutional nature of the Rule. The above-quoted language of

Judge Anderson evidences recognition of those equities by the

New Haven Court and is certainly in contradiction to the conclu-

sions reached by the First Circuit Court. It may fairly be stated

that mortgagees furnish depreciation, the consumption of their

security, to the production of current income and in this real

sense they are operations creditors to the same extent as are sup-

pliers of necessary goods and services. Accordingly, the

withholding from other operation expense creditors of a portion

of revenues as a consequence of the deduction for depreciation

produces no inequity.

It is apparent from the foregoing that in recognizing a priority

under the Six Months Rule simply on the basis of the current fur-

nishing of necessary goods and services in reliance on the

railroad’s revenues and apparently permitting the payment of

that priority pari passu with post-petition administration claims

from the corpus of the mortgaged property regardless of whether

there has been a diversion for the benefit of mortgagees and in

holding that depreciation is not deductible in determining the

surplus earnings component of the current debt fund, the First

Circuit Court’s decision is directly contra to the law of the Second

Circuit.

B. The Third Circuit

In Central R.R. Company of N.J. v. Manufacturers Hanover

Trust Co., 421 F.2d 604 (3d Cir. 1970), the Court of Appeals for

the Third Circuit indicated approval of the Second Circuit’s posi-

tion in regard to the necessity of a diversion in favor of mort-

gagees as a prerequisite to invasion of the corpus of mortgaged

property for the purposes of the recognition of a priority for Six

Month claims. Although the issue in Central R.R. concerned the

trustee’s removal of funds from the bondholders’ account to pay

operating expenses, the Court cited In re New York, N.H. & H.

R.R. Co., 278 F.Supp. 592 (D. Conn. 1967) as an “excellent

discussion of the law regarding creditor priority.” 421 F.2d at 608

n.13. The Third Circuit Court, referring to the Six Months Rule

and citing Judge Anderson, stated:

16

The principle of this priority, however, applies only to

operations revenues. Property subject to mortgage liens, or

‘corpus’. . . ‘cannot be invaded to satisfy the priority of the

operations creditors’. . . This latter rule does not apply if

operations expenses have been ‘diverted’ to the benefit of

the bondholders. . .

Id.

The Court of Appeals for the Third Circuit therefore concurs

with the courts of the Second Circuit in proscribing an invasion

of the property rights of mortgage bondholders in absence of a

a diversion of current revenues which benefited the bondholders.

The District Court opinion in In re Penn Central Transp. Co.,

458 F.Supp. 1234 (E.D. Pa. 1978) directly addresses both issues

currently before the Court ir the present case. Relying strongly

on Judge Anderson’s opinion in In re New York, N.H. & H. R.R.

Co., 278 F.Supp. 592 (D. Conn. 1967), the Penn Central

reorganization court held that a current debt fund must exist as a

prerequisite to recognition of a priority for Six Months claims,

458 F.Supp. at 1321, and further held that the deduction of

depreciation was proper in determining the existence of the cur-

rent debt fund and did not constitute a diversion in favor of

mortgagees. Id. at 1324.

Again, the decision below by the Court of Appeals for the First

Circuit is clearly contra to the law on the issues in the Third Cir-

cuit.

C. The Seventh Circuit

In Carbon Fuel Co. v. Chicago C. & L. R. Co., 202 F. 172

(7th Cir. 1912), the Court of Appeals for the Seventh Circuit in-

terpreted this Court’s decision in Gregg v. Metropolitan Trust

Co., 197 U.S. 183 (1905) as limiting the prior decision in

Miltenberger to a “necessity of payment” rule as distinguished

from a rule establishing a priority. In this respect the Seventh

Circuit decision is contra to the First Circuit's decision in the case

at bar.

17

D. The Fourth Circuit

The Court of Appeals for the Fourth Circuit in Southern Ry.

Co. v. Flournoy, 301 F.2d 847 851 (4th Cir. 1962), contrary to

this Court’s decision in Gregg, held that a current debt fund is

not a prerequisite to recognition of a priority under the Six Mon-

ths Rule.

II. THe Courr or Apreats’ Decision BeLow Conruicrs Wrrn

Prion Decisions or Tus Courr CONCERNING THE SIx

Montus RULE

The decision of the Court of Appeals for the First Circuit

acknowledged that a priority under the Six Months Rule may be

premised on the principle of equitable restitution enunciated by

this Court in Fosdick v. Schall, 99 U.S. 235 (1878), and subse-

quent cases'* and that the existence of a current debt fund con-

sisting of either surplus earnings or operating revenues diverted to

mortgagees is prerequisite to the recognition of a priority on that

basis. (Al8, 42). The Petitioners respectfully disagree with the

Court of Appeals concerning this basis for application of the Rule

only insofar as the Court determined that depreciation should

not be deducted from revenue in determining the surplus earn-

ings component of the current debt fund. As previously noted,

however, the Court of Appeals further held that a priority is also

afforded to pre-reorganization current operating expense claims

for necessary current operating expenses furnished on credit in

reliance on the railroad’s current operating revenue on the same

basis and from the same operating income as administration ex-

penses. It appears that a corollary of that holding is that such

priority may be paid by invading the corpus of the mortgaged

property and impairing the rights of mortgagees in the absence of

any diversion for the benefit of mortgagees if there are insuffi-

cient operating revenues to pay or provide for those claims and

'* See, e.g., Gregg v. Metropolitan Trust Co., 197 U.S. 183 (1905);

Southern Ry. v. Carnegie Steel Co., 176 U.S. 257 (1900); Kneeland v.

tries Co., 136 U.S. 89 (1890); Burnham v. Bowen, 111 U.S.

18

all post-petition expenses. It is clear in the case at bar, in light of

the estate’s substantial operating losses, that recognition of this

priority will result in such an invasion and impairment not-

withstanding the absence of a net diversion for the benefit of

mortgagees. In this respect, the Court’s decision is in direct con-

flict with decisions of this Court that clearly proscribe invasions

of the corpus of mortgaged property in the absence of a diversion

for the benefit of mortgagees.

In Fosdick v. Schall, 99 U.S. 235 (1878), this Court first set

forth the grounds on which the property rights of mortgagees

may be altered to recognize the claims of Six Months creditors.

The business of all railroad companies is done to a greater or

less extent on credit. This credit is longer or shorter, as the

necessities of the case require; and when companies become

pecuniarily embarrassed, it frequently happens that debts for

labor, supplies, equipment, and improvements are permitted

to accumulate, in order that bonded interest may be paid and

a disastrous foreclosure postponed, if not altogether avoided.

In this way the daily and monthly earnings, which ordinarily

should go to pay the daily and monthly expenses, are kept

from those to whom in equity they belong, and used to pay the

mortgage debt. The income out of which the mortgage is to be

paid is the net income obtained by deducting from the gross

earnings what is required for necessary operating and manag-

ing expenses, proper equipment and useful improvements.

Every railroad mortgagee in accepting his security impliedly

agrees that the current debts made in the ordinary course of

business shall be paid from the current receipts before he has

any claim upon the income. If for the convenience of the mo-

ment something is taken from what may not improperly be

called the current debt fund, and put into that which belongs

to the mortgage creditors, it certainly is not inequitable for the

court, when asked by the mortgagees to take possession of the

future income and hold it for their benefit, to require as a con-

dition for such an order that what is due from the earnings to

the current debt shall be paid by the court from the future cur-

rent receipts before anything derived from that source goes to

19

We think, also, that if it appears in the progress of the cause

that bonded interest has been paia, additional equipment pro-

vided, or lasting and valuable improvements made out of ear-

nings which ought in equity to have been employed to keep

down debts for labor, supplies, and the like, it is within the

power of the court to use the income of the receivership to

discharge obligations which, but for the diversion of funds,

would have been paid in the ordinary course of business. This,

not because the creditors to whom such debts are due have in

law a lien upon the mortgaged property or the income, but

because, in a sense, the officers of the company are trustees of

the earniags for the benefit of the different classes of creditors

and the stockholders; and if they give to one class of creditors

that which properly belongs to another, the court may, upon

an adjustment of the accounts, so use the income which comes

into its own hands as, if practicable, to restore the parties to

their original equitable rights. . .

Whatever is done, therefore, must be with a view to a restora-

tion by the mortgage creditors of that which they have thus in-

equitably obtained. It follows that if there has been in reality

no diversion, there can be no restoration; and that the amount

of restoration should be made to depend upon the amount of

the diversion.

Id. at 252-54 (emphasis added). The Court in Fosdick clearly

states that payment to current expense creditors shall not be in

derogation of the rights of the secured bondholders unless such

bondholders actually received something which properly be-

longed to the current expense creditors.

Again, in Kneeland v. American Loan and Trust Co., 136

U.S. 89 (1890), a case in which payment for rolling stock was

sought as a priority ahead of the pre-exisng rights of mort-

gagees, and a case in which neither a surplus of current earnings

nor a diversion of funds for the benefit of mortgagees existed, this

Court stated:

20

Because in a few specified and limited cases this court has

declared that unsecured claims were entitled to priority

over mortgage debts, an idea seems to have obtained that a

court appointing a receiver acquires power to give such

preference to any general and unsecured claims. ... One

holding a mortgage debt upon a railroad has the same right

to demand and expect of the court respect for his vested and

contracted priority as the holder of a mortgage on a farm or

lot. So, when a court appoints a receiver of railroad prop-

erty, it has no right to make that receivership conditional on

the payment of other than those few unsecured claims

which, by the rulings of this court, have been declared to

have an equitable priority. No one is bound to sell to a

railroad company or to work for it, and whoever has deal-

ings with a company whose property is mortgaged must be

assumed to have dealt with it on the faith of its personal

responsibility, and not in expectation of subsequently

displacing the priority of the mortgage liens. It is the excep-

tion and not the rule that such priority of liens can be

displaced. We emphasize this fact of the sacredness of con-

tract liens, for the reason that there seems to be growing an

idea, that the chancellor, in the exercise of his equitable

powers, has unlimited discretion in this matter of the

displacement of vested liens.

Id. at 97-98 (emphasis added).

In holding that additional grounds existed apart from the prin-

ciple of equitable restitution for according a priority to Six

Months claimants, the First Circuit relied heavily on this Court’s

decision in Miltenberger v. Logansport C. & S.W. Ry. Co., 106

U.S. 286 (1882). In this regard the Court of Appeals seriously

misinterpreted the Miltenberger decision and is in conflict with

this Court’s decision in Gregg v. Metropolitan Trust Company,

197 U.S. 183 (1905). Indeed, the Court of Appeals’ interpretation

and application of Miltenberger is substantially the same as that

21

contained in a prior decision of the First Circuit which was later

explicitly repudiated by this Court in Gregg.

As the Court of Appeals itself noted (A19), the critical issue in

Miltenberger was the court’s authorization of capital expen-

ditures and financing of these expenditures by receiver's cer-

tificates secured by a lien which primed the first mortgage. The

lesser aspect of the case involved a belated challenge by certain

first mortgage bondholders to the receiver's payment, previously

authorized by the Court, of certain pre-receivership expenses,

payment of which the receiver believed to be indispensable to the

continued operation of the railroad. In affirming the lower

court’s approval of such payments, the Miltenberger Court

stated:

Many circumstances may exist which may make it necessary

and indispensable to the business of the road and the preser-

vation of the property, for the receiver to pay pre-existing

debts of certain classes, out of the earnings of the receiver-

ship, or even the corpus of the property, under the order of

the court, with a priority of lien. Yet the discretion to do so

should be exercised with very great care. The payment of

such debts stands, prima facie, on a different basis from the

payment of claims arising under the receivership, while it

may be brought within the principle of the latter by special

circumstances. It is easy to see that the payment of unpaid

debts for operating expenses, accrued within ninety days,

due by a railroad company suddenly deprived of the control

of its property, due to operatives in its employ, whose cessa-

tion from work simultaneously is to be deprecated, in the

interests both of the property and of the public, and the

payment of limited amounts due to other and connecting

lines of road for materials and repairs for unpaid ticket and

freight balances, the outcome of indispensable business rela-

tions, where a stoppage of the continuance of such business

relations would be a probable result, in case of non-

payment, the general consequences involving largely, also,

the interests and accommodation of travel and traffic, may

22

well place such payments in the category of payments to

preserve the mortgaged property in a large sense, by main-

taining the good-will and integrity of the enterprise, and

entitle them to be made a first lien. This view of the public

interest in suck a highway for public use as a railroad is, as

bearing on the maintenance and use of its franchises and

property in the hands of a receiver, with a view to public

convenience, was the subject of approval by this court,

speaking through Mr. Justice Woods, in Barton v. Barbour,

104 U.S. 126. The appellants furnish no basis for question-

ing any specific amounts allowed in respect of the arrears

referred to, but object to the allowance of anything out of

the sale of the corpus for such expenditures. Under all the

circumstances of this case, we see no valid objection to the

provisions of the orders complained of.

Id. at 311-12 (emphasis added).

The Court of Appeals in the decision below has shifted the

focus of Miltenberger from the necessity of payment by a receiver

in order to keep the railroad operating to the granting of a pri-

ority to suppliers of necessary services. (A36, 37). This interpreta-

tion of Miltenberger by the Court of Appeals is substantially the

same as that posited in a prior decision of the First Circuit in New

England R.R. Co. v. Carnegie Steel Co., 75 F.54 (1896). In New

England R.R., the First Circuit approved payment of a pre-

receivership supply claim out of the corpus of mortgaged prop-

erty on the authority of Miltenberge:. stating:

Whatever might be our decision if the case was of novel im-

pression, we think we are concluded by Miltenberger v.

Railway Co., 106 U.S. 286, 292, 293, 295, 298, 302, 304,

308, 311, 1 Sup. Ct. 140, as explained, and perhaps limited,

in Kneeland v. Trust Co., 136 U.S. 89, 96, 97, 10 Sup. Ct.

950; Thomas v. Car Co., 149 U.S. 95, 110, 112, 13 Sup. Ct.

824; Bound v. Railway Co., 7 C. C. A. 332, 58 Fed. 473,

480; and Finance Co. of Pennsylvania v. Charleston, C. &

C. R. Co., 10 C.C.A. 323, 62 Fed. 205, 208. We are

23

therefore required to hold that the circuit court had the

power to give the priority complained of to supply bills of

the charter, contracted at the time, and remaining unpaid,

under the circumstances shown in reference to those now at

issue. What would have been the conclusion if the trustees

of the second mortgage had not asked for a receiver, and

had not submitted to the order of September 8, 1894, modi-

fying to some extent the then existing receivership, and thus

giving it retroactive effect as of the time of its original crea-

tion, we need not determine. So far as we have discovered,

Miltenberger v. Railway Co. is the only instance in which

the supreme court has in fact allowed accrued supply bills a

priority against the corpus of mortgaged property; and, as

we understand that suit, the circumstances of the case at

bar in its final stages are substantially the same for our pre-

sent purposes, and we have followed strictly its conclusions

without going beyond them.

Id. at 59.

This earlier interpretation of Miltenberger (which is appar-

ently the interpretation adopted in the decision which is the sub-

ject of this Petition) was specifically repudiated by this Court in

Gregg v. Metropolitan Trust Co., 197 U.S. 183, 187 (1905). In

Gregg, a pre-receivership supplier of railroad ties sought to be

paid out of the proceeds of mortgaged property in the hands of

the receiver. The claimant argued that a diversion for the benefit

of the mortgagees was not a prerequisite to his prior right in the

proceeds of sale of the mortgaged property and cited

Miltenberger in support of his position. In fact, there was no

diversion for the benefit of mortgagees. The supplier’s claim was

denied by the Court, and Miltenberger was distinguished as a

case justifying payment of a pre-receivership supplier not because

he was a current supplier of necessary goods or services, but

because the payment of the pre-receivership obligation was

necessary if the receivers were to continue the business.

24

This Court stated:

The case stands as one in which there has been no diversion

of income by which the mortgagees have profited, or other-

wise, and the main question is the general one, whether in

such a case a claim for necessary supplies furnished within

six months before the receiver was appointed, should be

charged on the corpus of the fund. There are no special cir-

cumstances affecting the claim as a whole, and if it is

charged on the corpus it can be only by laying down a

general rule that such claims for supplies are entitled to

precedence over a lien expressly created by a mortgage

recorded before the contracts for supplies were made. An

impression that such a general rule was to be deduced from

the decisions of this court led to an evidently unwilling ap-

plication of it in New England R. Co. v. Carnegie Steel

Co., 75 Fed. Rep. 54, 58, and perhaps in other cases. But

we are of opinion, for reasons that need no further state-

ment, Kneeland v. American Loan & Trust Co., 136 U.S.

89, 97, that the general rule is the other way, and has been

recognized as being the other way by this court.

The case principally relied on for giving priority to the

claim for supplies is Miltenberger v. Logansport &c.

Railway Co. (sic), 106 U.S. 286. But while the payment of

some preexisting claims was sanctioned in that case, it was

expressly stated that “the payment of such debts stands,

prima facie, on a different basis from the payment of claims

arising under the receivership.” The ground of such

allowance as was made was not merely that the supplies

were necessary for the preservation of the road, but the pay-

ment was necessary to the business of the road—a very dif-

ferent proposition. In the later cases the wholly exceptional

chay’ cter of the allowance is observed and marked. Knee-

land v. American Loan & Trust Co., 136 U.S. 89, 97, 98.

Thomas v. Western Car Co., 149 U.S. 95, 110, 111;

Virginia & Alabama Coal Co., v. Central Railroad & Bank-

ing Co., 170 U.S. 255, 370.

197 U.S. at 186-87 (emphasis added).

>=

25

The foregoing language makes explicit that neither in

Miltenberger nor in any other case did this Court premise a

priority for pre-petition operation expense on anything but the

equitable restitutional basis which requires either surplus

operating income after the payment of all expenses or a diversion

for the benefit of mortagees which alone justifies an impairment

of the mortgagees’ property rights. As a consequence of this

Court’s teaching in Gregg, the rule of the Miltenberger decision

has since become known as the “Necessity of Payment Rule”, and

has generally been treated as separate and distinct from the Six

Months Rule. See, e.g., In re New York, N.H. & H.R.R. Co.,

278 F.Supp. 592, 602 n.15 (D. Conn. 1967) (reprinted supra,

pp. 12-13); Note The Present Status of the Six Months Rule, 34

Colum. L. Rev. 230, 234 n.11 (1937); Note, Bankruptcy Law —

The Continued Vitality of the Six Months Rule in Railroad

Receiverships, 57 N.C.L. Rev. 137, 140 n.30 (1978). Indeed, the

First Circuit in the present case recognized the Necessity of Pay-

ment Rule as distinct from the Six Months Rule, but failed to cite

' Miltenberger, or any other authority, as the basis of that rule.

(A45). The Court of Appeals’ utilization of Miltenberger as an

alternate basis for operation of the Six Mouths Rule is directly

contra to this Court’s opinion in Gregg. Inasmuch as Gregg

represents the last major discourse on the Rule by the Supreme

Court, intervening authority to support the First Circuit Court’s

conception of the Rule does not exist.

III. THe Court or Appeas’ Decision BeELow Conruicts WrrH

CONGRESSIONAL Poticy as RECENTLY REFLECTED IN THE

ADOPTION OF THE RAILROAD REORGANIZATION PROVISIONS

OF THE BANKRUPTCY Rerorm Act or 1978.

The Court of Appeals’ determination that a priority may be

accorded to Six Months claimants on the Miltenberger

receivership-administration principle is premised on a view of Six

Months claims as being no different from administration expense

claims and also no different from similar current operating

26

claims actually paid in the ordinary course on the eve of

reorganization.'* Believing that there should be equality of treat-

ment between administration expenses and Six Months claims

notwithstanding the filing of the reorganization petition, the

Court stated:

That equality is readily achieved by recognizing administra-

tion expenses as extending backward to the period

preceding reorganization to the extent necessary to assure

that there is continuity in the payment of indispensable

operating expenses without reference to the date the peti-

tion is filed so long as the current expenses of the pre-

reorganization period that are brought forward for pay-

ment conform to the strict standard established for ad-

ministration expenses of the current operating class, and are

not so dated as to forbid the conclusion that they are in fact

current. The inequity in treatment arising out of the ac-

cidental circumstance of non-payment before the filing of

the petition is eliminated.

(A39).

Interestingly enough, both the attempt to void the conse-

quences of the filing of the reorganization petition and the First

Circuit Court’s interpretation of the priority were recommended

by the Commission on the Bankruptcy Laws of the United States

in its 1973 report and recommendations for revision of the

bankruptcy laws submitted to the President, the Chief Justice

and the Congress. In its Report, the Commission proposed that as

a prerequisite to confirmation of any plan of railroad reorganiza-

tion, the court must find that:

18 The Court of Appeals erroneously assumed that such actual

payments are necessarily not preferential in nature and therefore con-

cluded based on that erroz.eous assumption that the nonpayment of

other like expenses involved inequality of treatment. (A39). In fact, the

payment on the eve of bankruptcy of previously arising claims is

preferential both under Section 60 of the Act and Section 547 of the

Bankruptcy Code and, depending on the circumstances, may be a

voidable preference.

27

in addition to providing for payment of all amounts re-

quired pursuant to section 7-303(2), the plan provides for

payment of all allowed claims for current operating ex-

penses incurred by the debtor during the six months im-

mediately preceding the filing of the petition.

Report of the Commission on the Bankruptcy Laws of the United

States, H.R. Doc. No. 93-137, 93rd Cong., Ist Sess. 288 (1973),

reprinted in, Collier on Bankruptcy, Appendix, Vol 2 (15th Ed.

1980). Pursuant to the Commission’s recommendation, the

Senate bill proposed a requirement that any confirmed plan

provides the priority traditionally accorded by section 77(b)

to claims by rail creditors for necessary services rendered

during the six months preceding the filing of the petition in

bankruptcy.

S. Rep. No. 95-989, 95th Cong., 2d Sess. 136, reprinted in, Col-

lier on Bankruptcy, Appendix, Vol. 3 (15th Ed. 1980). The

House version of the proposed legislation, however, did not re-

quire the recognition of all six month operating expenses as

priorities as a prerequisite to confirmation. H.R. 8200 simply

recognized as priorities those claims that would have been en-

titled to priority in a federal equity receivership—essentially

leaving the law as it existed under the Bankruptcy Act un-

changed. The House version of the legislation was ultimately

enacted as section 1171(b) of the Bankruptcy Reform Act of

1978.

This legislative history is significant in that it reflects congres-

sional rejection of an automatic priority for operations creditors

who supplied necessary goods and services during the six months

preceding the filing of the reorganization petition. Obviously,

the drafters of the Reform Act were aware of the limitations im-

posed by this Court and others on the recognition of a priority

under the Six Months Rule. Inasmuch as the decision of the

Court of Appeals in the case at bar recognizes an automatic

priority for Six Months claims on the same basis and from the

28

same source as administration expenses, it directly conflicts with

this recent statement of congressional policy.

IV. THE PresENT CAsE Orrers AN EXCELLENT OPPORTUNITY TO

ELIMINATE DISAGREEMENT AMONG THE CIRCUITS AND Con-

TINUALLY RECURRING DiIsPUTES REGARDING THE APPLICA-

BILITY OF THE Six MONTHS RULE.

In the face of a number of pending railroad reorganization

proceedings and the likelihood of future proceedings, all of

which will confront the questions herein presented regarding ap-

plication of the Rule, the Court should avail itself of the oppor-

tunity to finally resolve these questions. The questions presented

are of national significance and require a determination by the

Court both because application of the Rule has a substantial

economic impact upon virtually all railroad reorganizations and

because differing applications of the Rule may well work

substantial inequities.

Because of the nature of the railroad industry, there is a high

incidence of mutuality of claims between railroads, including

railroads in reorganization proceedings. The Penn Central has

claims against the Boston and Maine and the latter has claims

against the Penn Central. Likewise, mutual claims exist between

the Boston and Maine and other roads in reorganization. If the

decision of the Court of Appeals for the First Circuit becomes

final, a portion of the claims of such railroad creditors of the

Boston and Maine may be entitled to a priority under the Six-

Months Rule while no similar treatment is accorded to the claims

of the Boston and Maine in the reorganization proceedings of

those railroad creditors under the holdings of the Courts in their

Circuits. It is by no means clear that the principle of set-off will

operate to correct the obvious inequity. We respectfully submit

that such inequity, the confusion resulting from differing views of

the Circuits, and future litigation may best be avoided by the

resolution by this Court of the questions presented on this Petition.

This case offers an excellent opportunity for the Court to ad-

dress and clarify the parameters and requirements of the Six

29

Months Rule. The issues are precise and no questions are

presented concerning the special nature of specific claims or the

propriety of inclusion of specific claims within any priority

classification.

As noted by the District Court in In re Third Ave. Transit

Corp., 138 F.Supp. 623 (S.D.N.Y. 1955), aff'd per curiam, 230

F.2d 425 (2d Cir. 1956), the history and application of the Rule

has been, at best, inconsistent.

The researches of counsel supplemented by such research as

has been at my command have not resulted in the discovery

of any principle by which would account for all of the deci-

sions so that one might say there was a principle behind

them.

Id, at 625. Although the Petitioners herein do not concur with

the above-quoted passage but rather posit that a clear principle

does indeed exist, the inconsistent statements and rulings of

various courts on the issues reflect substantial confusion among

the lower courts.

It is important to note that this Court has not addressed the Six

Months Rule since the adoption of the railroad reorganization

provisions of Section 77 of the Act. Thus, the present case also of-

fers an excellent opportunity for the Court to determine whether

recognition of a priority for Six Months claims is indeed

beneficial or detrimental to the interests of the public in the pre-

sent circumstances. Although the Respondents suggest that one of

the purposes of the Rule is to ensure continued supply of

necessary goods and services to maintain operation of the road, it

has been observed that continued extensions of credit all too often

delay necessary reorganization to the point where the road’s

assets are so depleted as to make reorganization a monumental

task at best — to the detriment of both the public and the

creditors of the road. See, e.g., In re New York, N.H & H.R.R.

Co., 278 F.Supp. 592, 606 (D. Conn. 1967); Comment, 33 Col-

um. L. Rev. 834, 850 (1933). Additionally, such an all-

encompassing priority as would be recognized by the First Cir-

cuit Court may well discourage necessary mortgage financing.

30

Conclusion

The present case presents an excellent opportunity for the

Court to resolve the significant and recurring issues presented

herein. The decision below clearly conflicts with decisions

rendered both by this Court and by other Circuit Courts of Ap-

peals and is contrary to congressional policy. The issues presented

are straight-forward and devoid of collateral issues and therefore

the case is an excellent vehicle for a conclusive judicial statement

on the questions presented.

For each of the foregoing reasons, the Petitioners respectfully

pray that a writ of certiorari be granted as herein requested.

Respectfully submitted,

THE First NATIONAL BANK

OF BOSTON AND

MALcoLM W. HALL,

Successor Indenture

Trustees

Counsel:

JoserH H. B. Epwarps

BincHAM, Dana & GouLp

100 Federal Street

Boston, MA 02110

(617) 357-9300

Ropert W. MESERVE AND

BENJAMIN H., Lacy,

Reorganization Trustees

Counsel:

CHar.es W. Mutcany, Jr.

Hawkes & GoLpINncs

One Walnut Street

Boston, MA 02108

(617) 367-2900

Special Counsel:

Ropert M, GARGILL

DONALD F.. FARRELL, JR.

CuHoate, HA & STEWART

60 State Street

Boston, MA 02109

(617) 227-5020

pre A

United States Court of Appeals

For the First Circuit

No. 79-1230

IN RE

BOSTON AND MAINE CORPORATION,

DEBTOR,

CHESAPEAKE AND OHIO RAILWAY COMPANY, ET AL.,

APPELLANTS.

No, 79-1231

IN RE

BOSTON AND MAINE CORPORATION,

DEBTOR,

MAINE CENTRAL RAILROAD COMPANY, ET AL.,

APPELLANTS.

No. 79-1234

IN RE

BOSTON AND MAINE CORPORATION,

DEBTOR,

PENN CENTRAL CORPORATION,

APPELLANT.

No. 79-1235

IN RE

BOSTON AND MAINE CORPORATION,

DEBTOR,

CANADIAN PACIFIC,

APPELLANT.

A-2

No, 79-1236

IN RE

BOSTON AND MAINE CORPORATION,

DEBTOR,

EASTERN ASSOCIATED COAL CORPORATION,

APPELLANT.

APPEALS FROM THE UNITED STATES DISTRICT COURT

FOR THE DISTRICT OF MASSACHUSETTS

[Hon. Frank J. Murray, Judge]

Before

Kunzic,* Judge, U.S. Court of Claims

Bownes, Circuit Judge

Doo.inG,** Senior District Judge

Entered October 6, 1980

John T. Collins, with whom Sherburne, Powers & Needham was

on brief, for Chesapeake and Ohio Railway Company, Baltimore

and Ohio Railway Company and Western Maryland Railway, ap-

pellants.

Paul B. Galvani, with whom Reed Witherby and Ropes & Gray

were on brief, for Maine Central Railroad Company and Portland

Terminal Company, Appellants.

George W. McLaughlin for Canadian Pacific, appellant.

Philip Burling, with whom Peter A. Fine and Foley, Hoag & Eliot

were on brief, for Eastern Associated Coal Corporation, appellant.

Robert M. Gargill, with whom Zdislaw W. Wieckowski, Choate,

Hall & Stewart, and Charles W. Mulcahy were on brief, for the

Trustees of the Boston and Maine Corporation, Debtor, appellees.

Joseph H.B. Edward, with whom Bingham, Dana & Gould was

on brief, for the First National Bank of Boston and Malcolm W. Hall

Successor Trustees, under First Mortgage Indenture Dated

December 1, 1919 of Boston and Maine Corporation, appellees.

* Sitting by designation.

** Of the Eastern District of New York, sitting by designation.

A-3

Doouine, D.]J.

The present appeals' in this railroad reorganization case

challenge the district court's order, 468 F. Supp. 996 (D. Mass.

1979), determining the priorities of the creditors and

stockholders in the reorganization of the Boston and Maine

Corporation. Railroads which, as required by the Interstate

Commerce Act and the cases decided under it, have interlined

freight cars with the Boston & Maine appeal from the district

court's refusal to accord their claims for per diem charges for

cars furnished in the periods August 1, 1953, to July 31, 1969,

and August 1, 1969, to March 12, 1970, such a priority in the

classification of creditors as would assure full payment of the

claims. The interlining railroads and Eastern Associated Coal

Corporation appeal also from the district court's refusal to

establish a separate class of creditors, to be accorded priority

as “six months creditors,” for the railroads’ claims for per diem

car hire, car repair, loss and damage, and freight overcharges

for the six months preceding the filing of the involuntary peti-

tion against the Boston and Maine on March 12, 1970, and for

the Coal Corporation's claim for diesel fuel furnished in the

same six months period.

' The appeals of the Committee of Interline Railroads and of

Trailer Train Co. have been withdrawn. No briefs have been sub-

mitted in support of the appeals of Penn Central Transportation

Company and Atchison, Topeka and Sante Fe Ry. The appeals of

the Chesapeake and Ohio Railway Company, et al., and of Cana-

dian Pacific present the issues concerning the classification of the per

diem claims of the interlining railroads for the August 1,

1953, through July 31, 1969, as well as of the railroads’ claims for

per diem car hire, car repairs and loss and damage for the six months

preceding the date on which the involuntary petition was filed

against the Boston and Maine. The appeals of Maine Central

Railroad Company and Portland Terminal Company and of Eastern

Associated Coal Corporation relate to the classification of claims for

per diem car hire, freight loss and damage and overcharge, car

repairs, and diesel fuel for the six months preceding the filing of the

petition.

A-4

I

The railroads’ per diem claims, aggregating $8,582,000, are

described in Chief Judge Coffin’s opinion for this court, 600

F.2d 307 (1st Cir. 1979), affirming the district court’s refusal,

456 F. Supp. 412 (D. Mass. 1978), to order immediate pay-

ment of the per diem charges before payment of all other

unsecured pre-reorganization claims. On that appeal this

court rejected the contention that because the trustees’ opera-

tion of the Boston and Maine is subject to the jurisdiction of

the Interstate Commerce Commission, see former Bankruptcy

Act § 77(c)(2), 11 U.S.C. § 205(c)(2) (1976), and because the

ICC has ordered payment of specific per diem rates at specific

settlement times, neither the trustees nor the court have discre-

tion to defer payment of the pre-petition per diem charges.

600 F.2d at 308. This court concluded that the ICC had not

exercised its statutory power, 49 U.S.C. § 1(14)(a) (1976), to

fix the rates for per diem settlements for the period August 1,

1953, to August 1, 1969, and that, so far as concerned the

period after August 1, 1969, following the ICC’s entry of a per

diem rate order, the general power of the ICC to supervise the

trustees’ operation of the railroad did not outweigh the fun-

damental power of the reorganization court to set priorities for

payment of pre-reorganization claims, Bankruptcy Act

§§ 77(b), (c)(7), (1), and to schedule payment of such claims

consistent with the need to conserve assets for rehabilitation of

the debtor. 600 F.2d at 309-10. The court added that the 1968

ICC order that interlining railroads pay specific per diem

charges, Chicago, B. & Q. R.R. v. New York, S. & W. R.R.,

332 1.C.C. 176, 241, 333 (1968), was an order of general ap-

plication, and that, since non-payment of the per diem claims

violated no specific order directed to the reorganization

trustees, the remedial provisions of Section 1(17)(a) of the

* The district court decision recounts the sequence of proceedings

leading to the ICC’s fixing of per diem rates in 1968. See 456 F.

Supp. at 413 n.2.

A-5

Interstate Commerce Act* could not be invoked. 600 F.2d at

312. The court observed that, fundamentally, the specific duty

to pay the per diem charges due for the pre-reorganization

period had been a duty of the railroad, and, after the filing of

the petition, those charges became claims against the debtor,

not claims against the trustees; the specific duty of the trustees,

as operators of the railroad, to pay per diems was limited to

the per diems incurred by the trustees in their operation of the

road.‘ The court rejected the contrary reasoning of In re

Chicago, R.I. & P.R.R., 537 F.2d 906 (7th Cir. 1976), cert.

denied, 429 U.S. 1092 (1977), and indicated agreement with

the result reached in In re Penn Central Transportation Co.,

486 F.2d 519 (3rd Cir. 1973), cert. denied, 415 U.S. 990

(1974), and which the Third Circuit reaffirmed in the dif-

ferent circumstances of In re Penn Central Transportation

Co., 553 F.2d 12 (3rd Cir. 1977). See 600 F.2d at 310-12.

On this appeal the interlining railroads argue, first, that

since the interlining of freight cars is mandatory under the In-

terstate Commerce Act, 49 U.S.C. §§ 1(4), (10), (11), (14),

(15), and (17), equity and considerations of national transpor-

tation policy unite to require that the roads receive just and

reasonable compensation for the compelled loan of freight

*19 U.S.C. § 1(17)(a) provides that if “any carrier, receiver, or

operating trustee” fails or refuses to comply with any order or direc-

tion of the ICC as to car service it shall be liable to stated penalties,

recoverable in a civil action brought by the United States. Citations

are to the Interstate Commerce Act, as amended, 49 U.S.C. § 1, et

seq. (1976). Parallel sections respecting car service are now

comprised in 49 U.S.C. § 11121, et seq.

* The court found in the terms of the Bankruptcy Reform Act

provision, 11 U.S.C. § 1166, a resolution of any supposed contradic-

tion between Section 77(c)(2) and Section 77 (1) in the requirement

that both the ICC and the reorganization court approve payment

for both pre- and post-reorganization per diem charges. The Con-

gress in adopting Section 1166 rejected a Senate provision requiring

the debtor to pay in cash current balances owed other carriers for in-

terlining charges, including incentive per diems, for periods both

before and after the filing of the petition.

A-6

cars; it is argued that the rail car fleet cannot be maintained at

the level essential to adequate rail service unless payment of

car hire is assured even in the case of the railroads that are in

reorganization. The argument is essentially that made on the

earlier appeal, and, so far as concerns the per diem claims for

the period 1953 to August 1, 1969, is disposed of by what was

then decided: the per diem claims for that sixteen year period

were not based on an ICC order fixing rates and ordering pay-

ment at those rates; the ICC in Chicago, B. & Q.R.R. v. New

York, S. & W.R.R., 332 1.C.C. 176, 183, 244-57 (1968) ,° did,

indeed, make findings as to the reasonableness of the rates

charged for the preceding fifteen years, but those findings, it

stated, were “of significance only as an aid to the courts in set-

tling the amount of damages in the pending lawsuits” (id. at

183).°

The unpaid per diem charges for car use during the period

August 1, 1969, to March 12, 1970, the date on which the

reorganization proceeding commenced, aggregated $564,000;

they were imposed at the rate determined by the order of the

ICC, Chicago, B. & Q. R.R. v. New York, S. & W. R.R.,

supra, 332 1.C.C. at 259; that order became final upon the

Supreme Court's affirmance of the district court decisions

’ The background and course of the litigation are outlined in the

district court's decision in the “immediate payment” case, In re

Boston & Maine Corp., 456 F. Supp. at 413 n.2.

® In the suit to recover from the Boston & Maine and other

railroads the difference between the amounts paid and the higher

charges fixed by the Association of American Railroads, the district

court deferred to the ICC’s determination of the reasonableness of

the AAR rates. Baltimore & O. R.R. v. N.Y., N.H. & H. B.R. Co.,

196 F. Supp. 724, 748-49 (S.D.N.Y. 1961). The ICC decision,

Chicago, B. & Q. R.R. v. New York, S.GW. R.R., 332 1.C.C. 176

(1968), fixing rates for the period commencing October 1, 1968, and

making findings on the reasonableness of the rates for the 1953-1968

period, was sustained, Boston & M. R.R. v. United States, 297 F.

Supp. 615 (D. Mass.), and Union Pacific R.R. v. United States, 300

F. Supp. 318 (D. Neb.), both aff'd., without opinion, 396 U.S. 27

(1969).

A-7

dismissing the railroads’ actions to set the order aside,’ and it

was made effective August 1, 1969. This court’s decision on

the earlier appeal is dispositive of all the contentions raised on

the present appeal as to this portion of the per diem claims ex-

cept the constitutional argument. While Chief Judge Coffin’s

opinion was occasioned by the “immediate payment” conten-

tion of the railroads, it dealt directly and necessarily with the

underlying issues of statutory interpretation and with the con-

tention that a priority in reorganization for per diem claims

would, by furnishing to the railroads an incentive for over-

coming the chronic shortage of freight cars, better serve the in-

terest of national transportation policy than would denying

the priority in the interest of preserving the public service

viability of bankrupt roads.

The railroads argue, on the constitutional issue, that since

Congress has mandated the interline loan of cars and the ICC

has fixed the per diem rates to be paid for the cars lent, deny-

ing to the car-owning railroads such a priority as will assure

payment of the per diem claims in reorganization effects a tak-

ing of their property without due process of law, an un-

constitutional taking akin to that found in Chicago, R.1., & P.

Ry. v. United States, 284 U.S. 80, 96-100 (1931); there a

divided court invalidated that part of the ICC order in Rules

for Car-hire Settlement, 160 1.C.C. 369, 386-395, 445 (1930),

that granted to the short line railroads two days of free time

for interchanged loaded cars and denied compensation

altogether in the case of cars received for return loading with

coal from mines customarily dependent upon connecting car-

riers for car supply. The Court put the decision on the ground

that, since the ICC had found that the owning roads were en-

titled to receive reasonable compensation in the form of a daily

rental for the use of their general-service freight cars when on

foreign lines, and that the $1 per car day charge then in effect

was such reasonable compensation, the ICC could not,

7 See note 6.

A-8

without inconsistency, relieve one class of railroads of the duty

to pay that reasonable compensation: “The use of railroad pro-

perty is subject to public regulation, but a regulation which is

so arbitrary and unreasonable as to become an infringement

upon the right of ownership constitutes a violation of the due

process of law clause of the Fifth Amendment.” 284 U.S. at

97.8

The rule, thus condemned by its very terms, effected at least

a partial denial of compensation for car use in every instance

of an interchange of cars between trunk line and short line.

However, the failure to accord a special priority in reorganiza-

tion to per diem claims neither denies an entitlement nor takes

either property or its use without compensation. It is rather a

refusal, on a ground of statutory policy, to confer on per diem

charges the special advantage of freedom from one commer-

cial risk, the risk of becoming an unsecured claim in

reorganization. Whatever might be the case if interchange of

cars was enforced in circumstances in which there was

certainty of non-payment, it is not the case that a scheme of

regulation that effects an appropriate public purpose may not,

without violation of constitutional principle, entail random

losses due to extrinsic factors. See Baltimore & O. R.R. v.

United States, 345 U.S. 146, 148 (1953) (carload rates

on certain kinds of fresh vegetables not violative of due process

merely because they are noncompensatory; so long as regula-

tions do not cause railroad to lose money on its overall business

“it is hard to think that it could successfully charge

8 The railroads also cite Chicago, M. & St. P.R.R. v. Wisconsin,

238 U.S. 491 (1915), in which the Court invalidated a Wisconsin

law which provided that whenever a person engaged a lower berth

in a sleeping car and the upper berth in the same section was neither

engaged nor occupied, the upper berth should not be let down but

should remain closed until engaged or occupied. The divided court

held that the statute was not a reasonable exercise of state police

power but a taking of property without compensation. The statute,

like the short line rule, mandated a transfer of a value without com-

pensation in money or justifying social value.

A-9

that its property was being taken for public use without just

compensation”);° Indiana Harbor Belt R.R. v. United States,

510 F.2d 644, 650 (7th Cir.) (ICC order requiring belt line to

move empty cars to repair shops without charge not an un-

constitutional taking of property without just compensation

absent a showing as to belt line’s overall operations), cert.

denied, 422 U.S. 1042 (1975); Western Air Lines, Inc. v. CAB,

495 F.2d 145, 152-153 (D.C. Cir. 1974) (Board’s denial

of operating certificate to carrier that sought to operate

only over profitable routes justified by consideration that

supra-competitive profits of a single carrier already serving the

route would enable it to undertake unprofitable local service

that required such subsidization).

The railroads’ contention must be considered strictly in

terms of the necessary impact of the rules for car-hire settle-

ment in the case of per diem claims against railroads in

reorganization. But no extension of credit to insolvent

railroads is inherent in the rules for car-hire settlement; the

Commission in Rules for Car-hire Settlement, supra,’

approved the rule of the “car service and per diem agreement”

among the subscribing railroads which required that the car

owner be furnished with a per diem statement within forty

days after the end of each calendar month giving the number

of days each car has been in the possession of the reporting

road; the Commission noted that customarily the car owner,

upon receipt of that information, drew on the using line for

the amount reported after deducting per diems, if any, owed

° Government of Guam v. FMC, 329 F.2d 251, 254 (D.C. Cir.

1964), and Pan American World Airways, Inc. v. CAB, 256 F.2d

711 (D.C. Cir. 1958), reach the same result on parallel facts.

Government of Guam spoke of the result as deriving from “the com-

pelling obligation of the carrier to render public service.”

'© An order giving effect to the findings of Rules for Car-hire Set-

tlement was entered in Rules for Car-hire Settlement, 165 1.C.C.

495 (1930), aff'd in part, reversed in part, Chicago, R.I. & P. Ry. v.

United States, 284 U.S. 80 (1931).

A-10

the other carrier. The accumulation of charges beyond the

forty days was the product of the interminable controversy

over rates, not a necessary consequence of interlining freight

cars; the modest credit term implicit in the car-hire settlement

rules could hardly be much shortened, and, given the impor-

tance of interchanging cars to the owning railroads’ earning of

freight revenue, the credit risk involved is not different from

that generally incident to the conduct of industrial and com-

mercial business. That some per diems of such short date may

go unpaid in some railroad reorganizations, and that the loan

of cars is required by law, do not combine to show a taking

without just compensation. What must be shown to

demonstrate unconstitutionality, and is not shown, is that the

regulatory scheme as a whole, not excluding the incidence of

the loss in reorganization cases arising from the extensions of

credit required by the settlement rules, operates to take the

property of the car-owning roads without just compensation,

or is so unreasonable or arbitrary that it violates due process.

The interline car-service rules and practices have evolved

pragmatically in reasoned stages with but one only partly suc-

cessful constitutional challenge (Chicago, R.I. & P. Ry. v.

United States, supra) from the beginning position that a

railroad could refuse to send its cars beyond its line when there

was a car shortage since its first duty was to the business of its

line, Riddle, Dean & Co. v. Pittsburgh & Lake Erie R.R., 1

I.C.C. 374, 388 (1888); through the critical decision that local

traffic does not enjoy rights superior to through traffic and

that carriers must make reasonable rules and regulations with

respect to the operation of through routes and the exchange,

interchange and return of cars used on these routes, Missouri

¢> Illinois Coal Co. v. Illinois Central R.R., 22 1.C.C. 39,

48-49 (1911); to the later comprehensive ICC review and im-

plementation of general car service standards in Rules for Car-

hire Settlement, supra, and the succession of ICC orders

of more recent years. In Chicago, B. & Q. R.R. v.

A-1l

New York, S. & W. B.R., 332 1.C.C. 176 (1968) ,'! the Com-

mission, accepting the concept that car hire should be enough

reasonably to compensate the owner for its costs of ownership

and no more, concluded that per diem charges should con-

stitute no more than a sharing of cost, and should not include

any amount for the value of the use of a car. Id. at 186-87.'°

Bad debt losses of the car-owning railroads in rail

reorganizations are simply elements of cost incident to the

massive system of interchanging freight cars, and unless the

system as a whole is shown to burden the car-owning railroads

unreasonably or arbitrarily or to deny them overall reasonable

compensation for the mandated loan of their cars, there is no

transgression of constitutional right. No such showing was at-

tempted, nor is it suggested that it could be made.

II

The claims for which priority is asserted under the “Six

Months Rule” do not exceed $3,000,000 and include per diems

for the period commencing September 13, 1969; priority is also

claimed for the greater part of the same claims under the

“Necessity of Payment” rule, but for some $400,000 of claims

priority is sought under the Necessity of Payment rule only.

'! For the history of the ICC decision see note 6, supra.

'2 Boston & Maine R.R. v. United States, 162 F. Supp. 289, 295

(D. Mass.), appeal dismissed, 358 U.S. 68 (1948), is to the same ef-

fect.

'3 More recent decisions have sustained further ICC action respec-

ting interchange of cars. United States v. Allegheny-Ludlum Steel

Corp., 406 U.S. 742 (1972), approved as reasonable under Section

1(14)(a) two car service rules promulgated in 1969 by the Commis-

sion which required freight cars, after being unloaded, to be

returned in the direction of the lines of the road owning the cars.

The Court, reviewing the car service history of the railroads, said

that, “The freight cars of the Nation thus became in essence a com-

mon pool, used by all roads.” Id. at 743. And in Ann Arbor R.R. v.

United States, 368 F. Supp. 101, 112-13 (E.D. Pa. 1973), aff'd

without opinion, 419 U.S. 807 (1974), the courts sustained the Com-

mission’s incentive per diem rules under the 1966 amendment to Sec-

tion 1(14)(a).

A-12

The district court held that to establish a priority under the Six

Months Rule the creditor had to show that its claim was for a

necessarily incurred current operating expense of the railroad,

that it accrued within the six months preceding the filing of

the reorganization petition, and that the goods or services

were furnished in the expectation of payment from current

railway operating revenues and not in reliance on the

railroad’s general credit. 468 F. Supp. at 1002. The court held

further that the creditor had to show that there existed a fund

in which qualifying six months claims would have a priority,

that is, a “current debt (or expense) fund” comprised of cur-

rent earnings of the six months period and during the

reorganization or, absent a surplus of such earnings, corpus of

the reorganization estate to the extent that such earnings have

been diverted to it for the benefit of the railroad’s

mortgagees.'* Jd. at 1002-1005. The court concluded from the

evidence that, treating depreciation as properly deductible in

determining the amount of surplus earnings available for a

“current debt fund,” no surplus revenues had accrued either in

the six months preceding the filing of the reorganization peti-

tion or during the reorganization proceeding; that, in addi-

tion, contributions to railway operating income and to the

reduction of railway operating expenses had been made from

the proceeds of sales of mortgaged property and from sales of

scrap derived from mortgaged property; and that, finally,

even if the net railway operating deficit for the relevant

period, $42.5 million, were reduced by disallowing capital ex-

penditures for property and improvements of $12.9 million,

payments of pre-reorganization secured obligations of $5.6

‘4 The district court held that Six Months Rule creditors were not

entitled to a priority in unmortgaged assets; the court declined to

follow dicta indicating a contrary assumption in In re New York,

N.H. & H. R.R., 278 F. Supp. 592, 598 (D. Conn. 1967), aff'd, 405

F.2d 50 (2d Cir. 1968), cert. denied, 394 U.S. 999 (1969), and in In

re Penn Central Transp. Co., 458 F. Supp. 1234, 1321 n. 81 (E.D.

Pa. 1978). 468 F. Supp. at 1007-08.

A-13

million, and estimated six months claims of $3 million, there

would remain a net railway operating deficit of $21 million

and an adjusted deficit in income available for fixed charges of

$11.7 million. Id. at 1005-07. The district court rejected the

claim for priority under the “Necessity of Payment” rule on the

ground that the rule was not one of priority but of payment,

and that it is inapplicable where, as in the present case, no

creditor claiming under the rule had demanded payment of its

claim as a condition to providing goods or services to the deb-

tor, and the trustees never sought authority to pay the cl...ms.

Id. at 1008.

A

The Six Months Rule was recognized but not given precision

of definition in one sentence in Section 77(b) of the

Bankruptcy Act, 11 U.S.C. § 205(b) (1976):

For all purposes of this sect‘on unsecured claims, which

would have been entitled to priority if a receiver in equity

of the property of the debtor had been appointed by a

Federal court on the day of the approval of the petition,

shall be entitled to such priority and the holders of such

claims shall be treated as a separate class or classes of

creditors.'®

The Six Months Rule emerged out of the practice of in-

itiating railroad receiverships with an order appointing a

receiver and authorizing or directing him to pay from

operating receipts certain expenses incurred in the period im-

mediately preceding the receivership. Thus the 1867 receiver-

ship order in Gurney v. Atlantic & Great Western Ry., 58

N.Y. 358 (1874), directed the receiver to pay and discharge out

'® When first enacted in 1933, 47 Stat. 1474, the provision ap-

peared in Section 77(c), and the first part read:

For all purposes of this section claims against a railroad cor-

poration which would have been entitled to priority over ex-

isting mortgages if a receiver . . .

The language of the 1978 Act, 11 U.S.C. § 1171(b), is the same in

substance as that of Section 77(b).

A-14

of the balance of receipts, after paying the expenses of main-

taining and operating the road, arrearages owing to laborers

and employees for work in connection with the railway and

such sums as were actually due for material and supplies fur-

nished for the use of the company’s railways. No general prin-

ciple, analogous to that in admiralty, was thought to give

priority to the last creditors who furnished necessary repairs

and supplies to a railroad. Galveston, H.vH. R.R. v.

Cowdrey, 78 U.S. (11 Wall.) 459, 480-82 (1871). As the court

said in Duncan v. Mobile & O.R.R., 8 F.Cas. 17, 19 (C.C.

S.D. Ala. 1876) (No. 4,137):

The fact that the floating debt was contracted in good

faith for the benefit of the railroad company’s property,

and therefore for the benefit of the bondholders, is true of

perhaps all such debts. But that does not give the floating

debt creditors any ground upon which to claim that their

debt should be paid first.

Nevertheless, receivership orders continued to authorize pay-

ment of wage and supply claims that accrued over various

periods, ranging up to eight months before receivership. E.g.

Skiddy v. Atlantic M. & O.R.R., 22 F. Cas. 274, 279-80

(C.C.E.D. Va. 1879) (No. 12,922) (reciting terms of 1876

receivership order); Taylor v. Philadelphia & Reading Co., 7

F. 377 (C.C.E.D. Pa. 1880) (reviewing terms of several pre-

Fosdick receivership orders). On the eve of Fosdick v. Schall,

99 U.S. 235 (1879), the practice of allowing payment for

operating expenses of the pre-receivership period was stated in

broad terms in Turner v. Indianapolis, B. & W. Ry., 24 F.

Cas. 366 (C.C.D. Ind., S.D. Ill. 1878) (No. 14,258); the court

observed that generally railroads were dilapidated when

receivership started, the first receipts were used to rehabilitate

the road, and the pre-receivership claims for labor and sup-

plies were paid by later order; the court emphasized that a

railway is a matter of public concern and that public as well as

private interests require its continued operation. The court

said that its experience

A-15

. . . has satisfied it that practically, it would be well nigh

impossible, looking at things as they actually exist, to

operate the roads by receivers without some allowance

for claims of the character mentioned, existing at the time

of their appointment, and that the limitation already

stated [i.e., to six months, by analogy to the Illinois lien

statute] is not an unreasonable one, in view of all the cir-

cumstances.

24 F.Cas. at 367. But the court in Turner thought it desirable

that the bar obtain from the Supreme Court a decision enun-

ciating some just principle that might be a guide in such cases.

Fosdick v. Schall, one of three cases argued and decided

together, '® is said to have been decided “after a general invita-

tion had been extended to the members of the bar of [the

supreme] court interested in like cases, to present briefs on the

questions arising in that case.” See Atkins v. Petersburg R.R.,

2 F.Cas. 90, 92 (C.C.E.D. Va. 1879) (No. 604).

Fosdick v. Schall rejected a conditional vendor’s claim for

“rent” of gondola cars for the six months preceding and several

months following receivership for a number of very sufficient

reasons. But the Court sought to establish a basis in principle

for the payment of certain pre-receivership claims. The Court

commenced by saying that a court, asked by a mortgagee to

appoint a receiver in a mortgage foreclosure suit

. . in the exercise of a sound judicial discretion, may, as

a condition of issuing the necessary order, impose such

terms in reference to the payment from the income dur-

ing the receivership of outstanding debts for labor, sup-

plies, equipment, or permanent improvement of the

mortgaged property as may, under the circumstances of

the particular case, appear to be reasonable.

'* The two cases argued with Fosdick v. Schall did not deal with

the Six Months Rule, but followed Fosdick v. Schall in holding that

the lien of the railroad mortgage did not extend to cars, Fosdick v.

Car Company, 99 U.S. 256 (1879), or locomotives, Huidekoper v.

Locomotive Works, 99 U.S. 258 (1879), purchased under contracts

of conditional sale.

A-16

99 U.S. at 251-52.'7 Noting that a railroad foreclosure case is

rarely completed without concessions by the parties from their

strict legal rights, that much of railroad business is done on

credit, and that often debts for “labor, supplies, equipment

and improvements” are deferred so that bond interest may be

paid and disastrous foreclosure postponed, the Court con-

tinued:

In this way the daily and monthly earnings, which or-

dinarily should go to pay the daily and monthly expenses,

are kept from those to whom in equity they belong, and

used to pay the mortgage debt. The income out of which

the mortgagee is to be paid is the net income obtained by

deducting from the gross earnings what is required for

necessary operating and managing expenses, proper

equipment, and useful improvements. Every railroad

mortgagee in accepting his security impliedly agrees that

the current debts made in the ordinary course of business

shall be paid from current receipts before he has any

claim upon the income. If for the convenience of the mo-

ment something is taken from what may not improperly

be called the current debt fund, and put into that which

belongs to the mortgage creditors, it certainly is not

inequitable for the court, when asked by the mortgagees

to take possession of the future income and hold it for

their benefit, to require as a condition of such an order

that what is due from the earnings to the current debt

shall be paid by the court from the future current receipts

before anything derived from that source goes to the

mortgagees.

Id. at 252-53. Saying that if the mortgagee sought the extraor-

dinary equitable relief of receivership, it had to do equity in

order to get equity, the Court continued:

\7 The 1875 receivership order in the Fosdick foreclosure directed

the receiver to pay all debts due for labor and services rendered

within the preceding three months and all debts for “engines, iron,

wood, supplies, cars, or other property purchased within said period

of three months for the use of the company.”

A-17

We think, also, that if no such order is made when the

receiver is appointed, and it appears in the progress of the

cause that bonded interest has been paid, additional

equipment provided, or lasting and valuable im-

provements made out of earnings which ought in equity

to have been employed to keep down debts for labor, sup-

plies, and the like, it is within the power of the court to

use the income of the receivership to discharge obliga-

tions which, but for the diversion of funds, would have

been paid in the ordinary course of business. This, not

because the creditors to whom such debts are due have in

law a lien upon the mortgaged property or the income,

but because, in a sense, the officers of the company are

trustees of the earnings for the benefit of the different

classes of creditors and the stockholders; and if they give

to one class of creditors that which properly belongs to

another, the court may, upon an adjustment of the ac-

counts, so use the income which comes into its own hands

as, if practicable, to restore the parties to their original

equitable rights. While, ordinarily, this power is

confined to the appropriation of the income of the

receivership and the proceeds of moneyed assets that have

been taken from the company, cases may arise where

equity will require the use of the proceeds of the sale of

the mortgaged property in the same way. Thus it often

happens that, in the course of the administration of the

cause, the court is called upon to take income which

would otherwise be applied to the payment of old debts

for current expenses, and use it to make permanent im-

provements on the fixed property, or to buy additional

equipment. In this way the value of the mortgaged pro-

perty is not unfrequentiy' materially

increased . . . . Under such circumstances, it is easy to

see that there may sometimes be a propriety in paying

back to the income from the proceeds of the sale

A-18

what is thus again diverted from the current debt fund in

order to increase the value of the property sold. The same

may sometimes be true in respect to expenditures before

the receivership. No fixed and inflexible rule can be laid

down for the government of the courts in all cases.

Id. at 253-54. The Court emphasized that the power to com-

pensate for diversions from the “current debt fund” rests on

the fact that mortgage creditors have “got possession” of what

in equity belongs to all or some of the general creditors:

It follows that if there has been in reality no diversion,

there can be no restoration; and that the amount of

restoration should be made to depend upon the amount

of the diversion.

Fosdick’s principle, then, is one of mortgage law: that the

mortgagee’s interest attaches to net income, which arises only

after the payment from gross earnings for all necessary

operating and managing expenses, proper equipment, and

useful improvements, and that, in consequence, to the extent

that before or during receivership bonded interest has been

paid, additional equipment provided, or lasting and valuable

improvements in the mortgaged property have been made out

of earnings which ought in equity to have been used to pay

debts for labor, supplies and the like, the receivership court

can use receivership income or, in some cases, the proceeds of

sale of the mortgaged property, to pay the debts that, but for

the diversion of funds, would have been paid in the ordinary

course of business. Hale v. Frost, 99 U.S. 389 (1879), was

decided later in the same term on the authority of Fosdick but

without discussion; it approved the payment from net income

earned during the receivership of pre-receivership claims for

repair parts to equipment and for supplies furnished to the

railroad’s machinery department. The report is silent concern-

ing any “diversion” of earnings to the advantage of the

mortgagee before or during the receivership.

Atkins v. Petersburg R.R., supra, professed reliance on

A-19

Fosdick, but approved the re-payment from income of the

receivership of an advance made before receivership to pay ar-

rears of wages in order to avert a strike. There was no

reference to “diversion.” The court said that:

. . . it would be difficult to draw a distinction between

the principles under which a court authorizes a receiver

to make necessary expenses for operating a railroad and

keeping it in a safe condition, and the principles em-

bodied in the language quoted from the opinion of the

supreme court, relating to sundry expenses of the railroad

companies incurred before the appointment of

receivers . . . . It is enough for us that no court has ever

refused to issue [receiver's] certificates when it was

necessary for repairing the road or keeping it agoing as a

safe road; and if it may authorize such expenditures by a

receiver, it may pay them if they have been made by the

company before the appointment of a receiver.

2 F. Cas. at 94. And in Taylor v. Philadelphia & Reading

R.R., supra, the court similarly cited Fosdick as justifying a

broad order permitting payment from income of claims for

“labor, materials, etc., furnished for the operation of the road

within five months” preceding receivership, 7 F. at 377-78,

and as authorizing the issuance of receiver’s certificates for the

amounts involved so that the receivers could defer payment in

case they found it necessary to apply earnings to protect

valuable investments of the railroad.

Miltenberger v. Logansport, C. & S.W. Ry., 106 U.S. 286

(1882), did not cite Fosdick. The critical issues in the case

related to the circuit court’s action in authorizing substantial

capital expenditures to be incurred, in giving them priority

over the first mortgage in a suit brought to foreclose the second

mortgage on the road, and in effecting payment for the capital

expenditures through first lien receiver’s certificates

authorized and sold before the first mortgagees sought to

foreclose. The Court cited only Wallace v. Loomis, 97 U.S.

A-20

146 (1878), the cornerstone case on receiver's certificates, and

Barton v. Barbour, 104 U.S. 126, 136 (1881), which cited

Wallace v. Loomis for the general proposition that a court of

equity may and in most cases ought to authorize the receiver to

keep the road in repair and to manage and use it in the or-

dinary way until it can be sold to the best advantage of all in-

terested. Miltenberger approved the circuit court’s order

directing immediate payment of interline claims for materials,

repairs, and ticket and freight balances, some of which had ac-

crued more than ninety days preceding the receivership, and

charging the payments upon the earnings of the road “as with

a first lien prior to all incumbrances upon” the railroad. The

Court pointed out that the receiver’s petition for the order

stated that “payment of that class of claims was indispensable

to the business of the road, and that, unless the receiver was

authorized to provide for them at once, the business of the

road would suffer great detriment.” 106 U.S. at 311.'* The

Court said:

Many circumstances may exist which may make it

necessary and indispensable to the business of the road

and the preservation of the property, for the receiver to

pay pre-existing debts of certain classes out of the earn-

ings of the receivership, or even the corpus of the

property, under the order of the court, with a priority of

lien. Yet the discretion to do so should be exercised with

‘8 The master who passed on the claims “disallowed several items

in the receiver's accounts, claimed under the above heads, where the

claims were made on the ground that the creditors threatened not to

furnish any more supplies on credit unless they were paid the ar-

rears.” 106 U.S. at 311. The next sentence appears to refer to the

master’s action in disallowing the claims rather than to the receiver's

action in paying them. “His action, sanctioned by the court, in

allowing items within the scope of the orders of the court appears to

have been careiul, discriminating and judicious, so far as the facts

can be arrived at from the record. It cannot be affirmed that no

items which accrued before the appointment of a receiver can be

allowed in any case.” Ibid.

A-21

very great care. The payment of such debts stands, prima

facie, on a different basis from the payment of claims

arising under the receivership, while it may be brought

within the principle of the latter by special cir-

cumstances. It is easy to see that the payment of unpaid

debts for operating expenses, accrued within 90 days, due

by a railroad company suddenly deprived of the control

of its property, due to operatives in its employ, whose

cessation from work simultaneously is to be deprecated,

in the interests both of the property and of the public,

and the payment of limited amounts due to other and

connecting lines of road for materials and repairs, and for

unpaid ticket and freight balances, the outcome of in-

dispensable business relations, where a stoppage of the

continuance of such business relations would be a pro-

bable result, in case of non-payment, the general conse-

quence involving largely, also, the interests and accom-

modation of travel and traffic, may well place such

payments in the category of payments to preserve the

mortgaged property in a large sense, by maintaining the

good-will and integrity of the enterprise, and entitle them

to be made a first lien.

106 U.S. at 311-12. Miltenberger is concerned, not with the

“diversion” precept of Fosdick, but with the more general

authority of the receivership court to accord priority status to

pre-receivership claims in order to prevent the stoppage of a

business impressed with the public interest. The case em-

phasizes the power of the court to effect payment of pre-

receivership claims and the validity of the means it chooses to

effect payment; the analysis is not in terms of the property in-

terest of operating expense creditors in operating revenues and

the limitation of the mortgagee’s rights to net income, but it is

in terms of paying those pre-receivership expenses that are

brought within the principle of administrative expenses by

their relation to the continuance of the railroad business.

A-22

The cases in the Supreme Court involving payment of pre-

receivership operating expense claims which were decided in

the twenty-odd years between Miltenberger and Gregg v.

Metropolitan Trust Co., 197 U.S. 183 (1905), preserved the

“diversion” principle expressed in Fosdick without losing sight

of the separate Miltenberger approach. Union Trust v.

Souther, 107 U.S. 591 (1883), allowed a pre-receivership

supply claim on Fosdick “diversion” grounds; but the Court

noted also that the receivership court’s “right to impose terms

does not depend alone on whether current earnings have been

used to pay the mortgage debt, principal or interest instead of

current expenses” (107 U.S. at 594), citing Miltenberger, and

it indicated that the bondholders’ election, in their own in-

terest, to leave the loss-making company in possession to

operate the road after there had been a default entitling the

mortgage bondholders to take possession justified the court’s

use of receivership income to pay the expenses of pre-

receivership operation.'? Burnham v. Bowen, 111 U.S. 776

(1884), approved the payment of claims for coal furnished for

the railroad’s locomotives in the months preceding receiver-

ship. The Court emphasized that the bondholders permitted

the company to possess and manage the road after default and

observed that the “maintenance of the road and the prosecu-

tion of its business were essential to the preservation of the

security of the bondholders.” 111 U.S. at 780. In Burnham the

order appointing the receiver did not provide for the payment

of pre-receivership operating expenses; however, the Court

held that the use of receivership income to pay fixed charges on

certain railroad structures, increasing the bondholders’ security

19 Union Trust Co. v. Walker, 107 U.S. 596 (1883), decided with

Souther, held that a purchaser of claims of “six months” creditors

could enforce the claims, not because the creditors had a lien on the

property and income but “because in equity the earnings of the com-

pany constitute a fund for the payment of the expenses which their

claims 0g 8 before any income arises which ought to be ap-

plied to the discharge of the mortgage debt.” 107 U.S. at 596.

A-23

at the expense of the labor and supply creditors, was a “diver-

sion” within Fosdick. “So far as current-expense creditors are

concerned, the court should use the income of the receivership

in the way the company would have been bound in equity and

good conscience to use it if no change in the possession had

been made.” 111 U.S. at 782. The Court in Union Trust Co. v.

Illinois Midland Ry., 117 U.S. 434 (1886), was primarily con-

cerned, as in Miltenberger, with the validity and priority of

receiver's certificates, but it affirmed the grant of priority in

the corpus of the property over the bonds for wages due for the

six months preceding receivership. 117 U.S. at 464-65. To an

objection that the order appointing the receiver provided only

for payment of current operating expenses from current in-

come the Court answered that “the terms of these orders do

not impair or exclude the ample authority which the court

would otherwise have, and otherwise has, to order the claims

in question to be paid out of the property itself, with priority.”

Id. at 465. Virginia & A. Coal Co. v. Central Railroad &

Banking Co., 170 U.S. 355 (1898), affirmed a decree directing

that a debt for locomotive coal delivered in the months

preceding receivership be paid out of the current earnings in

the hands of the receiver; the Court relied on language from

Burnham v. Bowen, supra, and Miltenberger, as expressing an

“equitable doctrine” the “dominant feature” of which was

that a “superior equity” as against the mortgage bondholders,

in income earned before and after the receiver's appointment,

arises in favor of materialmen who furnish supplies essentially

necessary to the continued operation of the railroad in the ex-

pectation of payment from current earnings. 170 U.S. at

367-68. The Court emphasized that, independently of the ex-

istence of any pre-receivership “diversion” of income, the

equity of the coal company for payment out of income

survived into the receivership, attached to the property in the

receiver's possession, and, if a surplus of income arose in the

receivership, entitled the coal company to demand that the

A-24

surplus be applied to payment of its claim. Id. at 369. The ex-

istence of that surplus the court found implicit in the fact that

during receivership the road’s receivers “expended for bet-

terments on its railroad lines from the income of the roads dur-

ing the receivership a sum much larger than the entire claim”

of the coal company. Id. at 367-70. Southern Ry. v. Carnegie

Steel Co., 176 U.S. 257 (1900), affirmed a decree according

priority payment for rail furnished during a period in excess of

six months preceding receivership; the Court inferred that the

rail was furnished for ordinary safe maintenance of existing

lines;*° the Court found that current receipts that should have

been applied to payment of the steel company’s claim had

been applied during the receivership for the benefit of the

bondholders by paying interest, sinking fund, and car trust

debts and for construction and equipment.

Circuit court decisions, influenced by Miltenberger, clearly

went beyond the Fosdick principle. E.g., Dow v. Memphis &

L. R.R., 20 F. 260, 267 (C.C.E.D, Ark. 1884); Blair v. St.

Louis, H. & K. R.R., 22 F. 471, 472-73 (C.C.E.D. Mo.

1884). One case, in the Fourth Circuit Court of Appeals,

in which Chief Justice Fuller wrote for the court, allowed

the payment from the proceeds of the foreclosure sale of

the road of interline claims for freight and freight balances

that accrued before the appointment of the receiver. Finance

Co. v. Charleston, C. & C. R.R., 62 F. 205 (4th Cir. 1894).

There were no surplus earnings before or during the receiver-

ship, nor had there been any diversion of income. The court

relied on the broad terms of the order appointing

2 A claim for extraordinary quantities of rails furnished before

the receivership but outside the ordinary course of business, and for

construction rather than repair, was not accorded priority.

Lackawanna Iron & Coal Co. v. Farmers’ Loan & Trust Co., 176

U.S. 298, 315-16 (1900); Hale v. Frost, supra, disapproved priority

payment for pre-receivership supplies furnished to the road’s con-

struction department while approving such payment for repair parts

and for supplies so furnished to the road’s machinery department.

A-25

the receiver, saying that it could not be construed as limited to

payment out of current earnings, “especially in view of the

condition of the road.” 62 F. at 208. Emphasizing that the

payment of such debts was related to the interest in preserving

and disposing of the property as a going concern, and to the in-

terest in the road’s discharging its public duty, the court said

that

. . such indebtedness may be given priority, not-

withstanding there may have been no diversion of in-

come, or that the order for payment was not made at the

time, and as a condition, of the receiver's appointment,

the necessity and propriety of making it depending upon

the facts and circumstances of the particular case, and

the character of the claims.

62 F. at 208.

The Supreme Court did not sweep so broadly. St. Louis, A.

& T. H. R.R. v. Cleveland, C.C. & I. Ry., 125 U.S. 658

(1888), acknowledged the authority of Fosdick, but it refused

to accord priority over the mortgage to a claim for the rental of

a leased line. The Court said that the lessor would have to

show that the rent arrearage had arisen “by the diversion and

misappropriation of the fund that ought to have been applied

to its payment to the use and benefit of the mortgage bond-

holders.” 125 U.S. at 674. To the extent that the Court im-

pliedly required a showing of diversion before the receiver-

ship, it appears to be repudiated in Virginia ¢& A. Coal Co. v.

Central Railroad & Banking Co., supra, 170 U.S. at 365, 369.

Kneeland v. American Loan & Trust Co., 136 U.S. 89 (1890),

was a case in which there were no surplus earnings before or

during the receivership, no receipts were diverted to pay mort-

gage interest or to improve the road, and the foreclosure sale

realized only a fraction of the mortgage debt; the Court held

that an unpaid conditional vendor of rolling stock, whose cars

were ordered returned to him before the foreclosure sale,

would not be granted a priority claim for the reasonable

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rental value of the cars used during the four months of their

use by a receiver appointed upon a judgment creditor's bill,

but that such a priority would be accorded to the claims for

reasonable rent for use of the cars by a successor receiver ap-

pointed at the end of the four months upon the mortgage

trustee's foreclosure bill. The Court was critical of “an idea”

which “seems to have obtained that a court appointing a

receiver acquires power to give such preference [that is,

preference over mortgage debts] to any general and unsecured

claims.” 136 U.S. at 97. But in the same year the Court in

Morgan's L. & T. R.R. & S.S. Co, v. Texas Central Ry., 137

U.S. 171, 197 (1890), although denying priority to the claim

before it, broadly restated both the Fosdick principle and that

of Miltenberger. And Kneeland v. Bass Foundry & Machine

Works, 140 U.S. 592 (1891), distinguished Kneeland v.

American Loan & Trust Co., supra, on its facts and as relating

to a contract to buy rolling stock in which the vendor reserved

title and reclaimed the rolling stock;?! the Court in Bass Foun-

dry affirmed an order for payment of claims for supplies fur-

nished during the four month period for which the earlier

Kneeland decision had rejected the reasonable rental value

claim; the Court relied on Fosdick and Miltenberger and on

Union Trust Co. v. Souther, supra. Thomas v. Western Car

Co., 149 U.S. 95 (1893), again rejected a car vendor's claim for

a reasonable rental for the pre-receivership months and cited

Kneeland v. American Loan & Trust Co., but it put the deci-

sion in large part on the ground that the terms of the contract

for the cars demonstrated that the vendor relied on the

security of the cars themselves and not on the interposition

of a court of equity.** 149 U.S. at 112. Similarly,

*1 Virginia & A. Coal Co. v. Central Railroad & Banking Co.,

supra, distinguished Kneeland v. American Loan & Trust Co.on

essentially the same ground. 170 U.S. at 370-71.

% Virginia & A. Coal Co. v. Central Railroad & Banking Co.

supra, treated Thomas as decided on the ground that the car com-

pany relied on the responsibility of the railroad company and not on

the interposition of a court of equity. 170 U.S. at 371-72.

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Penn v. Calhoun, 121 U.S. 251 (1887), and, later, Lacka-

wanna Iron & Coal Co. v. Farmers’ Loan & Trust Co., 176

U.S. 298 (1900), rejected priority claims where, in the first

case, the creditor took as security bonds of the railroad for

twice the amount of the claim, and, in the second, the creditor

had taken collateral security for part of the debt and had ex-

tended and renewed long terms of credit; in neither case could

it be found that the creditor relied on the railroad’s current

earnings for payment.

Gregg v. Metropolitan Trust Co., 197 U.S. 183 (1905), dealt

with Gregg’s claim for railroad ties delivered to the railroad in

the month preceding the receivership; they were used prin-

cipally during the receivership to maintain the railroad as a

going concern, and the claim for payment was admittedly for

a necessary operating expense incurred to keep and use the

railroad and preserve the property in fit and safe condition.

There had been no diversion of income by which the mort-

gagee had profited, or otherwise, and, the Court concluded,

the circumstances affecting the claim were not “special.” The

Court said that the claim could not be charged on the corpus

of the fund unless there was

.. @ general rule that such claims for supplies are

entitled to precedence over a lien expressly created by a

mortgage recorded before the contracts for supplies were

made.

197 U.S. at 186-87. The Court said that

. . we are of opinion, for reasons that need no further

statement, Kneeland v. American Loan & Trust Co., 136

U.S. 89, 97, that the general rule is the other way, and

has been recognized as being the other way by this court.

197 U.S. at 187. Of the allowance of pre-receivership claims in

Miltenberger, the supplier's principal reliance, the Court said:

The ground of such allowance as was made was not

merely that the supplies were necessary for the preserva-

tion of the road, but that the payment was necessary to

the business of the road — a very different proposition.

A-28

Ibid. Other cases were distinguished as related to the special

principle of Miltenberger, or as involving diversion of earn-

ings, and cases like Union Trust Co. v. Souther, supra, where

the receivership order authorized payment of six months

claims for labor and supplies out of income, were explained as

standing |

. . on the special theory which has been developed with

regard to income, and afford no authority for a charge on

the body of the fund.

Id. at 188. The cases the Court cited as developing the “special

theory” with regard to income are Fosdick, Burnham v.

Bowen, supra, Morgan’s L. & T. R.R. & S.S. Co. v. Texas

Central Ry., supra, Virginia & A. Coal Co. v. Central

Railroad & Banking Co., supra, and Southern Ry. v. Carnegie

Steel Co., supra. The Court added:

It is agreed that the petitioner may have a claim against

surplus earnings, if any, in the hands of the receiver, but

that question is not before us here.

ibid. The original receivership order in Gregg authorized the

receiver to pay material and supply claims which accrued not

more than six months before the receivership. Of this provision

the Court said:

But even if any words in the order authorized a charge on

the corpus in order to pay claims like that of the peti-

tioner, or a payment of them except from income, cer-

tainly there are none requiring it, or going beyond giving

authority to the receiver if, for instance, he thought

payments of previous debts necessary to the continued

operation of the road.

Id. at 188-89.

Gregg is the last extended opinion on the Six Months Rule,

and on the Necessity of Payment rule in the Supreme Court.”

*° Baker v. Gold Seal Liquors, Inc., 417 U.S. 467, 471 n. 5 (1974),

refers to the priority language of Section 77(b), to Gregg as to that

priority, and to St. Louis & S.F.R.R. v. Spiller, 274 U.S.

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The dissent clearly states the more inclusive principle that the

Court’s majority seemed to reject:

And that principle has its foundation in the public in-

terests. A railroad, from its nature and public respon-

sibilities, must be kept a going concern. This is the

supreme necessity, and affords the test of the equity in-

voked for the claims for supplies. It cannot depend upon

diversion of income or upon the existence of income. It

cannot be confined to debts contracted during the

receivership. It may extend to debts contracted before the

appointment of the receiver. But recognizing that there

must be some limitation of time, the courts have fixed six

months as the period within which preferential claims

may accrue. And there is no infringement of the rights of

mortgagees. Their interests are served, as those of the

public are, by keeping the railroad in operation. The

limitations of the rule dependent upon the conditions

under which supplies are furnished are expressed in

Virginia & Alabama Coal Co. v. Central Railroad ¢>

Banking Co., 170 U.S. 355, and in Southern Ry. Co. v.

Carnegie Steel Co., 176 U.S. 257.

Id. at 196.

Carbon Fuel Co. v. Chicago, C. & L.R.R., 202 F. 172 (7th

Cir. 1912), a case in which there was neither surplus earnings

nor any diversion of income, interpreted Gregg as limiting

Miltenberger to the cases in which not the supply or service

furnished to the railroad but payment by the receiver is essen-

tial to the continuance of the business of the railroad. See, to

the same effect, Taylor v. Delaware ¢& E.R.R.. 213

304, 311 (1927), as stating the general six months limitation on

Fosdick claims. New York Dock Co. v. 8.8. Poznan. 274 U.S. 117,

121 (1927), stated the Fosdick principle as requiring payment for

supplies furnished before receivership where the debtor's or

receiver's use of them “has produced the earnings: the Court con-

sidered the result to flow from the courts’ self-imposed duty to re-

quire that, before distribution, expenses that have contributed to the

preservation or creation of the fund in its custody should be paid.

A-30

F. 622, 624 (2d Cir. 1914), Moore v. Donahoo, 217 F. 177,

180-83 (9th Cir. 1914), cert. denied, 235 U.S. (1915), Chicago

dr A.R.R. v. United States ¢ Mexican Trust Co., 225 F. 940,

945 (8th Cir. 1915), and Crane Co. v. Fidelity Trust Co., 238

F. 693, 695-96 (9th Cir. 1916), cert. denied, 244 U.S. 658

(1917).

Pennsylvania Steel Co. v. New York City Ry., 216 F. 458,

470 (2d Cir. 1914), however, referred to Gregg as the “most

striking example of the uncertainty which surrounds the whole

subject.” The Court allowed pre-receivership supply claims

against unmortgaged assets of the railway in the absence of

any “current debt fund.” The court said:

If the preference is properly rested on public policy we do

not see how it can be restricted to current earnings. Such

claimants should be preferred over all general creditors,

and if current earnings are not sufficient to secure the

preference it should be extended to the company’s un-

mortgaged assets.

216 F. at 471. Johnson Fare Box Co. v. Doyle, 250 F.2d 656,

657 (2d Cir.), cert. denied, 357 U.S. 938 (1958), paraphrased

with apparent approval, a district court’s assertion™ that it is —

very difficult to discover any principle which would account

for all the decisions, and that the only generality obtainable

from the cases is that the decision in each depended on its

special facts.

Southern Ry. v. Flournoy, 301 F.2d 847 (4th Cir. 1962), re-

jected the theory that Gregg severly limited Miltenberger, 301

F.2d at 852, and emphasized that, from Miltenberger for-

ward, “public concern with the continued operation of the

railroad has been a factor supporting the priority accorded

% In re Third Avenue Transit Corp., 138 F. Supp. 623 (S.D. N.Y.

1955), aff'd on opinion below, 230 F.2d 425 (2d Cir. 1956). Third

Avenue Transit treated pre-receivership operating expense claims as

enjoying priority only in net income of the railroad and of the

receiver.

A-31

general creditors.” Id. at 853.25 The court accorded interline

traffic balances and other interline accounts a priority in cor-

pus over the mortgage bondholders. The court treated the

time limitation, generally six months, as preventing operating

claims from undermining the mortgage through secret liens.

Ibid.

In re New York, N.H. & H. R.R., 278 F. Supp. 592 (D.

Conn. 1967), aff'd, 405 F.2d 50 (2d Cir. 1968), cert. denied,

394 U.S. 999 (1969) (“New Haven”), saw the Six Months Rule

as one that over the years had been inconsistently stated and

applied in decisions that lacked any harmonizing principle, so

that “ambiguities must generally be resolved against those

claiming the benefit of the rule.” 278 F. Supp. at 595-96. The

rule of Fosdick was summarized:

Revenues accruing from operations should be paid first to

the operations creditors whose materials and services

made those revenues possible; and only after all such

operational claims have been paid, should the balance be

available for the benefit of the mortgagees. If any

operating revenues do improperly get into the hands of

the mortgagees, equity requires that those revenues be

restored to the operations creditors by the mortgagees

yielding them a priority. (Footnote omitted.)

278 F. Supp. at 597-98. The “surplus earnings” element of the

“current debt” or “expense” fund of Fosdick the court defined

as the sum of all operating revenues accrued during the six

months period and during reorganization and which have ac-

tually been received or taken over by the trustee less deprecia-

tion and all operating expenses that have actually

*° The court noted its earlier statement in Virginia Passenge '>

Power Co. v. Lane Bros., 174 F. 513, 516 (4th Cir. 1909), tha: in

certain cases preferential payments have been allowed out of corpus.

“One of the foundations of the principle is that the public interest re-

quires that a railroad must be kept a ‘going concern.’ It does not de-

pend, therefore, upon the diversion, or even upon the existence of

income.”

A-32

been paid, or are payable by the trustee, or wh'ch constitute

administrative expenses.”° Id. at 599. In New Haven the court

found neither “surplus earnings,” as it defined them, nor “in-

come availab’ » for fixed charges,” nor unmortgaged assets, nor

any diversion to the mortgagees’ advantage of current

revenues to which the operations creditors were entitled, since

neither the depreciation allowances nor payments on equip-

ment trust and conditional sales obligations could be con-

sidered such diversions. Id. at 600-05. The court concluded

that the six months creditors could not be accorded a priority

in corpus over the mortgage bondholders. The court con-

sidered that Flournoy had confused and merged the Six

Months Rule and the Necessity of Payment rule, “first enun-

ciated in Miltenberger,” by making-necessity of payment a re-

quirement of the Six Months Rule and eliminating diversion as

a requirement of corpus invasion,” directly contrary to Gregg.

Id. at 602 n. 15. The court, on the supposed authority of

Gregg, reduced Miltenberger to the case in which immediate

payment is necessary to avert a threat to continued operation

of the road, and characterized as “absurd” reliance on the

Necessity of Payment rule by creditors whose claims had gone

unpaid during six years of operation in reorganization. Id. at

602-03 n. 15.”

In re Tennessee Central Ry., 316 F. Supp. 1103 (M.D.

Tenn. 1970), vacated on other grounds, 463 F.2d 73 (6th

Cir.), cert. denied, 409 U.S. 893 (1972), accorded a

* The court differentiated its treatment of the six months earn-

ings (“gross operating income” taken over and collected by the

trustee less expense items payable on the date the petition was filed

which the trustee was required to pay) from the scheme referred to

in Guaranty Trust Co. v. Albia Coal Co., 36 F.2d 34, 36 (8th Cir.

1929), that is, “gross operating income taken over or collected by the

receiver less taxes accrued.” 278 F. Supp. at 599.

*? The Court of Appeals affirmed, 405 F.2d 50 (2d Cir. 1968),

saying that the “current expense fund” for six months claims “is to be

computed by deducting operating expenses and depreciation from

current revenues.” 405 F.2d at 52.

A-33

priority over mortgage bonds to claims for interline freight

balances; the court found that the extensions of credit that the

balances reflected averted a complete shutdown of the

railroad’s operation and facilitated the sale of the railroad to

three other carriers which continued to operate it. The court

relied in part on the special character of interline freight

balances as collections for which the road had to account to

connecting carriers, 316 F. Supp. at 1110, and ultimately on

the circumstance that the connecting carriers’ extension of

credit preserved the corpus of the mortgaged railroad by main-

taining it as a “going concern” and enabled the area formerly

served by the railroad to enjoy continued rail services. Id. at

1111. The court argued that Gregg seemed to indicate that,

where special circumstances or equities favored six months

claimants, their claims might be allowed a priority in assets

even in the absence of a diversion of income to the secured

creditors’ benefit. Ibid.

In re Penn Central Transp. Co., 458 F. Supp. 1234, 1319-28

(E.D. Pa. 1978), relied principally on New Haven as a distilla-

tion of a large number of earlier cases; the “current debt

fund,” the court said, included surplus income of the six

months preceding reorganization as well as for the reorganiza-

tion period, inclusive of non-rail income customarily made

available to support rail operations; generally accepted

railroad accounting principles were held applicable, deprecia-

tion being deducted from operating revenues in computing the

“current expense fund.” The deficit in Penn Central’s income

for the six months period and during reorganization exceeded

the depreciation for the same period by very much more than

the aggregate of the six months claims; since there was no

earnings component for the Fosdick “current debt fund,” and

capital improvements for the same period (nearly four times

the amount of the six months claims) were far less than the

depreciation for the period, the court concluded that there

A-34

was neither enhancement of property nor “diversion.”** 458 F.

Supp. at 1325. The court rejected Flournoy as “discredited”

and as impermissibly combining the six months and necessity

rules, and treated the Necessity of Payment rule as stating the

circumstance in which a court could justify entry of an order

authorizing payment of a pre-reorganization creditor who in-

voked the sanction of refusal to furnish further supplies or ser-

vices as a means of obtaining payment of his old claim.” Id. at

1326-27.

B.

The persistence of the Six Months Rule and the persistence

of two distinct attitudes toward it, the one receptive and

*® The trustee evidently argued that $770 million spent on capital

improvement should not be considered in the “diversion” calcula-

tion because the expenditure did not exceed the increase in deprecia-

tion reserve through charges to income in the period. The six months

creditors apparently argued that this was “double dipping,” taking

depreciation into account twice, once to compute surplus earnings

and a second time to absorb the capital expenditures’ effect as a

diversion to the advantage of the mortgage bondholders. The court

sought to meet the argument with the statement that, if the amount

of depreciation charged had actually been spent to make good the

depreciation, that outlay “would not thereby have enhanced the

mortgaged assets at the expense of the six months claimants.” 458 F.

Supp. at 1375. That, however, is, logically, a restatement of the

conclusion that depreciation should be deducted in computing the

earnings component of the Fosdick “current debt fund.” The court

met the argument directly by concluding that even adding back the

depreciation did not produce Fosdick surplus earnings, leaving the

capital expenditures in large part unexplained, however. Ibid.

2° The court said that In re Penn Central Transp. Co., 467 F.2d

100 (3d Cir. 1972), correctly stated the Necessity of Payment doc-

trine. The appellate court summarized the Necessity of Payment

rule, an “exception to the normal deferment of payment of pre-

reorganization claims until their disposition can be made part of a

plan of reorganization,” as permitting immediate payment where

creditors will not supply services or material essential to the conduct

of the business until their pre-reorganization claims are paid. 467

F.2d at 102 n.1. The appellate court intimated that a reor tion

court might well have power to compel a continuance of a service

pe to be withheld in order to coerce payment of an old claim.

Id. at 102.

A-35

expansive, the other insistent upon its limitations and narrow

sphere of operation, suggest the co-existence of two essentially

different principles, neither of which limits the operation of

the other, and both of which may operate in the same

reorganization to embrace many of the same claims. The

Fosdick rule is one of equitable restitution; in receivership the

mortgagee must restore to operating creditors revenues

diverted to the mortgagee’s advantage; the lien of the mort-

gage extends to railroad revenue or income only when posses-

sion of the road and its income is demanded, pursuant to the

mortgage terms after default, Fosdick, supra, 99 U.S. at 253;

Gilman v. Illinois and Mississippi Telegraph Co., 91 U.S. 603,

617 (1876); Galveston, H. & H. R.R. v. Cowdrey, supra, 78

U.S. (11 Wall.) at 482-83, and the lien reaches only what re-

mains of revenue after payment of all current operating ex-

penses. Burnham v. Bowen, supra, 111 U.S. at 782-83. The

receivership furnishes the occasion and judicial means of effec-

ting the equitable restitution, but mortgage law, not the

special principles governing the administration of railroad

receiverships, is the source of the right to restitution.

The second rule, elaborated and applied in Wiltenberger, is

peculiarly a principle of railroad receivership law, reflecting

the view that a “railroad is authorized to be constructed more

for the public good to be subserved, than for private

gain. ...It is...a matter of public right by. which the

courts, when they take possession of the property, authorize

the receiver . . . in whose charge it is placed to carry on in the

usual way those active operations for which it was designed

and constructed, so that the public may not receive detriment

by the non-user of the franchises.” Barton v. Barbour, 104

U.S. 126, 135 (1881). Miltenberger, relied on Wallace v.

Loomis, supra, 97 U.S. at 162-63, for the authority to issue

receiver's certificates superior to the first mortgage lien to

finance the payment of pre-receivership operating expenses,

administrative expenses of the receiver and costs of new

A-36

construction, and relied on Barton v. Barbour for the public

interest justification for continued operation of the railroad as

a going business. 106 U.S. at 309-12. The Court said that pay-

ment of pre-receivership debts

. . where a stoppage of the continuance of such business

relations would be a probable result, in case of non-

payment, the general consequence involving largely,

also, the interests and accommodation of travel and traf-

fic, may well place such payments in the category of

payments to preserve the mortgaged property in a large

sense, by maintaining the good-will and integrity of the

enterprise, and entitle them to be made a first lien.

Id, at 312. The Court’s rationale excludes the inference that

only those creditors are entitled to priority of payment who de-

mand immediate payment as a condition of continuing to sup-

ply a service or commodity of which they are monopolists.*°

The Court was defining the classes of claims payment of which

was indispensable to the business of the road and which,

“unless the receiver was authorized to provide for them at

once, the business of the road would suffer great detriment.”

Id. at 311. The Court’s depiction of the disastrous conse-

quences of failing to pay labor claims — a work stoppage*! —

or interline claims — a stoppage of traffic interchange — is

directed to restricting the class of claims entitled to priority of

payment to claims for those goods and services that are

% As noted above, footnote 18, the special master disallowed

“several items” where the claimants threatened “not to furnish any

more supplies on credit unless they were paid the arrears.” 106 U.S.

at 311.

9! In Skiddy v. Atlantic, M. & O. R.R., supra, 22 F.Cas. at

281-82, the court, acting on such a ground, directed the receiver to

pay eight months back wages to ies employees only who con-

tinued in employment; claims of the remaining employees and

claims for materials supplied under contracts made on the eve of

receivership were denied priority. The district judge who ioined in

the Skiddy opinion evidently regarded it as overruled in its latter

aspect by Fosdick. Atkins v. Petersburg R.R., supra, 2 F. Cas. at 92.

A-37

indispensable to the continued performance of the transporta-

tion service. The point is to single out the pre-receivership ex-

penses the payment of which although it — prima facie —

may stand on a different principle from that governing pay-

ment of administrative expenses, “may be brought within the

principle of the latter by special circumstances.” Ibid. The test

is not whether the claimant has the naked power to exert

economic duress, but whether the expenses have the

characteristics of those that the receiver pays from revenue as

expenses of administration or pays out of the proceeds of the

sale of first lien receiver's certificates. E.g., Boston ¢ Maine

Corp. Trustee's Competitive Bidding Exemption, 347 1.C.C.

234, 235 (1971). (Sale of certificates “for meeting payroll and

other expenses which, if not met, would preclude continued

provision of essential railroad transportation services.”) An

early district court decision, authorizing the issuance of

receiver's certificates, summed up the principle:

It is enough for us that no court has ever refused to issue

[receiver's] certificates when it was necessary for repair-

ing the road or keeping it agoing as a safe road; and if it

may authorize such expenditures by a receiver, it may

pay them if they have been made by the company before

the appointment of a receiver.

Atkins v. Petersburg R.R., supra, 2 F. Cas. at 94.

Some decisions have, very evidently, read Gregg as reducing

Miltenberger to a Necessity of Payment holding in the starkest

economic duress form,** but Gregg is, rather, circumspect in

*® With one exception, later cases in the Supreme Court that cited

Miltenberger relied also on the equitable restitution principle of

Fosdick. Virginia & Alabama Coal Co. v. Central Railroad & Bank-

ing Co., supra, 170 U.S. at 365-66; Illinois Midland Ry., supra, 117

U.S. at 456-58; Union Trust Co. v. Souther, supra, 107 U.S. at 594.

The exception is Kneeland v. Bass Foundry & Machine Works,

supra, 140 U.S. at 596-97, where the claivn was ordered paid out of

corpus because the supplies covered by the claim “had been

necessary to the continued operation of the road, and had gone into

the general property covered by the mortgage” and “contributed to

the preservation of the property during the receivership.” Neither a

surplus of earnings nor a diversion was involved.

A-38

its treatment of Miltenberger; it preserves the ambiguity of the

Miltenberger language without explaining or applying it, and

declines to find that Gregg’s facts presented special cir-

cumstances warranting priority. The Supreme Court has since

cited Miltenberger for the principle that claims with equities

superior to the mortgagee’s “may be accorded priority in pay-

ment although they arose prior to the receivership.” Carpenter

v. Wabash Ry., 309 U.S. 23, 28 (1940).

The criterion of priority to have intrinsic validity must be

found in the nature of the claim and in the nature of the

reorganization. If the claim is for a service or supply indispen-

sable to the maintenance and operation of the railroad, and if

the railroad continues to operate while in ,eorganization, the

real difficulty is in finding a ground on which a court can

fairly deny payment of a pre-reorganization expense claim in-

distinguishable from current administration expenses that are

being paid and indistinguishable from kindred operating ex-

penses that were incurred in the ordinary course of business by

the railroad company in the months preceding reorganization

and were paid by the railroad before reorganization or were

paid thereafter by the trustees as liabilities arising out of the

operation of the railroad. If a claim has the generally accepted

characteristics of a six months claim, as stated in the district

court’s opinion, 468 F. Supp. at 1002, that is, (1) it represents

a current operating expense necessarily incurred, (2) was in-

curred within six months before the reorganization petition

was filed, and (3) the goods or services were delivered in the

expectation that they would be paid for out of current

operating revenues of the railroad, and not in reliance on the

road’s general credit,** it will inevitably be for an expense in-

distinguishable from and essentially contemporaneous with

%3 To the same effect are In re Penn Central Transp. Co., supra,

458 F. Supp. at 1321; In re New York, N.H. & H. R.R., supra, 278

F. Supp. at 596; Guaranty Trust Co. v. Albia Coal Co., supra, 36

F.2d at 35.

A-39

expenses paid by the railroad before reorganization, and will

be indistinguishable from currently paid administration ex-

penses, The singularity of the claim will not be either in the

goods or services which it represents, nor in their contribution

to the railroad’s service to the public, nor in their contribution

to the preservation of the fabric of the railroad, but only in the

fact that it will, of course, not be paid. No principle marks

current expenses paid in ordinary course on the eve of

reorganization as preferences, but denial of an equivalent

right to priority payment for expenses of the same kind

likewise incurred on the eve of reorganization introduces an

inequality of treatment that finds no justification either in the

principles on which businesses are continued in operation dur-

ing receivership, or in the mortgagee’s lien interest. The

desideratum is equality of treatment for the current operating

expenses of a railroad enterprise the operations of which have

continued without interruption of service, revenues and ex-

penses. That equality is readily achieved by recognizing ad-

ministration expenses as extending backward to the period

preceding reorganization to the extent necessary to ~ssure that

there is continuity in the payment of indispensable operating

expenses without reference to the date the petition is filed so

long as the current expenses of the pre-reorganization period

that are brought forward for payment conform to the strict

standard established for administration expenses of the current

operating class, and are not so dated as to forbid the conclu-

sion that they are in fact current. The inequity in treatment

arising out of the accidental circumstance of non-payment

before the filing of the petition is eliminated.

The hostility to “six months” claims evident in Gregg,

supra, 197 U.S. at 186-87 and New Haven, supra, 278 F.

Supp. at 596,™ is no doubt in some part a product of the

* In contrast is the support for a broad receivership principle ap-

proach successively evident in Finance Co. v. Charleston C. & C.

R.R., supra, 62 F. at 208, the dissent in Gregg, supra,

A-40

uncertain limits of the class of claims: six months is not an in-

flexible time limit, and each case “must depend largely upon

its special facts,” Southern Ry. v. Carnegie Steel Co., supra,

176 U.S. at 292; the “surplus earnings” and the quantum of

“diversion” relevant under Fosdick are puzzling concepts, id.

at 294-95; In re Penn Central Transp. Co., supra, 278 F.

Supp. at 598-601; reliance on the general credit of the railroad

seems an illusory concept, Lackawanna Iron & Coal Co. v.

Farmers’ Loan & Trust Co., 176 U.S. 298, 316-17 (1900)

(security taken upon renewal of notes given for rail); Southern

Ry. v. Carnegie Steel Co., supra, 176 U.S. at 292 (if first notes

given for rail contemplated payment from current earnings,

seller “lost no equity merely by renewing the notes”); Penn v.

Calhoun, 121 U.S. 251, 252 (1887) (bank took bonds of

railroad to secure repayment of loan). But the definition of the

class has been left to the courts by the Congress,*° and when

197 U.S. at 196, and Flournoy, supra, 301 F.2d at 851-52. The

paragraph by which Chief Justice Waite introduced the discussion

of priorities in Fosdick, supra, 99 U.S. at 251-52, is more easily

referred to the broad receivership principle later elaborated in

Miltenberger than to the narrow principle of equitable restitution

that the following paragraphs of the opinion outline.

35 The Commission on the Bankruptcy Laws of the United States,

Report, H.R. Doc. No. 93-137, 93d Cong., Ist Sess. (1973),

reprinted in King, Klee and Levin, Collier on Bankruptcy (15th

Ed.), Appendix, Vol. 2, Part I, p. 270, recommended retaining the

“so-called six-month priority rule according to creditors who sup-

plied necessities to the debtor within six months prior to the filing of

the petition the status of administrative expense claimants.” The

Commiission’s recommended bill, in the “Confirmation of Plan” sec-

tion (9-503), included a requirement that the plan provide “for pay-

ment of all allowed claims for current operating expenses incurred

by the debtor during the six months immediately preceding the fil-

ing of the petition.” Id., Part I, p. 288. The Senate in 1978 would

have followed the Commission recommendation to provide that

“traditionally accorded” priority (S. Rep. No. 95-989, 95th Cong.,

2d Sess. 135-36, reprinted in [1978] U.S. Code Cong. & Ad. News

5921-22), and S. 2266, 95th Cong., Ist Sess. § 1173(a) (9) (1978), re-

quired that the “Plan” include a provision for payment in cash of all

allowed claims for current operating expenses during the six months

preceding the filing of the petition. The House Bill, H.R. 8200,

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the time comes to determine membership in the class** it will

be for the reorganization court to determine what claims

belong in the class because they represent indebtedness for or-

dinary and necessary current operating expenses indispensable

to continued rail service of the kinds being paid currently as

expenses of administration; whether the non-payment reflects

an intentional extension of credit to the railroad, or the in-

tervention of the reorganization petition before expiration of

the ordinary billing and payment period, or some non-

contractual indulgence or inadvertence on the part of the

claimant, or deferment of payment on the part of the railroad;

and whether, if the transaction giving rise to the claim had any

credit term, it was compatible with a general expectation of

payment from current receipts or indicated reliance on the

railroad’s general credit. In any event, it must be concluded

that the class of creditors entitled to the priority contemplated

by Section 77(b), 11 U.S.C. § 205(b) (1976), is not limited to

participation in the current debt (expense) fund defined in

terms of Fosdick equitable restitution, but extends to par-

ticipation in reorganization railway operating revenues essen-

tially on the same basis as administration expenses incurred

during the reorganization period.

C.

Where payment for pre-reorganization services and supplies

is claimed on the ground that the expenses are within

95th Cong., Ist Sess. (1977), which in substance proposed to con-

tinue, as Section 1170(b), the language of former Section 77(b), and

H.R. Rep. No. 95-595, 95th Cong., Ist Sess. 424, reprinted in [1978]

U.S. Code Cong. & Ad. News 6380, stated that “As under current

law, the courts will determine the precise contours of the priority

recognized by this subsection in each case.” The provision enacted as

11 U.S.C. § 1171(b) follows the House Bill and substantially con-

tinues the language of Section 77(b).

*° Since the district court disposed of the six months claims on the

ground that there was no current debt fund, 468 F. Supp. at 1003,

and no diversion, id. at 1004-06, and did not designate a priority

classification for six months creditors, id. at 1008, the court did not

refine its definition of the class, id. at 1002, nor set out the limita-

tions on membership in such a class.

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the principle governing the priority accorded to administra-

tion claims, questions respecting the existence of a current ex-

pense or debt fund, that is, of surplus earnings or net income,

are not directly involved; the controlling considerations are

those taken into account in authorizing administration ex-

penses.

However, if payment is claimed under the Fosdick princi-

ple, the existence of a current debt fund must be

demonstrated. The district court’s an

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