October 15, 2013 Articles

Railroads in Bankruptcy: What Happens after a Financial Derailment

New short line railroads face costs that could lead to future bankruptcy cases.

By Thomas Rice

Recently, rail traffic on already existing rail lines has increased, and new short line railroads have been created. The additional traffic has been great for revenues, but that success has not been without some adversity. To maintain operations, short line railroads need to reinvest nearly 30 percent of their annual revenues in infrastructure, including large investments in repairing and maintaining the track. For some short line railroads, these investments may prove to be too costly and lead to future bankruptcy cases.

To address railroad reorganizations, Congress enacted special provisions that specifically address railroad bankruptcy cases. See 11 U.S.C. § 1161–1174. These provisions of the Bankruptcy Code are very different from the traditional Chapter 11 bankruptcy practice. The challenges of a railroad bankruptcy case include the requirement that a Chapter 11 trustee be appointed as soon as possible, the regulatory framework involved in operating a railroad, and addressing the public interest standard when making decisions for the railroad.

Here Comes the Trustee
In a typical Chapter 11 bankruptcy case, a debtor-in-possession can continue the debtor’s operations, unless a party-in-interest successfully demonstrates that a Chapter 11 trustee is required to maintain the debtor’s operations. See 11 U.S.C. § 1104(a)(1). In sharp contrast, a Chapter 11 trustee is always appointed in a railroad reorganization. See 11 U.S.C. § 1163. In fact, section 1107 of the Bankruptcy Code, dealing with the rights, power, and duties of a debtor-in-possession, is not applicable in a railroad reorganization. See 11 U.S.C. § 1161.

This dynamic creates a dilemma for the continued operations of the railroad immediately following the filing of a voluntary petition. Although a Chapter 11 trustee must be appointed, that appointment is delayed until the U.S. secretary of transportation submits a list to the U. S. trustee of five qualified and disinterested persons to serve as Chapter 11 trustee. During this time, many critical actions must be taken to stabilize the debtor’s operations. Given that the debtor-in-possession is specifically excluded from taking these actions, there is a gap between the filing of the voluntary petition and the appointment of the Chapter 11 trustee, during which time the debtor is technically without management. In an effort to address this apparent lack of authority, the court may need to temporarily authorize the debtor to operate as if the debtor was a debtor-in-possession, pending appointment of a Chapter 11 trustee. The railroad debtor’s ability to overcome this initial gap will be critical to a successful reorganization.

Regulators Are Everywhere
In addition to the appointment of a Chapter 11 trustee, a railroad reorganization can be complicated by the number of regulatory agencies that govern the railroad’s activities. The Bankruptcy Code provides that the Surface Transportation Board (STB) and the Department of Transportation may appear and be heard on any issue in the case. 11 U.S.C. § 1164. The STB regulates the railroad industry by enforcing common carrier obligations, approving mergers and acquisitions, authorizing cooperative agreements between carriers that are not anticompetitive, and providing a specialized forum to adjudicate service-related disputes between a carrier and shipper or between two or more carriers. The STB also governs the abandonment of the railroad. Thus, while the Chapter 11 trustee operates the railroad, the ability to reorganize or dissolve will require approval by the STB.

In addition to the STB, the operations of the railroad are governed by Federal Railroad Administration (FRA), which is part of the Department of Transportation. The FRA governs the operations of the railroad to ensure the safety of the employees and the public. The FRA focuses its compliance and enforcement on the transport of hazardous materials, operation of the locomotives, operating practices of the railroad, the signal and train control, and the integrity of the track. Given the significant cost of infrastructure for the railroad, the constant maintenance to satisfy safety inspections may ultimately determine the debtor’s ability to reorganize. In connection with post-petition operations, the failure to rectify compliance issues raised by the FRA can lead to the shutdown of operations until the issues are addressed, which means the debtor loses significant revenues while spending its limited amount of cash to address safety issues.

The Public Interest Standard
In addition to the traditional obstacles associated with a debtor operating in Chapter 11, such as court approval for selling assets, rejecting leases, and confirmation of a plan, a railroad debtor must also satisfy a public interest standard to undertake certain actions. See 11 U.S.C. § 1165. The public interest standard requires a weighing of the benefits of continued operation of the railroad against the continued financial burden owed to creditors. In re Chicago, M. & W.R. Co., 109 B.R. 308, 312 (N.D. Ill. 1989).

While specific provisions of the Bankruptcy Code are implicated as part of the public interest standard, other parts of the Bankruptcy Code may be unaffected. Id. at 311 (finding that the determination of adequate protection is not subject to the public interest standard). Notwithstanding the limited sections listed in section 1165, a court is not constrained to find that the public interest standard applies only to those enumerated sections. Id. at 312. The public interest standard may well apply to a sale of the assets under section 363, where the sale would transfer substantially all the assets of the debtor. Given that the sale may ultimately culminate in cash that would be used to fund a plan, it would be appropriate for a court to consider the public interest when selling the assets; otherwise, the debtor can effectively avoid the public interest standard.

A successful railroad reorganization requires the cooperation of many parties. From the appointment of a Chapter 11 trustee to approvals by the STB, the reorganization effort will face obstacles. In addition, the court will need to weigh whether the transactions affecting the railroad’s operations are in the best interest of the public. Each of these factors complicates the ability to develop and implement a successful railroad reorganization.

Thomas Rice – October 15, 2013