Petition — New Jersey v. Reading Co.

80--

0- ] 2 9 3 Gifics-Suprams Court, US,

JAN 14 98]

In THE ALEXANL.... — SiEVAS,

LERK

Supreme Court of the United Stetes—

OcrosEer TERM, 1980

THE STATE OF NEW JERSEY,

Petitioner,

READING COMPANY, Debtor in Reorganization, THE

UNITED STATES OF AMERICA, CONSOLIDATED

RAIL CORPORATION and the COMMITTEE OF

INTERLINE RAILROADS,

Respondents.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS FOR THE

THIRD CIRCUIT

JoHn J. DEGNAN,

Attorney General of New Jersey,

Attorney for Petitioner, State of

New Jersey,

State House Annex,

Trenton, New Jersey 08625

(609) 292-4925

STEPGEN SKILLMAN,

Assistant Attorney General

Of Counsel and

On the Petition.

JosepH L. YANNOTTI

Deputy Attorney General

On the Petition.

Adams Press Corp., 5 Commerce Street, Newark, N. J. 07102—(201) 623-8611

Questions Presented

1. May a bankruptcy court in a proceeding for the re-

organization of a railroad, having ordered the deferral

of the payment of taxes accruing during the pendency of

the reorganization, approve a plan of reorganization which

fails to provide for full prompt cash payment of the

deferred taxes.

2. Does a plan of reorganization conform to the “fair

and equitable” requirement of Section 77(e)(1) of the

Bankruptey Act if it provides for payment of only 30%

of deferred administration real estate taxes in cash at

consummation, and no cash at consummation for deferred

administration franchise tax claims, with the balance of

these tax claims to be paid in the form of long term low

interest notes of uncertain payment, and yet provides for

extensive cash payments to lower priority secured and un-

secured creditors both at consummation and during the

initial years of the reorganized company as well as the

retention of cash not needed for the feasibility of the

reorganized company.

3. Do the limitations on Congressional power set forth

in the Tenth Amendment to the Constitution of the United

States bar the approval by a Section 77 reorganization

court of a plan of reorgainzation which provides for the

payment of deferred administration tax claims in the form

of long term low interest notes of uncertain payment.

>

TABLE OF CONTENTS

QUESTIONS PRESENTED ..

Oprnion BEeLow \

JURISDICTION .

STATUTORY AND CONSTITUTIONAL P ROVISIONS INVOLVED

STATEMENT OF THE CASE ..........

Reasons FoR GRANTING THE WRIT:

Point I—The Court should grant the Petition

for a Writ of Certi. sari so that it may de-

termine whether a Section 77 Reorganiza-

tion Court’ is empowered to approve a plan

of reorganization which fails to provide full

prompt cash payment of taxes which became

due and owing during reorganization but which

were not paid due to the entry of a tax pay-

ment deferral order .................-.:c-ccseceeees

Point II—A Writ of Certiorari should issue to

the Court of Appeals for the Third Circuit so

that this Court may review the Third Cir-

cuit’s determination that the plan of reor-

ganization approved by the Reading reorgani-

zation court is consistent with Section 77(e) (1)

of the Bankruptcy Act and the prior deci-

ES Ge SE GNIS sovcdpitcnsnsiienipsocdocniacebanieibiedeanaaion

PAGE

TABLE OF CONTENTS ili

PAGE

Point I1I—The approval of the plan of reor-

ganization represents the exercise of congres-

sionally delegated power in a fashion that im-

pairs the State’s integrity and its ability to

function effectively in a federal system which

is contrary to the Tenth Amendment of the

Constitution of the United States -.0022 2. 19

See it Een ERO TART RMD NADIE ID Ne TN ee PIN LS DRT 21

APPENDIX:

A—Opinion Re: Approval of the Plan of Re-

organization of the United States District

Court for the Eastern District of Pennsyl-

WOUIIDR ishcXacentiorn Acinatdaicincisd olen aaltepet nlerekbeadind dais la

Order of the United States District Court

for the Eastern District of Pennsylvania .... 39a

B—Judgment Order of the United States Court

of Appeals for the Third Cireuit ........0.1......... 40a

C—Order of the United States Court of Ap-

peals Denying Petition for Rehearing ........ 42a

Cases Cited

Case v. Los Angeles Lumber Products Co., 308 U.S.

FO ROMP. asicitsiicdusebleniintbianeniatenplalinticinion 14,18

Central Railroad Co. of New Jersey, In the Matter

of, 425 F.Supp. 1055 (D.N.J. 1977), vac. and rem.

0.g. 579 F.2d SO4 (Srd Cir, 19TB) nnecsnsnnnnceeenscsceevsnovnee 12,13

Consolidated Rock Products Co. v. DuBois, 321 U.S.

UR MMR ILD aint cilnisiesas dilebdniootehaesiddiecensicbdeicaetldaeniconijons 15, 17,18

Erie Lackawanna Railway Co., In the Matter of

CORT ee Teas MONE? scsdilclehilts aa hecnccloseeginiiidtonnetiaas 10

| Mey TABLE OF CONTENTS

PAGE

Fry v. United States, 421 U.S. 542 (1975) 200. 19

International Harvester Co. v. Wisconsin Dept. of

Taxation, 322 U.S. 485 (1944) -......- 19

Kansas City Terminal Ry. v. Central Union Trust

Co., 271 U.S. 445 (1926) ...... 5 « 15

Lehigh Valley Railroad Co., In the Matter of (Bky

No. 70-432 E.D. Pa.) 10

Lyford v. State of New York, 140 F.2d 840 (2d Cir.

1944) ..... re sie 7]

Michigan vy. Michigan Trust Co., 286 U.S. 334 (1932) 8-10

National League of Cities v. Usery, 426 U.S. 833

(1976) .11, 19-21

New York, New Haven and Hartford R. Co., In re,

147 F.2d 40 (2d Cir. 1945), cert. den. 325 U.S. 884

| RRO Ga Nae stored Ay ther re Aa PE TEE aa 12,13

\

New York, New Haven and Hartford R. Co., In re,

304 F.Supp. 1121 (D.Conn. 1969) «...2........-.-..-.-.....0-. 12

New York, Susquehanna and Western Railroad Co.,

In the Matter of (Bky No. 76-182 D. N.J.) -2002202... 10

Nicholas v. United States, 384 U.S. 678 (1966) .......... 9

Northern Pacific Ry. Co. v. Boyd, 228 U.S. 482

(1913) ..... ssoieiniaitakadictlbhetacdckikapiicindiediiicaictedatanienlassabibelgiia 14, 15

Palmer v. Webster & Atlas Bank, 312 U.S. 156

ON aceite dL Lh i St iicatibncnchtearedpenneiaea fabs 9

Penn Central Transportation Co., In the Matter of,

452 F.2d 1107 (3rd Cir. 1971), cert. den. New Jer-

sey v. Penn Central Transportation Co., 406 U.S.

I aria aialihcdiiinseenciiteniciinbdaetinntighiasientieuecusiar 9-12

Penn Central Transportation Co., In the Matter of,

458 F.Supp... 1234 (B.D. Pa, 1978) ............:...se-cscoqooee 12

TABLE OF CONTENTS v

Philadelphia Co. v. Dipple, 312 U.S. 168 (1941) ........ 9 .

Reading Co., In re, 439 F.Supp. 389 (E.D. Pa. 1977) 9

Regional Rail Reorganization Act Cases, 419 U.S.

102 (1974): 10, 11

Southern Ry. v. United States, 306 F.2d 119 (5th

Cle: SGD dence : 12

Tyler, In ro, 14 US. 164 (1508) ee 8

United States v. Key, 397 U.S. 323 (1970) 14,17

United States Constitution Cited

Article I, Section 8, Paragraph 4 20

Drmitha Ammen oeneiccnccsecsivcccnneentetcnisieeallaaagal i, 3, 7, 19, 21

Statutes Cited

Bankruptey Act:

See. 77 -<cniaaanigiaiaiisaiaipaelciaittaiaiaaaale i, 3, 8, 9, 20

Baw: TEGO ERD scicccigencee dlccatabion 12

S506. TICE) nncscncinsnincsensleessintenieneenaaa i, 2, 7, 14, 17

Bee. TEE REB) evtenenenmdeien ee 2, 7, 11-14

N.J.S.A. 54:29A-1 (New Jersey Railroad Tax Act) 17

NJGA. 5430A-06 © nee 17

11 US.C.:

| anne 3

es, SOND) ae m3 2,14

Sew. BOC) CS) icenesecenineransenessiesasieeeieeeeiele 2

3

vi TABLE OF CONTENTS

PAGE

28 U.S.C

See. 960 3, 9, 11, 18, 14

RI I hs ate ccncsasasinnente 9

pai hd nen siceectccehepeababiorengnibtioncpniciaininanagiione 2

45 U.S.C. (Regional Rail Reorganization Act):

Rr A OY adinttieceaseoncknsnicen 5

Sec. 701 et seq. . 5, 10

ee a EE a Ue Dea 5

NO.

In THE

Supreme Court of the United States

Octoser Term, 1980

>

—_

THE STATE OF NEW JERSEY,

Petitioner,

READING COMPANY, Debtor in Reorganization, THE

UNITED STATES OF AMERICA, CONSOLIDATED

RAIL CORPORATION and the COMMITTEE OF

INTERLINE RAILROADS,

Respondents.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS FOR THE

THIRD CIRCUIT

The petitioner, State of New Jersey, respectfully prays

that a Writ of Certiorari issue to review the judgment ot

the United States Court of Appeals for the Third Cir-

cuit in Appeal No. 80-1993, entered on September 28, 1980,

affirming Order No. 1804 of the United States District

Court for the Eastern District of Pennsylvania which ap-

proved a Plan of Reorganization for the Reading Com-

pany.

Opinion Below

The opinion and order of the United States District

Court for the Eastern District of Pennsylvania, not yet

reported, is set forth in the Appendix A hereto. The

Court of Appeals for the Third Cireuit did not render

an opinion but decided the ease by entry of a judgment

order set forth in Appendix B hereto.

Jurisdiction

The judgment of the Court of Appeals was entered on

September 23, 1980. A timely petition for rehearing en

banc was denied on October 17, 1980, and this petition for

certiorart was filed within 90 days of that date. This

Court’s jurisdiction is invoked under 28 U.S.C. § 1254(1).

Statutory and Constitutional Provisions Involved

Bankruptey Act § 77(e)(1) (11 U.S.C. § 205(e)(1)):

“'.. the judge shall approve the plan if satisfied

that: (1) It complies with the provisions of sub-

section (b) of this section, is fair and equitable,

affords due recognition to the rights of each class

of ereditors and stockholders, does not diserimi-

nate unfairly>in favor of any class of creditors or

stockholders, and will conform to the requirements

of the law of the land regarding the participation

of the various classes of ereditors and stockholders;

”

Bankruptey Act § 77(e)(8) (11 U.S.C. § 205(e)(3)):

“ .. the judge shall approve the plan if satisfied

that: . . . (3) the plan provides for the payment

of all costs of administration and all other allow-

ances made or to be made by the judge, except

that allowances provided for in subsection (¢), para-

graph (12) of this section, may be paid in securi-

ties provided for in the plan if those entitled there-

to will aecept such payment, and the judge is here-

by given power to approve the same.”

. 28 U.S.C. § 960:

“Any officers and agents conducting any business

under authority of a United States court shall be

subject to all Federal, State and Local taxes ap-

plicable to such business to the same extent as if

it were conducted by an individual or corporation.”

Tenth Amendment of the Constitution of the United

States:

“The powers not delegated to the United States

by the Constitution, nor prohibited by it to the

States, are reserved to the States respectively or

to the people.”

Statement of the Case

On November 23, 1971, the Reading Company filed a

petition for reorganization of a railroad under Section

77 of the Bankruptey Act (11 U.S.C. § 205). The court

appointed Trustees thereafter sought and won authoriza-

tion by the court to defer the payment of taxes accruing

during the pendency of the reorganization proceedings.

The reorganization court’s order, Order No. 186, entered

on July 18, 1972, also enjoined the taxing authorities from

taking any action to collect the unpaid taxes (Pa7 to

|

'%

4

Pa9).* The trustees accordingly did not pay taxes on

a current basis from July of 1972 until the end of 1978

when the reorganization court approved the resumption

of tax payments. Consequently, the State of New Jersey

has tax claims against the Trustees for the years 1972

through 1977 in the amount of a quarter of a million

dollars.**

The Trustees filed a Proposed Plan of Reorganization

on June 25, 1979 (Pal0 to Pa39). The Plan proposed the

establishment of eight separate classes of claims. State

and local real estate tax claims were to be placed in Class

C. State and Local corporate tax claims were included in

Class D along with a variety of other claims which arose

during the reorganization (Pa20). The State of New Jer-

sey has both Class C real estate and Class D corporate

franchise tax claims.

The plan proposed to satisfy the State’s real estate tax

claims by payment of 30% of the claim in cash and 70%

of the claim in Series B Administrative Notes (Pa26). The

plan specified that the Series B Notes were to be conting-

ent obligations of the reorganized company which would

bear interest at 8% per annum, compounded annually, from

and after the date of consummation of the plan. The

notes are to be secured by a second lien on a designated

portion of the proceeds of the Valuation Case, the pro-

ceedings before the Special Court to determine the com-

* This notation refers to the appendix filed by the State with

the Court of Appeals for the Third Circuit.

** Tt should be noted that if the taxes which had become due

on properties owned by certain non-bankrupt entities connected

with the Debtor’s operations had not been paid at the time said prop-

erties were sold, the amount would have approached a million

dollars.

pensation that the Reading Company is to receive for con-

veyance of its rail assets to the Consolidated Rail Cor-

poration pursuant to the Regional Rail Reorganization

Act 45 U.S.C. §701 et seq.* The notes are secured by

“additional compensation,” which the plan defines as those

valuation case proceeds received by the debtor in excess

of the net liquidation value of the transferred assets as

fixed by the United States Railway Association with the

interest due thereon (Pal6). The Series B Notes fall due

90 days after liquidation of all or a portion of: the Valu-

ation Case proceeds to cash. Accrued interest is only to be

paid when the Notes are redeemed. If there is, in fact, no

additional compensation, the Series B Notes are null and

void. The plan estimates that the earliest date for resolu-

tion of the Valuation Case will be April 1, 1988 (Pa22).

The State and local franchise tax claims in Class D are

to be satisfied, if not settled, by issuance of Series C

Administration Notes in an amount equal to the claim.

The Series C Notes are to be general obligations of the

reorganized company, with interest accruing at 8% per

annum, compounded annually. These notes, too, are tied

to the Valuation Case in terms of time and source of pay-

ment. The notes mature on April 1, 1988 or 90 days after

liquidation of all or a portion of Valuation Case proceeds

to cash, whichever is the first to occur. The Series C Notes

are secured by a lien on valuation case proceeds although

this lien is junior to the first priority lien securing the

Series A Notes as to all valuation case proceeds, and

* A first priority lien upon all valuation case proceeds is to be

established in favor of the Series A Administration Notes to be

issued to the United States in satisfaction of its claims for loans

advanced under Section 211(h) of the Rail Act, 45 U.S.C. §721(h)

and claims under Trustees’ Certificates. These claims total some

$31.6 million (Pal50)

junior to the lien securing the Series B Notes as to “addi-

tional con.pensation” (Pa22).

While providing for the further deferral in payment of

70% of the real estate tax claims, and 100% of the ecor-

porate tax claims, the plan proposed extensive cash pay-

ments to lower priority secured and unseeured creditors.

Class F included two types of secured claims: Prineipal

and interest on Government Guaranteed Loans and prinei-

pal and interest on the 1954 Mortgage Bonds. The plan

proposed to aggregate the interest on beth. Interest on

the government loan was to be paid with 25% im eash

and 75% in Series A Bonds. The percentage treatment

was the same for the interest on the 1945 Mortgage Bonds,

however, Series B Bonds rather than Series A Bonds

would be issued (Pa27). Both series of bonds bear inter-

est at 10% per year. The plan previded for the tomend

tory redemption of the Series A Bonds each year with full

payment by the fifth anniversary of the date of consump-

tion, and mandatory redemption of the Series B Bonds by

the sixth anniversary (Pa23). Exhibits to the plan, as

revised through June 30, 1980, indieated that over $21.6

million in Series A and Series B Bonds are to be issued

(Pal50).

The principal due on the 1945 Mortgage Bonds was pro-

posed to be satisfied by issuance of Series C-1 Bonds.

Series C-2 Bonds are to be issued to satisfy the unpaid

principal of the Government Guranteed Loans. The proe-

posed plan called for mandatory redemption of the Series

C Bonds commencing one year from the date after the

Series A and Series B Bonds and interest thereon have

been paid in full. The plan specified that some $3 million

in principal face amount of the Series C Bonds were te

be redeemed each year after the Series A and B Bonds

were paid until the C Bonds matured on April 1, 19S8S or

90 days after liquidation of all or a portion of the valu-

ation case proceeds to cash, whichever is the first to occur

(Pa23 to Pa24).

The unsecured personal injury claims, in Class G, were

proposed to be satisfied by cash payment of one-third

(3344%) of the claims on consummation date. The remain-

ing two-thirds was to be satisfied by issuance of Personal

Injury Notes which provide for payment of one-third of

the original claim on the first anniversary. The entire

class of unsecured personal injury claims is to be paid by

the second anniversary of consummation (Pa28). Over $2

million in Personal Injury Notes are to be issued (Pal50).

The State objected to the plan because it failed to pro-.

vide full prompt cash payment of the deferred taxes and

contemplated yet a further deferral of the Trustees’ duty

to pay taxes as they accrue during reorganization; be-

cause it failed to provide prompt cash payment of the

State’s long deferred administration tax claims in viola-

tion of Section 77(e)(3) of the Bankruptey Act; because

the plan provided for a distribution of cash to lower

priority creditors and the retention of cash not necessary

to the feasibility of the company in violation of Section

77(e)(1); and because the plans proposed treatment of tax

claims was violative of the Tenth Amendment of the Con-

stitution of the United States.

On May 21, 1980, after approving amendments to the

plan, the reorganization court entered Order No. 1804 ap-

proving the plan over the State’s objections (App.A). The

reasons for the approval were set forth in an accompany-

ing opinion (App.A). The reorganization court deter-

mined that the State of New Jersey was not entitled to

eash payment of its tax claims, that the plan was fair and

equitable, and that the plan was feasible. On appeal to

the United States Court of Appeals for the Third Circuit,

the judgment of the reorganization court was affirmed

without opinion by entry of a judgment order on Septem-

ber 23, 1980 (App.B). On October 17, 1980, the Court of

Appeals denied the State’s petition for rehearing en banc

(App.C).

REASONS FOR GRANTING THE WRIT

POINT I

The Court should grant the Petition for a Writ of

Certiorari so that it may determine whether a Section

77 Reorganization Court is empowered to approve a plan

of reorganization which fails to provide full prompt

cash payment of taxes which became due and owing

during reorganization but which were not paid due to

the entry of a tax payment deferral order.

The decisions of this Court establish that a Trustee,

while conducting the business of a debtor railroad, is sub-

ject to state and local taxes and must pay them as they

accrue. In Jn re Tyler, 149 U.S. 164 (1893), a railroad

receivership action, the Court stated that removal of a

taxing authority’s power to seize and sell a railroad’s prop-

erty to obtain payment of its taxes made

“imperative [the] duty of the court to recognize as

paramount, and enforce with promptness and vigor,

the just claims of the authorities for the prescribed

contributions to state and municipal revenue.” Jd.

149 U.S. at 187.

So, too, in Michigan v. Michigan Trust Co., 286 U.S. 334

(1932), Justice Cardozo, writing for the Court, stated with

respect to taxes accruing during receivership:

“(T]he receiver was under a duty to pay them when

they accrued, and having failed to fulfill that duty

then, it should be compelled to pay them now.” Id.

286 U.S. at 345.

In 1934, Congress enacted 28 U.S.C. §124a, a predecessor

to the present 28 U.S.C. $960, which states:

“Any officers and agents conducting any business

under authority of a United States court shall be

subject to all Federal, State and local taxes appli-

cable to such business to the same extent as if it

were conducted by an individual or corporation.”

The plain terms of the statute require a trustee in bank-

ruptey to pay State and Local taxes in the same manner

and to the same extent as if the debtor’s business were con-

ducted by an individual or corporation. Nicholas v. United

States, 384 U.S. 678, 690 (1966); Palmer v. Webster &

Atlas Bank, 312 U.S. 156, 163° (1941); Philadelphia Co. v.

Dipple, 312 U.S. 168, 175 (1941); Lyford v. State of New

York, 140 F.2d 840, 846 (2d Cir. 1944).

It is clear that 28 U.S.C. §960 requires that a Trustee

pay State and Local taxes as they accrue. The reorganiza-

tion court so stated. Jn re Reading Co., 439 F.Supp. 389,

391 (E.D. Pa. 1977). Nevertheless, the Court had approved

the deferral of the payment of taxes by entry of Order

No. 186. The legal basis for the entry of that order was

the decision of the Court of Appeals for the Third Cireuit

in In the Matter of Penn Central Transportation Co., 452

F.2d 1107 (3rd Cir. 1971), cert. den. New Jersey v. Penn

Central Transportation Co., 406 U.S. 944 (1972), wherein

the Third Cireuit concluded that a Section 77 reorganiza-

tion court was empowered to temporarily defer the pay-

ment of taxes accruing during reorganization. While recog-

nizing that this Court’s decision in Michigan v. Michigan

10

Trust Co., swpra, obligated the Trustees to pay taxes “as

they accrue,” the Court of Appeals nonetheless concluded

that the Trustees’ obligation to perform that duty could

be temporarily postponed in light of the need to pre-

serve the railroad as an operating unit in the public

interest. In the Matter of Penn Central Transportation

Co., supra, 452 F.2d at 1108, n.1.

The deferral of the current payment of taxes sanctioned

by the Third Cireuit in Penn Central has become the rule

in railroad reorganizations. Order No. 186 in this matter

was entered shortly after the decision of the Court of

Appeals. Similar tax payment deferral orders have been

entered in In the Matter of Erie Lackawanna Railway

Co., (B72-2838 N.D. Ohio); In the Matter of Lehigh Val-

ley Railroad Co., (Bky No. 70-482 E.D. Pa); and in Jn

the Matter of New York, Susquehanna and Western Rail-

road Co., (Bky No. 76-182 D. N.J.). The State of New

Jersey has tax claims in each of these pending matters

which represent the deferral of over $20 million in taxes

and accrued interest. »

By affirming the reorganization court’s approval of a

plan of reorganization which does not provide for the

full, prompt cash payment of the State’s tax claims, the

Court of Appeals has approved yet a further deferral

of the Trustees’ duty to pay the already too long de-

ferred taxes. Taxes which became due as early as 1972

may not be paid, if they are paid at all, until 1988. This

is so despite the fact that the initial rationale for de-

ferral, the need to preserve the railroad as an operat-

ing unit, no longer exists. The Reading Company no

longer operates a railroad in the public interest, having

transferred its rail assets to the Consolidated Rail Corp.

on -April 1, 1976 pursuant to the Regional Rail Reor-

ganization Act, 45 U.S.C. $701 et seg. See Regional Rail

~

11

Reorganization Act Cases, 419 U.S. 102 (1974). Further

deferral of the payment of the State’s tax claims is con-

trary to the original understanding upon which the taxes

were deferred, is contrary to the plain terms of 28 U.S.C.

§960, and compounds the egregious intrusion upon State

sovereignty represented by the initial and supposedly “tem-

porary” deferral order. See National League of Cities

v. Usery, 426 U.S. 833 (1976).

Although other costs and expenses of administering the

debtor’s estate were paid on a current basis, the pay-

ment of taxes was deferred on the understanding that

deferral would be temporary and would not result in

unequal treatment among administration claimants. The

Court of Appeals in Jn the Matter of Penn Central Trans-

portation Co., supra, held that all administration expenses

must be treated equally but ruled that simultaneous pay-

ment was not required. /d., 452 F.2d at 1108. Under

the approved plan, there would be not only an extreme

difference in the timing of payment but also a differ-

ence in the mode of payment since the deferred taxes

are to be paid principally in the form of long term notes

not cash. Since the notes are secured by the uncertain

proceeds of the Reading Valuation Case, it is quite possi-

ble that the deferred taxes might never be paid.

In addition to the Congressional mandate of 28 U.S.C.

§ 960, Section 77(e)(3) of the Bankruptey Act requires

that a reorganization court approve a plan of reorgani-

zation only if satisfied that, inter alia:

“ . . the plan provides for the payment of all

costs of administration and all other allowances

made or to be made by the judge, except that al-

lowances provided for in subsection (c), paragraph

12

(12) of this section, may be paid in securities pro-

vided for in the plan if those entitled thereto will

accept such payment .. .”*

The plain terms of Section 77(e)(3) require that admini-

stration expenses be paid in cash. Securities may only be

used to satisfy expenses that fall within the purview of

Section 77(¢c)(12) and then only when those claimants

agree to accept payment in securities. In re New York,

New Haven and Hartford R. Co., 304 F.Supp. 1121, 1126

(D.Conn, 1969); In the Matter of Central Railroad Co.

of New Jersey, 425 F.Supp. 1055, 1060 (D.N.J. 1977), vae.

and rem. o.g. 579 F.2d 804 (3rd Cir. 1978).

In this matter the reorganization court, in reliance upon

In the Matter of Penn Central Transportation Co., 458

F.Supp. 1234 1282 (E.D. Pa. 1978), concluded that See-

tion 77(e)(38) requires payment of only “expenses directly

associated with the reorganization proceedings, such as

compensation for trustees and attorneys.” (App. A, p. 28).

The decided cases thus represent a substantial difference

of opinion among the reorganization courts that have con-

strued Section 77(e)(3). In affirming the Reading reor-

ganization court’s crabbed interpretation of Section 77(e)

(3), the Third Cireuit has adopted a far reaching inter-

pretation of the statute. This interpretation is contrary

to the well established principle that State and local tax

claims accruing during reorganization are expenses of ad-

ministration. Jn the Matter of Penn Central Transporta-

tion Co., supra., 452 F.2d at 1108; Southern Ry. v. United

States, 306 F.2d 119, 126 (5th Cir. 1962); In re New

York, New Haven and Ilartford R. Co., 147 F.2d 40, 52-53

* Section 77(c)(12) allows the reorganization court to make

allowance for expenses incurred in the proceedings, including

attorney’s fees, which are to be paid out of the debtor’s estate.

.

13

(2d Cir. 1945), cert. den. 325 U.S. 884 (1945). Excelu-

sion of these costs from the scope of Section 77(e) (3)

is contrary to the terms of the statute and in conflict

with the underlying purpose of a reorganization. As one

reorganization court has said:

“Besides having a strong foundation in the wording

of the statute, the traditional rule that reorganiza-

tion expenses must be paid in cash make sense. The

reorganization process depends in large part upon

the ability to continue operations pending reorgani-

zation. The continued reorganization depends, in

turn, upon the willingness of other business and gov-

ernmental entities, as well as employees, to con-

tinue to deal with the trustee of the bankrupt estate.

If they cannot be persuaded to extend eredit for

such necessities as fuel, supplies, and labor, the re-

organization process would be severely handicapped,

if not entirely frustrated. Thus, it would seem logi-

cal to ensure the potential administration creditors

that they will be paid in cash, not in securities of

the reorganized company, securities of other com-

panies, or in kind, 7.e. a box ear.” (footnotes omit-

ted) . In the Matter of Central Railroad Company

of New Jersey, supra, 425 F. Supp. at 1062.

In short, the decision of the Court of Appeals, in allow-

ing the further deferral of the State’s long deferred tax

claims, is in conflict with the Congressional mandate of 28

U.S.C. §960, the decisions of this Court, and the require-

ments of Section 77(e)(3). The question is one of the

utmost importance in the administration of the Bank

ruptey Laws. Its importance requires review by this Court.

The Petition for a Writ of Certiorari should be granted.

14

POINT II

|

A Writ of Certiorari should issue to the Court of

Appeals for the Third Circuit so that this Court may

review the Third Circuit’s determination that the plan

of reorganization approved by the Reading reorgani-

zation court is consistent with Section 77(e) (1) of the

Bankruptcy Act and the prior decisions of this Court.

Even if the Third Cireuit were correct in holding that

full, prompt cash payment of the State’s claims is not re-

quired by 28 U.S.C. §960 or Section 77(e) (3), the approval

-of the Reading plan would nonetheless be contrary to the

requirements of Section 77(e)(1) of the Bankruptey Act,

11 U.S.C. §205(e)(1). Section 77(e)(1) requires that be-

fore approving a plan of reorganization, the reorganiza-

tion court must be satisfied that the plan is

“ ,. . fair and equitable, affords due recognition

to the rights of each class of creditors and stock-

holders, and will conform to the requirements of the

law of the land regarding the participation of the

various classes of creditors and stockholders, .. .”

The “fair and equitable” requirement, also known as the

“absolute priority rule,” mandates that senior claimants

receive the full value of their claims out of the debtor’s

estate before junior claimants receive anything for their

interests. Case v. Los Angeles Lumber Products Co., 308

U.S. 106, 116 (1939); Northern Pacific Ry. Co. v. Boyd,

228 U.S. 482, 505 (1913). No plan can be deemed “fair and

equitable” if it compromises the rights of senior creditors

in order to protect those with lower priorities. See United

States v. Key, 397 U. 8. 323, 327 (1970).

It is well settled that the “absolute priority rule,” con-

fers upon a senior claimant the primary right to be pre-

15

ferred to lower priority creditors against the full value of

all of the property belonging to the debtor corporation.

Kansas City Terminal Ry. v. Central Union Trust Co., 271

U.S. 445, 454 (1926). The rule requires that each senior

claimant be given such opportunity as the circumstances

permit to secure the full enjoyment of this preference. A

senior claimant is therefore entitled to full compensatory

treatment with the best consideration available under the

existing circumstances. Anything less runs afoul of the

rule and comes within judicial denunciation. Kansas City

Terminal Ry. Co. v. Central Union Trust Co., supra; Con-

soliated Rock Products Ce. v. DuBois, 321 U.S. 510, 529

(1941).

The Third Circuit’s judgment in this matter represents

a fundamental departure from the strictures of the “abso-

lute priority rule” and the decisions of this Court which

declare the rule to be a “fixed principle” which must be

rigidly adhered to. Kansas City Terminal Ry. v. Central

Union Trust Co., supra, 271 U.S. at 454. See also Northern

Pacific Ry. Co. v. Boyd, supra, 228 U.S. at 507. The plan’s

violation of the “fair and equitable” requirement is clear.

Under the plan, the State’s high priority real estate tax

claims are to receive only 30% in cash at consummation.

The balance is to be paid by issuance of notes which are

contingent obligations of the reorganized company which

are to be paid only if there are sufficient proceeds from

the Reading Valuation Case (Pa22). The State’s high

priority franchise tax claims are to receive no cash at

consummation and will be entirely paid with notes also se-

cured by the uncertain proceeds of the Valuation Case liti-

gation (Pa22). The notes issued in respect of the real

estate and the franchise tax claims are not to be paid until

the conclusion of the Valuation Case which is estimated to

occur no earlier than April 1, 1988.

16

While 70% of the State’s real estate tax claims and 100%

of the State’s franchise tax claims are deferred to April

1, 1988, the plan of reorganization nevertheless provides

for extensive cash payments to secured and unsecured cred-

itors both at consummation and during the early years of

the reorganized company. At consummation, $7.220 million

is to be distributed to secured ereditors (Pal50). Bonds

will be issued to the secured creditors which will guarantee

payment of $6.132 million in 1981, $5.735 million in 1982,

$5.338 million in 1983 and $4.941 million in 1984 (Pal48).

Although not reflected upon the Trustees’ financial exhibits

additional cash payments to secured creditors will total

$4.54 million in 1985, $2.01 million in 1986, and $4.68 mil-

lion in 1987.

At consummation, $1.191 million is to be paid to unse-

cured personal injury claimants representing 3314,% of the

claims (Pal50). An additional 331/,% is to be paid on the

first anniversary of the consummation, and the remaining

balance on the second anniversary. In addition the reor-

ganized company is to retain $13.7 million at consummation

(Pal48).

It is fundamental that a plan of reorganization which

contemplates full payment of unsecured claims before full

payment is made to higher priority administration claims

runs afoul of the “absolute priority rule.” Similarly,

the extensive guaranteed cash payments to secured ered-

itors while the higher priority tax claims are deferred

is violative of the rule. Clearly, the financial cireum-

stances of the reorganized company compel the prior

application of the available cash to the State’s tax claims

which have unquestioned priority over the secured and

unsecured creditors who are being preferred by earlier,

purtial payment.

17

Even were it to be concluded that. Section 77(e)(1) does

not mandate the full cash payment of senior claims be-

fore any payment is made to junior creditors, the combina-

tions of cash and securities to be parcelled out to the claim-

ants and creditors fails to recognize the relative priorities

of the claimants and creditors. The unsecured personal

injury creditors are to receive a greater percentage of their

claims in cash at consummation than the State is to receive

for its tax claims. These unsecured creditors are to receive

notes which guarantee payment within two years of con-

summation, while the State is to receive notes which are

estimated to be paid, if at all, no earlier than April 1, 1988.

The secured creditors are to receive notes which bear in-

terest at 10% while a mere 8% is to accrue on the notes

issued to tax claimants (Pa23 to Pa24).

In addition, the “fair and equitable” requirement of Sec-

tion 77(e)(1) mandates full compensatory treatment for

senior claims before junior claims are paid. Without

full compensation, property rights of a senior claimant

are appropriated by and for the benefit of lower priority

creditors. See Consolidated Rock Products Co. v. DuBois,

supra, 312 U.S. at 529. The tax liabilities at issue are

established by virtue of the New Jersey Railroad Tax Act,

N.J.S.A. 54:29A-1 et seq. The unpaid principal and inter-

est is fully secured by a paramount lien on all of the debtor's

assets in New Jersey. N.J.S.A. 54:29A-54, The claims

are administration claims, with clear priority. In exchange

for these fixed, fully secured, high priority claims, the State

is to receive “delayed and therefore discounted” payment.

United States v. Key, supra, 397 U.S. at 334 (Douglas, J.,

concurring). The statutory obligation to pay the real es-

tate taxes has been substituted by payment in securities

which are a contingent obligation of the reorganized eom-

pany backed by the uncertainties of recovery in a law suit.

18

The securities applied to payment of the State’s franchise

taxes are similarly “secured.” The securities bear interest

at only 8% per annum.* Plainly, these lost rights are of

value. The State is entitled to full compensation for the

entire bundle of rights it is called upon to surrender. Con-

solidated Rock Products Co. v. DuBois, supra, 312 U.S.

at 527-528. The plan does not provide full compensation

and yet lower priority creditors are to participate and re-

ceive payment under the plan.

It is to be conceded that the State’s claim in this matter

is not relatively large. It is to be added that other taxing

authorities have accepted the treatment under the plan

without objection. However, the fairness and equity of a

plan of reorganization do not hinge upon either the size

of a particular claim or the number of other creditors and

claimants who take no exception. See Case v. Los Angeles

Products Lumber Co., supra, 308 U.S. at 115. The issues

presented in this case are also present in other pending

reorganizations in which the State is a party. There-

fore, the questions raised as to the fairness and equity

of the Reading plan are substantial and far-reaching. Re-

view should be granted by this Court.

* The uncontradicted testimony introduced below demonstrated

that the notes to be issued to the State would have to bear in-

terest of at least 11% to compensate for the delay and uncer-

tainty in payment (Transcript 9/17/79: ‘T157-18 to T157-23).

19

POINT III

The approval of the plan of reorganization repre-

sents the exercise of congressionally delegated power in

a fashion that impairs the State’s integrity and its ability

to function effectively in a federal system which is con-

trary to the Tenth Amendment of the Constitution of

the United States.

In National League of Cities v. Usery, 426 U.S. 833

(1976), the Court recognized that the Tenth Amendment

to the Constitution of the United States

“'.. expressly declares the constitutional policy that

Congress may not exercise power in a fashion that

impairs the States’ integrity or their ability to fune-

tion effectively in a federal system.” Jd. at 843,

quoting from Fry v. United States, 421 U.S. 542,

547 n.7 (1975).

The limitation upon the exercise of expressly delegated

powers is premised upon the principle that there are at-

tributes of sovereignty attaching to each state government

which may not be impaired by Congress. In striking down

the amendments to the Fair Labor Standards Act which

extended the Act’s minimum wage and maximum hour pro-

visions to almost all employees of state and local govern-

ments, the Court concluded that the exercise of the com-

merece power was beyond the power of Congress. The

amendments served “to directly displace the States’ free-

dom to structure integral operations in areas of tradi-

tional governmental functions.” Jd. 426 U.S. at 852.

That states have the sovereign right to assess and col-

lect taxes for the support of the state governments is in-

disputable. See Jnternational Harvester Co. vy. Wisconsin

Dept. of Taxation, 322 U.S. 485, 441-445 (1944). The State

20

of New Jersey’s sovereign right of taxation was suspended

by the reorganization court when it entered its tax pay-

ment deferral order in July of 1972. The State was fur-

ther enjoined from taking any action to compel payment

of its taxes. The exercise of such an implied power under

Section 77 of the Bankruptcy Act represented a funda-

mental intrusion upon the sovereignty of the State. The

policy determination reflected by this decision compelled

the State to either raise other revenues to support its

existing services or to scale back its services. The State

was compelled, further, to extend its protection and bene-

fits to the debtor and its property, including police and fire

protection, during reorganization without payment of any

of the taxes to support these services.

The plan of reorganization approved below compounds

the initial impairment of State sovereignty and represents

a continued displacement of State policy choices of how

its funds should be employed. Under the approved plan,

the State is compelled to invest its funds in speculative

securities of a private enterprise. The reorganization

court rejected the State’s contention that the plan repre-

sented an exercise of the bankruptcy power of Art. I, § 8,

par. 4 beyond the power of the federal government, rea-

soning that the amount of the State’s claim which is to be

deferred was not large enough to impose changes on the

conduct of integral State functions. This Court, in National

League of Cities v. Usery, made clear that the financial

impact of the exercise of federal power was not determina-

tive. Rather, the issue is whether or not the State’s ability

to exercise its sovereign power and its ability to make its

own policy determinations regarding integral State fune-

tions has been displaced by federal action. Jd. 426 U.S. at

853.

The displacement of the State’s policy choices as to how

the State will employ its tax revenues as reflected in the

21

payment provisions of the Reading plan are clear. The

State is again told, as it was told in 1972 when the tax

payment deferral order was initially entered, that taxes

legally owing to it are to be retained and put to use by

the Reading Company. The State is compelled to invest

its money in the reorganized company. Such an exercise

of the bankruptcy power, under authority conferred by

the Congress, enforced by a federal court, is violative of

the Tenth Amendment. The Third Circuit’s conclusion that

the approval of the plan. of reorganization does not ex-

ceed the power of the federal government is contrary to

National League of Cities v. Usery, supra. This conflict

requires review by this Court.

CONCLUSION

It is respectfully submitted that for the foregoing

reasons, the petition for writ of certiorari should be

granted.

Respectfully submitted,

Joun J. Deanan,

Attorney General of New Jersey,

Attorney for Petitioner, State of

New Jersey,

State House Annex,

Trenton, New Jersey 08625

(609) 292-4925

STEPHEN SKILLMAN,

Assistant Attorney General

Of Counsel and

On the Petition.

JosepH L. YANNOTTI

Deputy Attorney General

On the Petition.

[ApPenpices FotLow]

APPENDIX A

Opinion Re: Approval of the Plan of Reorganization of the

United States District Court for the Eastern District of

Pennsylvania

IN THE

UNITED STATES DISTRICT COURT

For THE EASTERN District oF PENNSYLVANIA

In Proceedings for the Reorganization of a Railroad

Bky. 71-828

in

—_-

In THE MATTER

OF

Reapinc COMPANY

Debtor

sf

OPINION RE APPROVAL OF THE PLAN OF REORGANIZATION

Ditter, J.

May 21, 1980

History OF THE Reapina Rarroap REORGANIZATION

Once the largest corporation in the world, the power and

financial base of the Reading Company has eroded steadily

since the demand for rail as a form of passenger and freight

[la]

2a

Appendix A

transportation diminished. Reading’s income fell short of

its expenses and finally, on November 23, 1971, it filed for

reorganization under section 77 of the Bankruptey Act, 11

U.S.C, §205, thus becoming a part of the nation’s rail crisis

which eventually found seven other major railroads in the

northeast and midwest seeking reorganization.

At the time of bankruptcy, Reading had a yearly oper-

ating income loss of $5.7 million and a net ordinary loss

of $11.5 million. Order No. 1 stayed the payment of taxes,

rents to leased lines, and proceedings by creditors against

the railroad for suits stemming from the operation of trains:

In 1972, the net operating loss increased to $12.1 million

and the net ordinary loss to $20 million. In 1973, the sit-

uation slightly improved in that the net operating loss

totaled $8.7 million and the net ordinary loss was $12.7 mil-

lion. These gloomy financial statistics for Reading as well

as the other bankrupt northeast and midwest railroads,

coupled with the great public need for continuing rail serv-

ice and the enormous inherent value of the railroads pro-

voked Congressional action to preserve an operating rail

system."

Intervention came by way of the Regional Rail Reorgani-

zation Act of 1973 (RRRA), 45 U.S.C. §$§701-94. Essenti-

1On June 15, 1973, the trustees filed a preliminary Plan of

Reorganization for Reading which presented two alternative solu-

tions: public sector intervention through federal legislation or

liquidation of the railroad. They hoped for federal rail legisla-

tion by the summer of 1973; otherwise, the trustees contemplated

submitting a definitive reorganization or liquidation plan on or

before November 23, 1973. This date was subsequently extended

by Order No. 495. Finally, on January 2, 1974, the Regional

Rail Reorganization Act of 1973 was signed into law.

.

oa

Appendia A

ally, the RRRA set up a plan for conveying the operating

assets of the bankrupt railroads to a new corporation cre-

ated by the Act, the Consolidated Rail Corporation (Con-

Rail), 45 U.S.C. §741-47, Pursuant to the RRRA the bank-

rupt railroads would continue to operate under their re-

spective reorganization courts for twenty months. During

that time, the newly formed United States Railway Asso-

ciation (USRA), see 45 U.S.C. §711, was to plan which parts

of the rail system were to be conveyed to ConRail. The

bankrupt railroads were to receive ConRail securities? in

exchange for the conveyance of their operating rail assets.

A three-judge “Special Court” was created to rule on the

valuation of the conveyed property. See 45 U.S.C. §§$719

and 743.

Before the Reading would be subject to the RRRA, I had

to find that it was not reorganizable under section 77, or,

if it was, that the public interest would be better served

by reorganization under the RRRA rather than under see-

tion 77. See 45 U.S.C. §717(b). I concluded that the Read-

ing Company was not reorganizable on an income basis

within a reasonable time under section 77 and thus, was

cligible to be reorganized under the RRRA. Jn re Reading

Company, 378 F. Supp. 474 (14.D. Pa. 1974). As required

for the RRRA to apply, 45 U.S.C. §717(b), I also found

that it provided a process which was ‘fair and equitable” to

the Reading’s estate. In re Reading Company, 378 F. Supp.

481 (K.D. Pa. 1974).

* Although the Act provided for the issuance of ConRail securi-

ties at conveyance, 45 U.S.C. §§719 and 743, they have been with-

held pending the outcome of the litigation to determine exactly

how much is due.

4a

Appendix A

The USRA formulated a planning package for the con-

veyance to ConRail. A preliminary system plan was filed

on February 27, 1975, and a final system plan on July 26,

1975. On April 1, 1976, the Reading’s rail assets described

in the final system plan were conveyed. The remainder of

the estate then consisted of real property, a trucking com-

pany, some marine equipment, other investments, and the

probable proceeds from the valuation case before the Spe-

cial Court.

SuMMARY OF THE PLAN

Fundamental to any bankruptcy is the reality that all

creditors cannot currently be fully paid in cash. Thus,

principles of priority or structuring of creditors are used -

in a plan of reorganization so that preferred or senior cred-

itors receive a proportionately better share than others.

The standards for approval of any priority system under

a plan involve a determination that the creditors will be

justly compensated in accordance with the fifth amendment,

that pursuant to 11 U.S.C. §205(e)(1) the plan is “fair and

equitable” and affords “due recognition to the rights of

each class of creditors and stockholders,” and that the plan

complies with the judicially created absolute priority rule.

Under the absolute priority rule, a plan is not “fair

and equitable” unless it provides participation for

claims and interests in complete recognition of their

strict priorities, and unless the value of the debtor’s

assets supports the extent of the participation afford-

ed each class of claims or interests included in the

plan. Any arrangement by which a junior class re-

ceives values allocable to a senior class “comes with-

| se

da

Appendia A

in judicial denunciation.” Beginning with the top-

most class of claims against the debtor, each class in

descending rank must receive full and complete com-

pensation for the rights surrendeed before the next

class below may properly participate. ( (footnotes

omitted)

In re Penn Central Transportation Co., 596 F. 2d 1102, 1110

(3d Cir. 1979) quoting 6A Collier on Bankruptcy 11.06, at

210-11 (14th ed. 1977).

Additionally, the reorganization court must conclude that

the plan is feasible, that is, that the new corporation will

have enough income to meet is expenses, 11 U.S.C. §205

(b) (4).

The present assets of the estate consist of approximately

$25 million in cash, between $35 and $45 > xillion in real es-

‘state and other investments not conveyed to ConRail,® and

a potential recovery in excess of $200 million from the val-

uation case. Under the Plan, many of these retained as-

sets will be liquidated in a very detailed manner, The

liabilities of the estate are estimated to be $165 million ex-

cluding the fees and expenses of the reorganization. KEven

though the amount of proceeds, if any, from the valuation

case will not be determined for years, the trustees believe

that the time is ripe for reorganizing the Reading estate.

The retained assets and the problems relating to them are

identified. An organization has been created to maximize

the return on the retained investments and to liquidate

% Certain claims being litigated may add substantially to the es-

tate. Of course, Reading may also. be unsuccessful in them. + See

Order No. 1392 as to Trailer Train Company and Order No. 1448

as to Blythe Township.

6a

Appendix A

as rapidly as possible retained assets which will not be

used by the reorganized company. The Plan of Reorgani-

zation has been devised to establish a feasible capital strue-

ture and to propose a fair and equitable method of distri-

bution. In this Plan, the estimated value of the corporation’s

retained assets is co-ordinated with the unknown value of

the proceeds of the valuation ease. This involves issuing

securities based on the outcome of the valuation case, and

satisfying various classes of creditors with combinations

of cash and securities. The distribution of securities in lieu

of eash satisfies the absolute priority rule. Jn re Penn

Central Transporation Co., supra, 596 F. 2d at 1110-11 (3d

Cir. 1979).

Generally, a reorganization plan must provide for tlie

claims of administration (expenses of conducting ongoing

operations during bankruptcy), secured claims, unsecured

claims, and equity interests. However, it is only after

satisfaction of the creditors’ claims that the stockholders

or equity interests are considered. The classification of

claims is within the purview of section 77(¢)(7) of the

Bankruptey Act, 11 U.S.C. §205(¢)(7) which provides in

relevant part:

(7) The judge shall promptly determine and fix

. for the purposes of the plan and its accept-

ance, after notice and hearing, the division of cre-

ditors and stockholders into classes according to the

nature of their respective claims and interests. Such

division shall not provide for separate classifica-

tion unless there be substantial differences in priori-

ties, claims, or interests.

The Reading Plan is structured around eight categories

of claimants with various securities being issued to satisfy

Ta

Appendiz A

the debts in each category. The Class A claims include

compensation for the trustees and their counsel and costs

and expenses incurred in connection with the Plan and

reorganization proceedings under sections 77(¢)(2) and 77

(c)(12). These claims have the highest priority and will

be paid in cash at consummation or paid in the ordinary

course of business.

Class B claims are those of the federal government

arising from loans made to ConRail under section 211(h)

of the RRRA for payment of Reading’s administrative

claims during the pre-conveyance, post bankruptcy period

and from trustees certificates issued to the United States.

These claims will be paid by issuance and delivery of

Series A administrative notes, having the highest pri-

ority.

Class C claimants include state and local taxing auth-

orities which have not settled prior to the Plan’s con-

summation. Their claims will be partially satisfied in

cash and partially in Series B administrative notes which

are contingent upon the Reading’s receiving additional com-

pensation for the valuation case.

Class D claims consist of other administrative claims

which are not reorganization expenses paid at consum-

mation. These debts will be settled in an administra-

tive claims settlement program prior to consummation or

will be paid in Series C administrative notes.

Class E claimants are railroads which provided mater-

ials and services to the Reading Company six months

prior to the petition for reorganization, here prior to

May 22,1971. Traditionally they have been given a higher

priority than secured claims since these railroads serv-

iced the Reading, cognizant of its poor financial condi-

8a

Appendix A

tion, so that the public transportation system could op-

erate. These six-month creditor claims will receive five

percent cash on consummation and 95 percent Series C

administration notes.

Class F is comprised of secured creditors holding mort-

gage bonds. The government guaranteed loans, secured

by Series E bonds, will receive cash for a portion of the

unpaid interest on the secured claim as of consumma-

tion date plus five year Series A bonds paying interest

at ten percent to satisfy the accrued but unpaid inter-

est obligation. The principal portion of the claim will

be paid by issuing Series C-2 bonds bearing interest at

eight percent. Present Series D bondholders will receive

eash for a portion of unpaid interest accrued plus six

year Series B bonds paying interest at ten percent to

satisfy the balance of the accrued but unpaid interest

obligation. The principal will be paid by issuing Series

C-1 bonds bearing interest at eight percent.

Class G or unsecured creditor claims include pre-bank-

ruptey personal injury claims and unsecured creditor

claims. Personal injury claims will be paid in cash in

three equal installments on the Plan’s consummation date

and on the first and second anniversaries of that date.

Other unsecured creditors may choose between a cash set-

tlement equal to 15 percent of their allowable claim and

a promissory note in an amount equal to the principal

of their claim bearing eight percent interest and pay-

able on April 1, 1988, or 90 days after liquidation of

the proceeds of the valuation case, whichever is earlier.

Class H claims involve stockholder’s equity. All stock-

holders shall receive a percentage of stock in the new

company equal to the percentage which they held of the

9a

aggregate of all preferred and common. stock in the old

company.

New SEcurITIES AND THEIR DISTRIBUTION

The Plan provides for the issuance of three types of

administrative notes: A through C; four series of re-

organization bonds: A through C-2; two types of un-

secured creditor notes; and new common stock. The ad-

ministrative notes, unsecured creditor notes, and reorgani-

zation bonds will be secured by mortgage indentures. A

description of the new securities detailing the schedule

of payment and the rights of the holder is essential to

an understanding of the Plan.

1. Series A Administrative Notes

Approximately $31 million in Series A notes will be is-

sued to satisfy the United States government’s section

211(h) and trustee certificate claims. These notes will have

the highest lien priority and right of payment. The inter-

est rate will be eight percent, compounded annually with

accrued interest to be paid at redemption of the notes.

They will be due on April 1, 1988, or 90 days after liquida-

tion of all or part of the valuation case proceeds.

2. Series B Administrative Notes

The payment of Series B securities will be contingent

upon the estate’s receiving compensation from the valu-

ation case in excess of the amount allocated to the Read-

ing under the final system plan. An estimated $71% mil-

lion in Series B notes have or will be issued in partial

satisfaction of state and local real estate cliams. Interest

10a

Appendia A

at eight percent will be compounded annually with ac-

crued interest to be paid at redemption of \the notes. They

will be due 90 days after liquidation of all or part of the

valuation case proceeds. A lien on any additional compen-

sation awarded by the Special Court will serve as security

for these notes.

3. Series C Administrative Notes

Administrative claims other than reorganization ex-

penses (which will be paid fully in cash on consummation)

will be satisfied by Series C administrative notes. Interest

at eight percent on these notes will be compounded annually

but payment will be deferred until maturity or redemp-

tion. They will be due on April 1, 1988, or 90 days after

liquidation of all or part of the valuation case proceeds.

The Series C notes will be secured by a lien on the re-

tained assets, assest disposition proceeds, and the valu-

ation case proceeds.

4. Reorganization Bonds

Reorganization bonds in various combinations will be is-

sued to satisfy the Reading’s secured ereditors—the

holders of the 1945 mortgage bonds and government guar-

anteed loans.* These bonds will be secured by a mortgage

*The secured creditor claims stem from two issues of mort-

gage bonds secured by the same mortgage on Reading's property,

the 1924 mortgage administered by Manufacturers Hanover Trust

Co. The two issues of mortgage bonds are the Series D, 1945

mortgage bonds, of which $54,070,000. face amount of bonds is

outstanding, and the Series EF, 1963 morigage bonds, of which

the entire face amount of the issue, $37,500,000 remains outstand-

ing. The 1963 mortgage bonds were issued to secure the govern-

ment guaranteed loan of which Debtor still owes $23,198,450. in

principal.

lla

Appendia A

lien on all the assets of the reorganized company. The

bonds will be junior in right of payment and lien priority

to the series A and C administrative notes with respect

to the retained assets, asset disposition proceeds, and valu-

ation case proceeds and junior to the Series B adminis-

trative notes with respect to any additional compensation

allowed by the Specia! Court. The Series A and B bonds

are senior to Series C bonds in right of payment and lien

priority.

_ The Series A and B bonds will be issued to satisfy the

accrued but unpaid interest as of the Plan consummation

date on the government guaranteed loan and the 1945

mortgage bonds, respectively. The Series A issues will be

five year bonds which will bear interest at ten percent.

One fifth of these bonds will be redeemed cach year com-

mencing with the first anniversary date of consummation.

The Series B issues will be six years bonds with interest

at ten percent. One-sixth of these bonds will be redeemed

each year commencing with the first anniversary date of,

consummation. The interest on both issues will be paid

currently. If the necessary cash to pay principal and in-

terest on Series A and B bonds is unavailable, such pay-

ments will accumulate and be paid when sufficient asset

disposition proceeds become available.

Series C bonds will be issued in consideration for the

unpaid principal on the 1945 mortgage bonds and the gov-

ernment guaranteed loan. These bonds will mature on

April 1, 1988, or 90 days after liquidation of all or a part

of the valuation case proceeds. They will bear eight per-

cent simple interest which will be due and payable only

when the bonds mature or are redeemed. At any time

prior to maturity and at the reorganized company’s op-

tion, Series B bonds will be redeemable with accrued inter-

r*

12a

Appendix A

est, on a pro rata basis, so long as administrative notes

and bonds with a higher maturity have been paid off. The

Series C-1 bonds will be issued to satisfy claims for the

unpaid principal obligation of the Series D, 1945 mort-

gage bonds. The Series C-2 bonds will be issued to satisfy

the unpaid principal obligation of the government guaran-

teed loan. The right of payment and lien priority are the

same for the Series C-1 and C-2 bonds; however, only the

holders of Series C-1 bonds will be entitled to vote for

directors of the reorganized company.

5. Unsecured Creditor Notes

Two types of notes will be issued to unsecured eredi-

tors: one for personal injury claimants and the other to

unsecured creditors. The personal injury notes® will not

bear interest and will be redeemable and mature one-half

on the first anniversary of the Plan consummation date

and one-half on the second anniversary. The unsecured

creditor notes will bear interest at eight percent simple

interest, and will also be secured by mortgage liens on all

the retained assets, asset disposition proceeds, and valu-

ation case proceeds. All principal and interest on these

notes will be due on April 1, 1988, or 90 days after the

liquidation of the valuation case proceeds, whichever is

earlier.

The unsecured creditor notes are junior in right of pay-

ment and lien priority to the administrative notes and re-

5 These notes will constitute two-thirds of the personal injury

claims. The first one-third will have been paid in cash at con-

summation of the Plan. These provisions were part of a com-

promise reached with the United States.

r*

13a

Appendia A

organization bonds but senior to any dividends on new

common stock. Personal injury notes are senior in right

of payment to the unsecured creditor notes.

6. New Common Stock

The reorganized company’s articles of incorporation will

authorize 10,000,000 shares of new common stock of which

2,795,291 shares will be issued on the Plan consummation

date. The stock will have a par value of one cent and will

not have preemptive rights. Each share will entitle the

holder to one vote at shareholders’ meetings but the stock

cannot be cumulated for voting in any manner.

7. Mortgage Indentures

The mortgage indentures will secure the administrative

notes and reorganization bonds as well as provide liens

securing obligations on all of the assets of the reorganized

company. There is one exception: Series B administrative

notes will be only secured by a lien on any additional com-

pensation allowed by the Special Court in the valuation

ease and will be subject to the prior lien of the Series A

administrative notes.

The indentures will provide that once the expenses of

operation and maintenance have been met, the certificates

of value and any additional proceeds from the valuation

ease and from the asset disposition program will become

security for and may be applied to the payment of the ob-

ligations of the reorganized company. Any such payments

will be free and clear of the liens and encumbrances of

higher priority creditors. The mortgage indentures will

restrict the ability of the reorganized company to create

14a

Appendia A

liens and incur or assume additional indebtedness except

in the ordinary course of busness and under the conditions

specified by the terms of the indentures.

Mazor ComproMIsEs

In a plan such as the Reading’s which is primarily con-

sensual, the importance of compromise cannot be overem-

phasized. Many settlements have laid the foundation for

the Plan, and the Plan itself is the product of many hours

of negotiation. Before describing the various compro-

mises between the major claimants of the estate, some un-

derstanding of the presumptions upon which the settlements

rely is necessary.

No settlement would be possible without the claimants’

agreeing to defer the major portion of the debt until the

valuation case proceeds, the largest single asset of the es-

tate, can be used for payment. The valuation case is the

ongoing litigation to determine how much money the gov-

ernment owes Reading for the conveyance of its operating

assets to ConRail, Under the RRRA, the USRA placed a

value on all of the operating assets of the estate in the final

system plan. Following the example of the other bankrupt

railroads, Reading and its subsidiaries did not accept as

the value of their operating assets the $32 million fixed by

the USRA. Instead, the Reading began to litigate the issue

de novo in the Special Court set up by the RRRA. My learned

colleague, Judge Fullam, has already detailed the issues

in the valuation case, and I need not repeat his scholarly

analysis here. Jn re Penn Central Transportation Co., 458

F. Supp. at 1270-76 (K.D. Pa. 1978). I agree with Judge

Fullam’s estimation that the railroads should be optimistic

about recovering a value in excess of the amount proposed

15a

Appendix A

by USRA for their assets. Jd. at 1274. Indeed, the SEC

in evaluating the Penn Central plan stated: “The expecta-

tion of a large recovery from the valuation case is not a

matter of contingency or unfounded hope. It is as certain

as any event can be.” SEC Report at 43. The Third Cir-

cuit noted that the Special Court characterized the govern-

ment’s initial offer of payment for the railroad’s conveyed

properties as “ineredible.” Jn re Penn Central Transpor-

tation Co., 596 F. 2d 1155, 1165 (3d Cir. 1979).

The exact amount of recovery, however, is wholly specu-

lative. Under an “alternate scenario,” in which the trustees

attempt to show what would have happened to their as-

sets without the RRRA,® Alfred W. Tlesse, Jr., current

president of the Reading Company, speculates that it would

have received in excess of $328 million. Under the formula

suggested by the Special Court in its October 12, 1977, opin-

ion—original cost less depreciation, rehabilitation, and

adaptation costs—the Reading should receive approximate-

ly $215 million. See, affidavit of Alfred W. Hesse, Jr., 710,

filed August 16, 1979. Although there is a risk that the

Reading will not recover a sizeable amount in the valuation

case, chances for recovery seem excellent, and claimants

which are to receive a percentage of the proceeds of the

valuation case as part of the Plan should be fairly certain

of some payment. Thus, the consideration of possible val-

uation case proceeds as a means to satisfy claimants under

the Reading Plan is realistic, reasonable, and fair.

® The “alternate scenario” is part of the testimony in the valu-

ation case presently before the Special Court in which Reading

attempts to show that it could have sold at least part of its rail

properties to profitable carriers or public bodies for rail use at

prices far higher than those determined by the USR.A. See, afti-

davit of Alfred W. Hesse, Jr., filed August 16, 1979.

ad 16a

Appendix A

The method for evaluating compromises in a railroad re-

organization has already been well articulated by Judge

Fullam. Jn re Penn Central Transportation Co., 458 F.

Supp. 1234, 1261-64 (E.D. Pa. 1978). Basically, two types

of compromises are incorporated into a plan of reorganiza-

tion: settlements agreed to by the concerned parties and

already approved by the court apart from the plan and

compromises suggested by the trustees in the plan itself

without the imprimatur of those involved in the dispute.

Both kinds of compromises must be examined in the same

way by the reorganization court. As Judge Fullam noted,

“lilt is firmly settled that a Plan may be approved which

embodies compromise resolution of conflicting contentions,

if the approval is based upon an informed evaluation of

the strengths and weaknesses of the respective contentions,

the likelihood, duration, and expense of litigation which

would otherwse be necessary, and the range of possible liti-

gation results.” Jd. at 1261.

In assessing the reasonableness of each individual set-

tlement, it is crucial to remember that these pieces are com-

bined into one plan of reorganization. This unit cannot be

disturbed without damaging the intricate balance estab-

lished through extended negotiations. The treatment of

one class of claimants must be examined in light of the

overall Plan.

The power of the reorganization court to approve a

plan embodying compromises does not mean that objec-

tions are ignored. On the contrary, the objections to the

Reading Plan were carefully considered. However, no one

involved in the Reading reorganization has advocated that

the Plan should be totally abandoned unless the wishes of

its class are met. The approval of the Plan necessarily

entails the sacrifice of some individual demands. For the

17a

Appendia A

reasons expressed in the following sections, I conclude

that the individual compromises incorporated into the

Reading Plan satisfy the test of fairness and equity and

are within the range of possible and reasonable litigation

results.

1. United States claims

The main compromise which makes all other agreements

possible is the waiver by the United States of its first

priority claim to which it is legally entitled under section

211(h). 45 U.S.C. §721(h), Transcript of hearings on the

Plan 9/17/79 pp. 5-7.7 Section 211(h) amended the RRRA

7Section 211(h)(4)(D):

(D)(i) Except as provided in clause (ii) of this subpara-

graph, any funds held in an escrow account by a railroad

in reorganization on October 19, 1976, which are thereafter

determined to be cash and other current assets of the es-

tate of such railroad in reorganization for purposes of para-

graph (3) of this subsection, shall be applied as follows—

(1) first, to the reduction of any outstanding loans to

the Corporation by the Association, pursuant to para-

graph (1) of this subsection, the proceeds of which were

used to discharge obligations of such railroad in reor-

ganization ;

(II) second, to the Association to the extent of any such

loans which have been forgiven pursuant to paragraph

(5) of this subsection; and

(III) third, to the payment of any remaining obliga-

tions of such railroad in reorganization, in accordance with

the provision of the agency agreement entered into pur-

suant to paragraph (2) of this subsection.

(Footnote continued on following page)

18a

Appendix A

to allow the bankrupt railroads to borrow money from the

government through ConRail to pay necessary pre-convey-

ance expenses. In return, the Reading had to recognize

the loan as a current administrative expense and provide

that full repayment would have a priority superior to any

other claims. Congress granted this “superpriority” since

the government made railroad service possible during

bankruptey. If the United States asserted its priority and

insisted on cash, there would be no available funds for any

other claimants. Obviously, the decision of the United

States to accept Series A administrative notes instead of

eash is not challenged by any claimant.

Currently, Reading owes the United States approxi-

mately $4.8 million plus interest for a loan to purchase 57

locomotives and approximately $19 million plus interest

for advances under the section 211(h) loan program. The

total amount owing the government in this first priority

(Footnote continued from preceding page)

(ii) The manner of disposition set forth in clause (i) of

this subparagraph shall not apply with respect to a rail-

road in reorganization if the Secretary (I) determines that

a different disposition of assets is necessary to carry out

a reorganization plan of such railroad in reorganization,

and that such different disposition adequately protects the

interest of the United States, and (II) transmits his de-

termination to the court having jurisdiction over the reor-

ganization of such railroad.

45 U.S.C. §721(h) (4) (D).

19a

Appendix A

class is estimated to be over $31 million. Exhibit B to the

Plan.’

A condition to the United States’ approval of Reading’s

Plan of Reorganization was the payment of $5 million in

eash to the government. However, the United States

agreed to waive this payment if the trustee could draw

down cash for the payment of about $5 million in section

211(h) eligible claims. I authorized such a payment in my

opinion and Order No. 1772.

After careful review of the treatment of the United

States under the Plan, I conclude that the provisions for

the United States’ claims are fair and reasonable.

2. Claims by Other Railroads

(a) Leased Lines

Reading had a 999 year lease with the Philadelphia, Ger-

mantown, and Norristown Railway Company and _ its

wholly-owned subsidiary, the Plymouth Railroad Company.

The Reading also had shorter leases, 990 years, with the

Delaware and Bound Brook Railroad and the North Penn-

sylvania Railroad Company. In anticipation of convey-

ances in 1976, settlement negotiations were commenced

between Reading and its leased lines. Under the terms of

all of these settlements, the trustees were to give a sub-

stantial cash advance to the leased railroads and take re-

8 This excludes a disputed $891,801 of section 211(h) drawdowns

by ConRail to pay Debtor’s retired employees’ single premium

life insurance premiums. All these amounts owing the govern-

ment will be satisfied in the highest priority Series A administra-

tive notes.

20a

Appendix A

sponsibility for all real estate taxes up to the date of con-

veyance. In exchange, the leased lines promised to share

equally with the Reading in the proceeds of any recovery

for operating assets conveyed to ConRail or for nonoper-

ating assets sold to others. Reading also agreed to manage

the retained, nonoperating properties for a fee. The settle-

ments included the forgiveness of claims for delinquent rent

and the mutual release of all claims. See Hearing Order

Nos. 1096, 1097, 1098. I approved these settlements with

the leased lines on July 27, 1976. See Order Nos. 1126,

1127, 1128. In respect to the Plan, Reading does not owe

any money to the leased lines. However, the interest of

the Reading in any proceeds which the leased lines will re-

ceive from the valuation case will be considered part of

the Reading’s valuation case proceeds available for dis-

tribution to its creditors. I conclude that this treatment

of the leased lines is fair and reasonable.

(b) Six month and Interline Creditors

Objections to the Plan of Reorganization were originally

filed by Erie Lackawanna, Lehigh Valley, Penn Central,

and the Committee for Interline Railroads. These claims

for payment accrued primarily from per diem and inter-

line accounts for joint use of railroad equipment and track.

However, none of these objectors made statements in the

hearings on the Plan since they felt settlements were im-

minent, As expected, the Erie Lackawanna and the Read-

ing signed an agreement on February 13, 1980, which pro-

vided for mutual releases of all claims, except those in-

volving personal injuries, upon Reading’s payment of

$30,007.23 to the Erie Lackawanna. Also, the Erie Lack-

awanna by letter to the court withdrew its earlier objec-

2la

Appendix A

tions to the Plan. In March, 1980, the Penn Central, Lehigh

Valley, and the Committee for Interline Railroads submit-

ted stipulations for my approval of settlements. These

agreements dealt with various classes of claims: pre-peti-

tion/six months creditors,’ post-petition/pre-conveyance

debts, and other post-petition claims.

Reading owes Penn Central approximately $640,000. in

pre-petition claims. Under the agreement I approved, half

of them were deemed Class FE or “six-month claims.” On

consummation five percent of their total will be paid in

cash and 95 percent in Series C administrative notes. The

other half were deemed general creditor claims and will

be secured by an indenture lower in priority and payment

than administrative notes and reorganization bonds.

Reading’s post-petition, pre-conveyance debts to Penn

Central total $1,828,998. These claims fall within section

211(h) eligible,’® administrative claims. The settlement

® Judge Fullam described in detail the prerequisites for this six

month priority in his Penn Central opinion, 458 F. Supp. at 1319-

28.

Before any right to priority under the six months rule can

be established, it must appear that the obligation was in-

curred as an expense of current operations, in the ordinary

course of business, for materials or services used in the

operation of the railroad, that the creditor expected to be

paid out of the current operating receipts of the railroad

(as distinguished from reliance upon the general credit of

the railroad); and that the claim arose within six months

before the filing of the petition.

Id. at 1321.

10 These post petition, pre-conveyance claims are primarily inter-

line freight claims eligible under section 211(h) (iii). See 45 U.S.C.

§721(h) (iii).

>

22a

Appendix A

allows for an immediate payment of one-third cash and

two-thirds cash held in escrow with payouts on the first

and second anniversaries of the settlement’s approval.

The status of the post-petition Penn Central trust fund

claims is still being negotiated and a final agreement on

these items will be presented to me for independent ap-

proval apart from the Plan.

The stipulation of settlement with Penn Central was ap-

provedgas fair and equitable on May 21, 1980. See Order

No. 1803. Thus, the objections of Penn Central to the Plan

were withdrawn.

The Lehigh Valley Railroad had a post-petition, pre-

conveyance interline freight claim of $838,447.18 against

the Reading which falls within the section 211(h) eligible,

administrative category. The settlement provided for the

cash payment of one-half of the total claim on October 15,

1979, with the rest to be eserowed and paid out with inter-

est on October 15, 1980. See Order No, 1803, and, conse-

quently, Lehigh Valley’s objections to the Plan were re-

solved.

The Committee of Interline Railroads (Interlines) is a

group of approximately 76 railroads which transported

freight and passengers, exchanged ears, and performed

other services with and for Reading. It has both pre-peti-

tion and post-petition claims, amounting to $2.1 million

and $187,000. respectively. The settlement provides that

one-half of the pre-bankruptcy claims will be classified as

Class FE, entitled to receive five percent cash on consumma-

tion and the balance in Series C administrative notes. The

other half of the pre-petition amount will be considered

an unsecured creditor’s claim and satisfied as such.

23a

Appendix A

The post-petitionglnterline claims were eligible for sat-

isfaction through section 211(h) loans. I previously au-

thorized their payment once adjustments have been made

under the appropriate Association of American Railroad

Rules, in such amounts as are then determined to be due.

See Order No. 1772.

I found this Interlines settlement fair and equitable on

May 21, 1980. See Order No. 1803. Thus, the objections

of the Interlines to the Plan were withdrawn.

One other railroad claim matter should be mentioned.

Certain obligations are still outstanding between Reading

and ConRail with negotiations still in progress. The

amounts in issue are not so great as to upset the Plan.

Therefore, whether an agreement is reached or some adju-

dication is required, the approval of the Plan need not be

delayed.

StaTE AND Locat Tax CLAIMs

1. Description of Claims

At one time Reading was faced with approximately $10.2

million in state and local real estate tax claims, $6.6 mil-

lion in corporate state tax claims, and $263,000. in other

tax claims. Since 1978, Reading has reached settlements

with various taxing authorities until only $938,000. in real

estate taxes and $37,000. in corporate taxes presently re-

main unresolved. Among the principal outstanding tax

balances is New Jersey’s franchise and rea} estate tax claims

estimated to be $255,000.

When the hearing on the Plan was held, the Common-

wealth of Pennsylvania joined New Jersey in objecting to

24a

Appendix A

the Reading’s treatment of tax claimants. After much

negotiation, Reading and the Commonwealth agreed upon

a basis to settle all of the Commonwealth’s taxes. Under

its terms, the Commonwealth would forgive $1 million in

taxes, and the Reading would pay $7 million to satisfy the

balance of $6.4 million in Class D state and corporate taxes

and approximately $1.6 million in Pennsylvania Utility

Realty Taxes, 30 percent in cash and the rest in securities.

After hearing, I approved this settlement as fair and equi-

table. See Order No. 1794.

The bulk of Reading’s other tax obligations had been for

real estate taxes owing to state and local governments. A

major settlement for $6.5 million with the City and School

District of Philadelphia involved payment of 30 percent

of the claim in cash and 70 percent in Series B notes. After

hearing, I approved this agreement as fair and equitable

and directed the Reading to offer the same ternis to settle

the remaining real estate claims. See Order No. 1519; In

re Reading Company, 463 F. Supp. 528 (E.D. Pa. 1978).

At present approximately 80 taxing authorities have set-

tled $2.9 million in claims against the Reading on terms

similar to that of Philadelphia. The Plan utilizes this same

30 percent cash/70 percent securities package to pay the

remaining tax claimants. The State of New Jersey has

consistently objected to the Philadelphia agreement and

the Plan’s treatment of state and local tax claims.

2. Objections of New Jersey

The state of New Jersey objects to the Plan on many

grounds (1) failure to provide for prompt cash payment

as statutorily required for administrative tax claims; (2)

failure to recognize and provide for interest at the statu-

25a

Appendix A

tory rate on unpaid administrative tax claims through con-

summation; (3) inclusion of non-real estate tax claims in

the same class for voting as other administrative claims;

and (4) construing tax claims which have settled as voting

for approval of the Plan.

New Jersey argues that its administrative tax claims

must be satisfied in cash instead of the Plan’s provision

of 30 percent in cash and 70 percent in securities. New

Jersey contends that 28 U.S.C. §960 and section 77(e) (3)

_ of the Bankruptey Act, 11 U.S.C. §205(e)(8), mandate

cash payment of current taxes unless exceptional cirecum-

stances exist.

I found the necessity for the continued operation of

the railroad sufficient justification to defer tax payments

soon after the Reading filed its petition for reorgani-

zation. See Order No. 186. A similar deferral of taxes

was allowed in Penn Central as necessary to the main-

tenance of a railroad system operating at a loss for the

public good. In re Penn Central Transportation Com-

pany, 325 F. Supp. 294 (E.D. Pa. 1970) aff’d 452 F. 2d

1107 (3d Cir. 1971) cert. denied New Jersey vy. Penn Cen-

tral Transportation Company, 406 U.S. 944 (1972).

New Jersey interprets the Third Cireuit’s approval in

Penn Central as mandating that the tax deferral be tem-

porary and be terminated at the earliest possible date.

New Jersey contends that the Plan’s provision of 70 per-

cent in Series B notes defers payment until the Special

Court determines whether any additional compensation

will be owing pursuant to the valuation case. The earli-

est projection for completion of the valuation case is

1988.

7%

26a

Appendix A

The Reading trustees counter that notwithstanding the

deferral of taxes pursuant to Order No. 186, the Reading

has paid New Jersey a substantial portion of its real

estate tax claim. Of the $600,000. once claimed by New

Jersey, Reading has paid approximately $350,000. The

trustees argue that a continued deferral of the remainder

is proper since the conveyance to ConRail included prop-

erties upon which tax liens were assessed. The convey-

ance was free and clear of those liens, which were then

transferred to the proceeds of the sale, that is, to the

valuation case, and New Jersey must look to those pro-

ceeds for payment. Judge Fullam in his Penn Central

opinion aptly summarized the complex problems involving

tax claims.

The impact of [the Rail Act] upon the status of

the claims for state and local taxes, and upon the re-

lationship between these claims and the claims of

other creditors, cannot be overemphasized. Because

continuation of loss operations was mandated, the

amount of unpaid tax claims and other unpaid ad-

ministration claims was greatly increased, probably

-by more than half a billion dollars in the aggregate.

At the same time, the rights which such claims would

have on liquidation (which is the standard for assign-

ing ‘value’ to all claims in the present context) were

significantly altered; moreover, the nature and ex-

tent of this alteration could well provide the grist

for many years of litigation...

The liquidation rights of the tax claimants in the

present circumstances are quite different. In the

first place, the properties against which roughly

three-fifths of the tax claims are assessed have been

conveyed to ConRail free and clear of all liens, in-

27a

Appendix A

eluding tax claims. With respect to pre-petition taxes,

this means that the liens are transferred to the pro-

ceeds to be derived from the Valuation Case; but

realization from that source is deferred and uncer-

tain. With respect to post-petition taxes, the prob-

lem is one of the proper allocation of administration

expenses. That is, it cannot be assumed that post-

petition taxes, even though they are administration

claims, would be satisfied promptly by retained as-

sets, in the event of liquidation. Assuming the va-

lidity of the Government’s superiority, the tax claims

would not have access to cash or other liquid assets,

and could not be satisfied from sales of retained as-

sets without doing violence to mortgage liens upon

retained assets. The notion that tax claims gener-

ated by conveyed assets would automatically be trans-

ferred to, and prime existing mortgages on, retained

assets is one which would not likely be aecepted by

mortgagees without a struggle. 458 F. Supp. at

1277-78.

The Plan’s treatment of tax claims by payment in eash

and securities is a fair and equitable solution to these diffi-

cult problems.

New Jersey argues that section 77(e)(3) of the Bank-

ruptey Act requires payment of administrative claims in

eash unless the claimant agrees otherwise. Section 77(e)

(3) states:

(3) the plan provides for the payment of all costs

of administration and all other allowances made or

to be made by the judge, except that allowances pro-

vided for in subsection (ce), paragraph (12) of this

section, may be paid in securities provided for in the

28a

Appendix A

plan if those entitled thereto will accept such pay-

ment, and the judge is hereby given power to approve

the same. 11 U.S.C. §205(e) (3).

The trustees dispute New Jersey’s interpretation of the

statutory language. Reading argues that “costs of admin-

istration” refers to expenses directly associated with the

reorganizatiou proceedings, such as compensation for trus-

tees and attorneys. See Jn re Penn Central Transportation

Co., 458 F. Supp. 1234, 1282 (.D. Pa. 1978). Deferred

taxes would properly fall under “claims” in section 77(b)

the rights of which may be modified by the Plan of Reor-

ganization. I agree.

Furthermore, the trustees contend that New Jersey’s

interpretation requiring agreement to the Plan by every

taxing authority would allow one “holdout” administrative

claimant to destroy the carefully interwoven pattern of

comprises. The reorganization court must be allowed flex-

ibility to preserve the compromises embodied in the Plan

by approving a fair and equitable treatment of adminis-

trative claims over a taxing authority’s objection. Com-

promise is the key to a consensual Plan. The trustees point

out that the United States, a creditor of the highest priority,

accepted securities in lieu of cash in satisfaction of its claim.

New Jersey is receiving a greater percentage of its claim

in cash than any other claimant except those in Class A

whose demands arise from reorganization.

New Jersey’s major objection is its insistence that the

word, “payment,” in section 77(e)(3) of the Bankruptcy

Act requires payment in cash not securities. New Jersey

contends that the absolute priority rule prohibits distribu-

tion of any cash to junior claimants before tax claims are

fully paid, i.e., administrative claimants may be paid in a

’>

29a

Appendiz A

form other than cash only if no cash is available. I agree

with the trustees that the absolute priority rule as applied

to railroad reorganizations does not mandate such an in-

flexible policy.

The Third Cireuit in Penn Central recognized the need

for a pragmatic and flexible approach to priorities in re-

organization. The court analyzed the purpose of the abso-

lute priority rule as ensuring that senior creditors receive

full compensatory treatment before the next class is al-

lowed to participate. The Third Circuit noted the differ-

ence between determining priorities in a reorganization as

opposed to a liquidation.

First, in a reorganization the aggregate value of

the debtor’s assets is determined, not by a judicial

sale, but by a hypothetical—albeit expert—caleula-

tion of their future worth to the enterprise. Second,

claimants are satisfied not with cash, but with seeuri-

ties which reflect an apportionment of value in an

ongoing business enterprise. It has long been recog-

nized that these features of the reorganization pro-

cess make it wholly unreasonable to expect that any

plan will meet with precision the standards of the

absolute priority rule. Jn re Penn Central Trans-

portation Co., 590 F. 2d 1102, 1110 (3d Cir. 1979).

It is clear from this analysis that the Third Cireuit real-

ized the necesesity and legality of satisfying reorganiza-

tion claimants with securities. The court found support

for its approach of flexibility in pursuit of feasibility in

these words from the Supreme Court:

The absolute priority rule does not mean that

bondholders cannot be given inferior grades of se-

curities, or even securities of the same grade as are

30a

Appendix A

received by junior interests. Requirements of feasi-

bility of reorganization plans frequently necessitate

it in the interests of simpler and more conservative

capital structures. And standards of fairness per-

mit it.

* * *

Practical adjustments, rather than a rigid formula

are necessary. The method of effecting full compen-

sation for senior claimants will vary from case to

case. ... [WH]hether in a ease of a solvent com-

pany the creditors should be made whole for the

change in or loss of their seniority by an increased

participation in assets, in earnings or in control, or

in any combination thereof, will be dependent on

the facts and requirements of each case. So long as

the new securities offered are of a value equal to

the creditors’ claims, the appropriateness of the

formula employed rests in the informed discretion of

the court. Consolidated Rock Products Co. v. Du

Bots, supra, 312 U.S. at 528-30, 61 S. Ct. at 686-87

(footnotes omitted).

quoted in In re Penn Central Transportation Co., supra,

596 F. 2d at 1111 (8d Cir. 1979).

The Reading’s treatment of state and local tax claim-

ants reflects the trustees’ best estimate of the real worth

of the tax claims compared to the-rest of the claims

avainst the estate. Reading does not acknowledge it owes

what New Jersey demands. Principally, the Reading con-

tends that a reduction in its tax liability is warranted

since the state insisted the Reading operate, even at a

loss, to serve New Jersey residents. Still, the Reading

proposes to satisfy the tax claimants with a significant

3la

‘ppendia A

portion of the claim in cash and the remainder in Series B

notes, high priority securities.

At tke hearing on the Plan, New Jersey offered the

testimony of Mr. Roland Machold, Director of the State’s

Division of Investments, to prove that the Series B and C

administrative notes were speculative and inferior. <Al-

though these securities are based on the outcome of the

valuation case, Mr. Machold had not read any of the testi-

mony presented to the Special Court. As previously dis-

cussed, Reading’s optimism for a substantial recovery from

the valuation case is shared by the SEC, Judge Fullam,

and Third Circiut in analyzing Penn Central. 1 conclude

that the Plan’s satisfaction of state and local tax claim-

ants by 30 percent cash and 70 percent Series B adminis-

trative notes fully compensates Class C claimants under

the absolute priority rule and complies with the fair and

equitable requirement of section 77.

New Jersey further maintains that Reading’s treatment

of its tax claims violates the fifth and tenth amendments

to the Constitution. The State argues that any deferral

of tax payment without the State’s consent is tantamount

to a requisitioning of State property, and the fifth amend-

ment would require just compensation for such a govern-

ment taking. Just compensation puts the creditor in as

good a financial position as if the property had not been

taken. New Jersey contends this means cash payment.

I agree with the trustees that deferral of taxes cannot

be construed as a taking since it does not impermissibly

impair the rights of tax claimants. Similarly, there is no

constitutional requirement that administrative claims be

paid only in cash. In a reorganization proceeding, satis-

faction of tax claims in cash and securities is Just compen-

32a

Appendia A

sation. Indeed the Supreme Court held that “no decision

of this Court holds that compensation other than money

is an inadequate form of compensation under eminent

domain statutes.” Regional Rail Reorganization Act

Cases, 419 U.S. 102, 150, 95 S. Ct. 335, 362, 42 L. Ed. 2d

320 (1974).

The tenth amendment is allegedly infringed by Read-

ing’s payment of tax claims in cash and securities since this

is an impermissible intrusion by the federal government on

the state’s right to assess and collect taxes. New Jersey

cites National League of Cities v. Usery, 426 U.S. 833, 96

S. Ct. 2465, 49 L. Ed. 2d 245 (1976), in support of this as-

sertion. In National League of Cities the Supreme Court

invalidated an amendment to the Fair Labor Standards

Act extending minimum wage-maximum hour provisions to

state and local governments. The Court held that the

amendment would directly interfere with the state’s exer-

cise of its day to day function as a public employer. The

Court articulated the tenth amendment standard in this

way.

Congress may not exercise that [commerce] power

so as to force directly upon the State its choices as

to how essential decisions regarding the conduct of

integral govermental functions are to be made. 426

U.S. at 855, 96 S. Ct. at 2476.

The deferral of state taxes due to a rail reorganization

does not impose changes on the conduct of integral state

government functions. The entire tax claim involved here

is $255,000. The Plan would allow the trustees to pay 30

percent in cash and 70 percent in securities instead of the

full amount in cash as New Jersey favors. The deferral

of approximately $175,000 of immediate cash payment is

33a

Appendia A

hardly disruptive of the day to i functions of an entire

state. [ conclude that the payment of tax claims in cash

and securities is not violative of the tenth amendment.

Finally, New Jersey raises several objéctions which I

do not need to decide at this time. The State argues that

the Plan fails to provide interest for its principal claim at

the statutory rate. This objection can best be decided when

the exact amount of all claims are adjudicated. What is

presently before me is the fairness and equity of the rank-

ing of claims and their treatment as part of one Plan.

The State’s objection concerning voting procedures is

similarly premature. New Jersey disapproves of tax claim-

ants being grouped with other administrative claimants

as one class for voting purposes. Also, the Plan deems

those taxing authorities who have accepted the Phila-

delphia settlement as voting for the Plan. These con-

tentions properly should be raised at consummation rather

than the approval stage. However, | direct the trustees

tu keep separate lists of the votes of tax and nontax ad-

ministrative claimants and the settling and non-settling

tax claimants. :

TF'BASIBILITY OF THE PLAN

In addition to determining whether or not the Plan’s

allocation of Reading’s available assets to its debts is

fair and reasonable, I must also determine whether the

Plan is feasible.

Section 77(b)(4) of the Bankrutey Act requires, in per-

tinent part, that a plan

(4) shall provide for fixed charges in such an

amount that, after due consideration of the prob-

34a

Appendix A

able prospective earnings of the property in light

of its earnings experience and all other relevant

facts, there shall be adequate coverage of such fixed

charges by the probable earnings available for the

payment thereof. 11 U.S.C. $205(b) (4).

Judge Fullam further articulated the standard in his

Penn Central opinion:

The design of the capital structure of the reor-

ganized enterprise must be such that the Debtor’s

earnings will support the new capital structure. The

reorganized company must be reasonably likely to

be able to comply with the requirements of the

securities issued. That is, it must be reasonable

to suppose that the reorganized company will be

able to meet when due the payments required by

the new debt securities, and that it will have suf-

ficient earnings to enable it to pay dividends and

grow, so that its equity securities will have value.

In re Penn Central Transportation Company, 458

F. Supp. 1234, 1247 (.D. Pa. 1978).

In the historie railroad reorganization, feasibility re-

ferred to the reorganized company’s ability to sueceed in

the railroad business. The question was whether it could

generate sufficient revenues to meet its operating costs

and support a pared down debt structure. The Penn

Central problem was different, but analogous. Penn Cen-

tral had subsidiary businesses which with proper manage-

ment could be expected to vield far more through their

operation than could be realized through their liquida-

tion.

In contrast, Reading’s sources of income are limited to

rents, interest and dividends, and the operations of a

35a

Appendix A

comparatively small coal company. A major portion of

its money over the next five years will come from its assets

disposition program. Reading’s total receipts, however,

will not provide enough to pay off its obligations—success

in the valuation case is the key to the ultimate discharge

of debts. Although optimism prevails about the chances

of a substantial recovery in the valuation case, this will

only occur if litigation efforts are diligently pursued. The

present Plan does not—and cannot—provide the questions,

niuch less the answers, as to what Reading’s income and

expenses will be if it acquires some sort of operating or

manufacturing business. Thus, feasibility, in the present

context only deals with whether projected income and the

proceeds from the disposition of assets will enable it to

pay its expenses, liquidate its debts on schedule, and seek

a satisfactory result in the valuation case.

The sole objection as to feasibility also came from New

Jersey. In itself, New Jersey’s claim is minimal and it

could be paid at any time. It is only important because

if New Jersey is afforded the favorable treatment it wants,

similar demands from other tax claimants might be pro-

voked. If they were met,” the feasibility of the Plan

would be jeopardized sinee the outflow of cash would

leave nothing to fund the valuation case litigation. It is

for this reason, and this reason alone, that the assertions

of New Jersey have been considered so fully.

11 This is not to say that they would be met. Claimants who

have not settled would not necessarily be governed by a decision

as to New Jersey’s claim. Although those tax claimants which

have settled are protected by a “most favored nations” clause, it

would not necessarily govern if immediate cash payment to New

Jersey was ordered by the court, as contrasted to Reading's asree-

ing to pay New Jersey in cash immediately.

36a

Appendix A

In support of their opinions that their Plan is feasible

the trustees and their staff made various studies and

_ projections. Their approach was to be conservative in-

sofar as receipts were concerned and realistic about dis-

bursements. Their forecast was attached to the Plan as

Exhibit A. In summary it shows the following: (all figures

are in millions)

1980 1981 1982 1983 1984

Beginning eash balance $25.0 $15.2 $14.6 $14.7 $13.5

Receipts:

Operations 6.2 5.0 4.9 5.0 4.9

Asset Dispositions 6.0 6.2 4.5 1.4 1.9

Total Receipts $12.2 $11.2 $94 $64 $ 68

Disbursements:

Operations and

Asset Disposition

Program $42 $42 $23 $23 $ 2.4

Plan Disbursements 17.8 7.6 7.0 5.3 5.0

Total Disbursements $22.0 $11.8 $9.3 $ 7.6 $ 7.4

Net Cash Increase $(9.8) $ (.6) $ .1 $(1.2) $ (.6)

Support for these projections can be found in the af-

fidavits of the trustees and officers of the Reading Com-

pany and their testimony given at the hearing on the

Plan.

These figures show three things. Frst of all, the Read-

ing has reasonable -expectations that it will be profit-

37a

Appendix A

abie.’? Secondly, there will be sufficient cash flow to meet

the debt payments scheduled by the Plan, and finally, it

will have sufficient reserves to prosecute matters before

the Special Court. Moreover, there should be enough

inargin to meet the unexpected and still survive. I re-

iierate the obvious, however. These figures do not pur-

port to show what will happen if Reading embarks on

some new venture. Feasibility, as I use the term, refers

only to what the Reading now is, now does, and now plans.

With this understanding, it is plain that the Plan pro-

vides a realistic means to pay off its debts on schedule—

those in the immediately foreseeable future—and through

the pressing of the valuation case, those that have been

deferred.

CoNcCLUSION

For the reasons that have been expressed at length, I

conclude that the Plan of Reorganization submitted by

Andrew L. Lewis, Jr., and Joseph L. Castle, III, Trustee

of Reading Company, Debtor, as amended |

1) Complies with all requirements of law;

2) Is feasible; and

3) Is fair and equitable.

Two more things must be said.

First, I have been spared the necessity of re-examining

and discussing many of the concepts which govern section

77 proceedings and those under the RRRA because of

12 Dividends will be deferred, however, until all reoragnization

debts have been paid.

r%

38a

Appendix A

Judge Fullam’s landmark opinion approving the Penn Cen-

tral plan. There was no point in my repeating except for

limited purposes what he had said so well and so recently.

On occasion I did so, but obviously, his scholarly work was

more than a source of quotations—it was a constant help

and guide to my task.

Secondly, the competing interests of the contending par-

ties are best served by a consensual plan. In many re-

spects the compromises which have been reached were

achieved through the leadership of the trustees and their

staff. In addition, their management skills have provided

a viable base on which compromises could be built and

against which the chances of ultimate success could be

measured. The trustees and their staff deserve my com-

mendation and the thanks of all whose investments they

have helped to salvage.

39a

Appendix A

Order of the United States District Court for the Eastern

District of Pennsylvania

In tHE Untrep States Distrricr Courr

For tHE Eastern Distrricr of PENNSYLVANIA

In THE MATTER

OF

Reapinc CoMPANY

Debtor

In Proceedings for the Reorganization

of -a Railroad

Bky. 71-828

Orver No. 1804

AND Now, this 21st day of May, 1980, I approve the Plan

of Reorganization of the Reading Company, as amended

by my Order No. 1803, for the reasons expressed in the

foregoing opinion.

By the Court:

J. Wituram Dirter, Jr., J.

Kintered: 5/21/80

Clerk of Court

40a

APPENDIX B

Judgment Order of the United States Court of Appeals

for the Third Circuit

Unitrep Srates Court oF APPEALS FoR THE THIRD CircuIT

Nos. 80-1298/99 and 80-1992/93

Lip.

_

In the Matter of Reapina Company,

Debtor

State or New JERSEY,

Appellant

>.

a

Appeal from the United States District Court

for the Eastern District of Pennsylvania

C. A. No. B-71-0828

Argued September 19, 1980

Before: Apams, Hunter and Hicarnsoruam, Circuit Judges

JUDGMENT ORDER

After consideration of all contentions raised by appel-

lant, it is |

ApsUDGED AND Orprrep that the judgment of the district

court be and is hereby affirmed.

7%

4la

Appendix B

Each side to bear its own costs.

By the Court,

Arurs M. Apams

Cireuit Judge

Attest:

Satty Mrvos

Sally Mrvos, Clerk

Dated: Sep 23 1980

42a

APPENDIX C

Order of the United States Court of Appeals Denying

Petition for Rehearing

Unitrep States Court or APPEALS

For THe Turrp Circuit

No. 80-1993

» ™

—

In the Matter of Reaprna Company,

Debtor

State or New JERSEY,

Appellant

¢

Sur Petition ror REHEARING

En Bano

Present: Serirz, Chief Judge, Auvpisert, ADAMS, GIBBONS,

Rosenn, Hunter, Weis, Garry, HiccinsorHam and

Svoviter, Circuit Judges.

The petition for rehearing filed by Appellant, State of

New Jersey, in the above entitled case having been sub-

mitted to the judges who participated in the decision of

this court and to all the other available circuit judges of

the cireuit in regular active service, and no judge who

concurred in the decision having asked for rehearing, and

a majority of the cireuit judges of the circuit in regular

43a

Appendix C

active service not having voted for rehearing by the court

in bane, the petition for rehearing is denied.

By the Court,

Artin M. Apams

Circuit Judge

Dated: October 17, 1980