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In re Chicago

May 20, 1986

IN THE MATTER OF CHICAGO, MILWAUKEE, ST. PAUL AND PACIFIC RAILROAD COMPANY, DEBTOR, APPEALS OF CHICAGO, MILWAUKEE, ST. PAUL AND PACIFIC RAILROAD COMPANY, CHICAGO MILWAUKEE CORPORATION, AND CHICAGO, MILWAUKEE, ST. PAUL AND PACIFIC RAILROAD BOND AND DEBENTURE HOLDERS PROTECTIVE COMMITTEE


Appeals from the United States District Court for the Northern District of Illinois, Eastern Division. No. 77 B 8999 ## 56, 58--Thomas R. McMillen, Judge.

Author: Posner

Before BAUER and POSNER, Circuit Judges, and MOODY, District Judge.*fn*

POSNER, Circuit Judge.

In 1955 the Chicago, Milwaukee, St. Paul and Pacific Railroad Company, known as the Milwaukee Road, issued $56 million in income debentures. The debenture indenture provided that the railroad would pay the holders of the debentures interest installments every year, at the rate of 5 percent, provided that the railroad had "available net income"--income in excess of various fixed expenses, in particular interest due secured creditors. This was to continue for 100 years, at the end of which time the principal would be repaid. In 1977 the railroad petitioned for reorganization under section 77 of the Bankruptcy Act, 11 U.S.C. § 205 (1952 ed.) (which has since been repealed but remains applicable to this proceeding, see Bankruptcy Reform Act of 1978, Pub. L. 95-598, § 403(a), 92 Stat. 2683), precipitating an avalanche of litigation unnecessary to recount here; for a thumbnail sketch see In re Chicago, Milwaukee St. Paul & Pac. R.R., 713 F.2d 274, 277-78 (7th Cir. 1983). A month later the indenture trustee declared the debentures in default. After selling off many of the railroad's lines the Milwaukee Road's trustee in bankruptcy in 1985 sold the remaining lines to the Soo Railroad, see In re Chicago, Milwaukee, St. Paul & Pac. R.R., 756 F.2d 508 (7th Cir. 1985), and turned over the proceeds to the CMC Real Estate Corporation, as the debtor has been renamed. CMC Real Estate Corporation is a wholly owned subsidiary of Chicago Milwaukee Corporation; to simplify exposition, we shall refer to parent and subsidiary interchangeably as CMC. With the proceeds of the various sales, and the nonrail assets (chiefly real estate) that have never been sold, CMC will emerge from bankruptcy with a net worth of more than $400 million after paying off all of the Milwaukee Road's creditors, including the debenture holders, at the highest valuation of their claims.

The issue is how much the debenture holders should receive. The district judge presiding over the reorganization held that they should receive the $56 million principal, plus interest on that principal for every year during which the debentures were in default--even though there was available net income sufficient to pay interest during only two of them--plus interest on this interest. The total is $92 million. CMC has appealed, contending that repayment of the principal should not be accelerated, that no interest is due for the years in which there was no available net income, and that interest on interest, should not be allowed. The interest for the two years in which there was available net income comes to $6 million. The present value of $56 million in 2055, when added to the present value of 5 percent interest for 70 years (2055-1985), is $24 million. (The discount rate used to make this calculation was 12 percent; its correctness is not an issue in this appeal.) Hence CMC is arguing that the debenture holders should get the equivalent of $30 million ($24 million plus $6 million), rather than the $92 million that the judge awarded.

The debenture holders have cross-appealed, making two arguments. One, which we shall not have to address, is that the judge used too low an interest rate in computing the interest due on interest. The other is that the debenture holders are entitled to interest on the overdue principal at a rate higher than 5 percent. We shall have to decide only four issues: whether repayment of the principal should have been accelerated, whether interest should have been allowed in years in which there was no available net income, whether if so 5 percent was the proper rate, and finally whether interest on interest should have been allowed.

1. The indenture provides that in the event of a default the indenture trustee shall be entitled to declare the principal immediately due and payable. There was a default; the trustee made the required declaration; hence the indenture by its terms entitled the debenture holders to receive the full $56 million in principal immediately rather than having to wait till the year 2055. Nevertheless they concede that the reorganization court had the power to make them wait ("decelerate"). In re Atlanta Int'l Raceway, Inc., 513 F.2d 546, 549 n. 7 (5th Cir. 1975). CMC argues that the court should have exercised this power--that because of the rise in interest rates since 1955, acceleration will confer an enormous windfall on the debenture holders, giving them $56 million when, but for the default, the present value of the debentures would be as we said only $24 million (and that only if they could be sure of receiving 5 percent interest every year from now and then). Many of the debenture holders brought the debentures at a tremendous discount from face value, after the inflationary rise in interest rates had reduced the debentures' market value-- though the risk of nonpayment of principal or interest or both may have been an even larger factor in the reduction. CMC has offered to give the debenture holders an ironclad guarantee that they will get 5 percent a year until 2055 and the full principal then; and given CMC's net worth, such a guarantee should not be hard to arrange. So the debenture holders will do no worse than if there had been no default.

Nevertheless, the district judge did not err in allowing acceleration. The only good reason for refusing to give a creditor in reorganization all that he bargained for when he extended credit is to help other creditors, the debtor's assets being insufficient to pay all creditors in full. All of the Milwaukee Road's creditors will be paid in full, even if the debenture holders are paid out at the highest valuation of their claim. The only competing equities are those of CMC's shareholders, and are weak, quite apart from the fact that many or for that matter all of them have bought their shares after the Milwaukee Road went into bankruptcy and may therefore have lost nothing because of the bankruptcy--admittedly a fact that does not distinguish them from the debenture holders.

The important point is that back in 1955 the Milwaukee Road unequivocally promised to repay the principal of the debentures immediately in the event of a default (provided, for some forms of default, that the indenture trustee demanded immediate repayment, but he did so here, as we shall see), and the Milwaukee Road did default, and it can honor its promise without hurting any other creditor. In these circumstances the presumption in favor of acceleration is a strong one, perhaps conclusive, and certainly is not overcome by pointing out that some or even all of the debenture holders are speculators. The provision for acceleration was part of the consideration for the Milwaukee Road's being able to borrow money for 100 years without having to amortize the loan. The debenture holders got in exchange a distribution of possible outcomes: probably they would receive interest for 100 years and the principal at the end of that time, but possibly they would get their principal back sooner. CMC proposes to truncate that distribution.

What is describes as a windfall gain to the debenture holders is simply the coming to pass of one of the contingencies for which they or their predecessors bargained. If you pay $1 for a lottery ticket and win $1,000 in the lottery, your winnings are not a windfall; you bought the chance to get them. The debenture holders bought the chance to get the principal back early, at a time when a rise in interest rates might enable them to reinvest it more advantageously elsewhere, as they will not be able to do. This change was a hedge against the risk of lending money for 100 years at a fixed interest rate. A sharp rise in interest rates might (as it did) signify a general disturbance of business conditions which would make the Milwaukee Road more likely to default; and if it did default, the debenture holders would be able to reinvest the principal of the debentures at the then higher rates. If the original debenture holders bought this right, then the current holders acquired it, for value, when they bought the debentures; enforcing the right will therefore confer no windfall on the current holders either.

The indenture provided for acceleration not only if there was a default but also if there was a purely voluntary liquidation. The Milwaukee Road's stockholders might well have decided to liquidate the corporation after the sale of its remaining assets to the Soo; for what remained was not an enterprise but a portfolio. If they had liquidated they would have had to repay the $56 million immediately. Maybe they did not liquidate because if the principal is not accelerated they will have 70 years of 5 percent money to play with (admittedly, tax considerations may also have played a role in this decision). It is not the objective of the bankruptcy laws to confer windfalls on debtors. See Blum, Full Priority and Full Compensation in Corporate Reorganizations: A Reappraisal, 25 U. Chi. L. Rev. 417, 423 (1958).

CMC's appeal to equity is misplaced for another reason. The fact that a proceeding is equitable does not give the judge a free-floating discretion to redistribute rights in accordance with his personal views of justice and fairness, however enlightened those views may be. See Shondel v. McDermott, 775 F.2d 859, 867-68 (7th Cir. 1985); Piper Aircraft Corp. v. Wag-Aero, Inc., 741 F.2d 925, 939 (7th Cir. 1984) (concurring opinion). The function of equitable considerations in a bankruptcy proceeding is to guide the division of a pie that is too small to allow each creditor to get the slice for which he originally contracted. See Boston & Maine Corp. v. Chicago Pacific Corp., 785 F.2d 562, 565 (7th Cir. 1986). Hence if the bankrupt is solvent the task for the bankruptcy court is simply to enforce creditors' rights according to the tenor of the contracts that created those rights; and one of those rights in this case was the right to accelerate the repayment of principal.

2. The issue with regard to interest in years when the railroad had no available net income requires close consideration of several provisions of the indenture. Article V sets forth the method of determining available net income. Section 6 thereof states: "The provisions of this Article V are hereby made expressly subject to each and all of the remedies of the Trustee or the Debentureholders as set forth in Article XI, and the operation of the provisions of this Article V shall be suspended during the continuance of either of the Events of Default specified in clause (a) or clause (b) of Section 2 of Article XI." We go to Article XI, and find that clause (a) relates to defaults in the payment of the principal of the debentures "when the same shall become due and payable either by the terms thereof or otherwise as herein provided," while clause (b) relates to defaults in the payment of any installment of interest "when and as such interest shall become due and payable as therein and in the Indenture expressed and such default shall continue for 60 days." The indenture trustee, however, declared the Milwaukee Road's default under another clause of Article XI, clause (f), which relates to the institution of bankruptcy proceedings, and which is not mentioned in Article V. CMC argues that since the default was declared under clause (f), the provisions regarding available net income were not suspended, and hence the debenture holders are not entitled to income during any year of reorganization in which the railroad lacked available net income.

Notice that section 6 of Article V, quoted above, has two clauses. The second (beginning "and the operation . . .") provides for automatic suspension of the provisions on available net income if the railroad defaults in paying either principal or (for 60 days) interest; the suspension begins at the moment of default in the case of a default in principal and on the 61st day following default in the case of a default in interest. The first clause of section 6, however, merely subjects Article V to the remedies that the trustee and the debenture holders have under Article XI, and thus is not self-executing. Article XI provides that in the event of a default other than in the payment of principal, the trustee may, and if the holders of at least 25 percent of the face amount of the debentures so request must, ...


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