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Boston and Maine Corp. v. Chicago Pacific Corp.

*fn*: March 4, 1986.


Appeal from the United States District Court for the Northern District of Illinois, Eastern Division. No. 75 B 2697 -- Frank J. McGarr, Chief Judge.

Author: Easterbrook

Before COFFEY, EASTERBROOK, and RIPPLE, Circuit Judges.

EASTERBROOK, Circuit Judge.

The Boston & Maine Railroad entered bankruptcy proceedings in 1970. On the day of its bankruptcy it owed about $180,000 to the Chicago, Rock Island, and Pacific Railroad for interline balances. (We use rounded numbers throughout, taking the figures agreed to after negotiation.)

Interline balances are the net amounts due from one railroad to another for mutual transactions. For example, one railroad may use another's cars, and it must pay a daily rate. Railroads also collect revenues for multi-line movements, and they must remit portions to others for their parts of the transportation service. Under regulations of the Interstate Commerce Commission, each railroad computes every month how much it owes to each other railroad for these interline services. If at the end of January the Boston & Maine owed the Rock Island $50,000 for car fees and the Rock Island owed the Boston & Maine $47,000, the difference of $3,000 would be an "interline balance" payable by the Boston & Maine on March 10.

The bankruptcy of the Boston & Maine interrupted its payment of past due interline balances. The Boston & Maine has paid new interline balances on a current basis, but the old balances remain outstanding. These make the Rock Island (now Chicago Pacific Corp.) a general creditor of the Boston & Maine. The First Circuit had considered and rejected a suggestion that the Boston & Maine be required to pay interline balances at a higher priority. In re Boston & Maine Corp., 600 F.2d 307 (1st Cir. 1979). Under the Boston & Maine's plan of reorganization, which has been confirmed by the district court in Boston, general unsecured creditors receive about 10 cents on the dollar.

The Rock Island joined the Boston & Maine in bankruptcy in 1975. The interline balances between 1970 and 1975 ran in favor of the Boston & Maine. The Rock Island tried to do what the Boston & Maine had done -- to treat interline balances as unsecured debt of the bankruptcy firm, to be paid some years hence. We held that the Rock Island could not do this but must immediately pay the entire pre-bankruptcy interline balances from per diem car charges and promptly remit all post-bankruptcy interline balances. In re Chicago, Rock Island & Pacific R.R., 537 F.2d 906 (7th Cir. 1976), cert. denied, 429 U.S. 1092, 97 S. Ct. 1102, 51 L. Ed. 2d 537 (1977). The Rock Island then paid the Boston & Maine for most pre-bankruptcy balances, and it continued to pay until 1979. The district court in Chicago declared the Rock Island "cashless" in 1979 and permitted it to shut down its railroad business, owing the Boston & Maine about $100,000 for interline balances. This left the Boston & Maine as a creditor in the Rock Island bankruptcy, just as the Rock Island is a creditor in the Boston & Maine bankruptcy.

Although each railroad is a creditor in the other's bankruptcy, there are two differences. First, the Rock Island has the assets to pay all claims fully, including interest, so although general unsecured creditors of the Boston & Maine get 10 cents on the dollar, the Rock Island pays such creditors more than 100 cents. Second, we held in 1976 that the Rock Island must pay even pre-bankruptcy interline balances immediately and fully, while the First Circuit held in 1979 that pre-bankruptcy interline balances are general unsecured claims. It expressly rejected, 600 F.2d at 310-12, our contrary conclusion. The upshot is that the Rock Island may collect $18,000 on a 15-year old debt of $180,000 while the Boston & Maine may collect more than $100,000 on a recent debt of $100,000.

The district court that supervises the Rock Island's bankruptcy thought the difference inequitable. So when the Boston & Maine showed up to collect its debt after the confirmation of the Rock Island's plan of reorganization, the district court sent it away empty handed. The court set off the two debts, leaving the Boston & Maine the net debtor. The district court recognized that debts may be set off in bankruptcy only if they are "mutual," which means in part that each party owed money to the other on the date of bankruptcy; it also recognized that under Baker v. Gold Seal Liquors, Inc., 417 U.S. 467, 41 L. Ed. 2d 243, 94 S. Ct. 2504 (1974), setoffs are not ordinarily allowed in railroad reorganizations. This case, the district court thought, is an occasion to lay these rules to the side. The court stated that the award of $18,000 to the Rock Island and more than $100,000 to the Boston & Maine is "fundamentally unfair. Therefore, while under ordinary circumstances B&M's claims might be entitled to immediate payment, under the unique facts present here, equitable considerations require a different result."

The Boston & Maine presses on us a number of arguments, including contentions that the district court's decision to set off the debts was an effort to annul the Boston reorganization court's decision limiting the payout to the Rock Island and therefore exceeded the Chicago court's power. We need not consider whether the Chicago court has the power to do what it did, because we conclude that substantive principles of bankruptcy law do not permit a setoff. The apportionment of adjudicatory powers between two reorganization courts -- a thorny issue indeed -- will abide the time when it spells the difference in result. (The Chicago court had "jurisdiction," because it was asked to dispose of a claim to assets of the Rock Island. We therefore may pretermit the issue without offending the principle that the court must resolve jurisdictional questions ahead of substantive ones.)

The initial, and we think dispositive, difficulty with the district court's resolution is that the debts of the two firms are not "mutual." Section 68(a) of the Bankruptcy Act of 1898, former 11 U.S.C. § 108(a), which applies to this case, provided that "[i]n all cases mutual debts and mutual credits between the estate of a bankrupt and the creditor shall be stated and one debt shall be set off against the other, and the balance only shall be allowed or paid."

The statute did not define "mutual." Neither does its 1978 replacement, 11 U.S.C. § 553, which also makes setoff depend on mutuality of debt. Surprisingly few cases address the meaning of this term. But one feature of all definitions is that the debts on both sides must predate the bankruptcy -- indeed most predate it by some time (four months under the old § 68(b) and 90 days under the new § 553(d)) to avoid being tagged a "preference" and thus avoided. See In re Verco Industries, 704 F.2d 1134, 1139 (9th Cir. 1983); In re Lehigh & Hudson River Ry., 468 F.2d 430 (2d Cir. 1972); Prudential Insurance Co. v. Nelson, 101 F.2d 441 (6th Cir.), cert. denied, 308 U.S. 583, 60 S. Ct. 106, 84 L. Ed. 489 (1939); In re Dartmouth House Nursing Home, Inc., 24 Bankr. 256 (D. Mass. 1982); Ansfield v. Whitewater Oil Co., 254 F. Supp. 494 (E.D. Wisc. 1966); In re Haffner, 25 Bankr. 882, 888 (Bankr. N.D. Ind. 1982). We could sustain the district court's decision only by removing from the definition the requirement that the debts predate bankruptcy. We think, however, that the timing rule serves a substantial purpose.

A corporate reorganization is fundamentally a process of dividing assets among the firm's creditors on the day of bankruptcy. The legal process prevents a rash of asset-grabbing and haggling that might prevent a viable business from continuing, and that surely would be an expensive fight. See Thomas H. Jackson, Bankruptcy, Non-Bankruptcy Entitlements, and the Creditors' Bargain, 91 Yale L.J. 857 (1982); Douglas G. Baird, The Uneasy Case for Corporate Reorganizations, 15 J. Legal Studies 127 (1986). Bankruptcy draws a line between the existing claims to a firm's assets and newly-arising claims. Existing claims are divided according to the contractual rights of the claimants. Butner v. United States, 440 U.S. 48, 59 L. Ed. 2d 136, 99 S. Ct. 914 (1979). If there are not enough assets to go around, some claims may be written down or extinguished. The ongoing operations of the business are treated entirely differently; new claims are paid in full as they arise. It is as if the bankruptcy process creates two separate firms -- the pre-bankruptcy firm that pays off old claims against pre-bankruptcy assets, and the post-bankruptcy firm that acts as a brand new venture.

A setoff of one pre-bankruptcy claim against another may be part of the process of adjusting creditors' entitlements to the pre-bankruptcy assets. Setoffs are recognized in state law as contractual rights independent of bankruptcy. See In re Assured Fastener Products Corp., 773 F.2d 105 (7th Cir. 1985). Self-help remedies often are limited by the bankruptcy code (the law ordinarily prevents secured creditors from realizing immediately on their collateral, for example), and setoff is one such self-help remedy that has been preserved in a restricted form. But the bankruptcy code does not authorize the extension of self-help remedies, on the part of pre-bankruptcy claimants, to ...

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