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In re Iowa Railroad Co.

decided: February 23, 1988.


Appeals from the United States District Court for the Northern District of Illinois, Eastern Division, No. 85 C 4463 -- John F. Grady, Chief Judge.

Easterbrook and Ripple, Circuit Judges, and Grant, Senior District Judge.*fn*

Author: Easterbrook

EASTERBROOK, Circuit Judge.

The Iowa Railroad endured from October 1981 to November 1984. During these years it conducted operations, largely with rented equipment, over 511 miles of other lines' track. Much of its business involved freight handled by two or more carriers. When the Iowa was the first carrier -- for example, when picking up a shipment of grain that it would turn over to the Union Pacific for the haul to the west coast -- it collected the charge for the entire movement. Other carriers would do the same for shipments they originated in which the Iowa was the terminating line. At the end of the month, the Iowa and its business partners sent each other vouchers showing the sums they had collected for transportation provided on other lines. Perhaps the Iowa would collect $50,000 on behalf of the Union Pacific, and the Union Pacific $10,000 on behalf of the Iowa. The carriers would set off these amounts, producing an "interline balance". If the difference ran in the Union Pacific's favor, that railroad sent the Iowa a bill. When the Iowa filed its petition in bankruptcy, it owed interline balances of about $4 million for shipments of freight, more than $1.4 million to the Union Pacific alone. We must decide whether the railroad creditors have first claim to the Iowa's assets on the ground that interline balances are held in trust for other railroads. If the interline balances are trust funds, then the railroads will be paid in full and the Iowa's other creditors get next to nothing; if they are general unsecured debts, all creditors will receive about 64 % of their claims.*fn**

The district court held that the interline freight balances are trust funds, with corresponding priority. The court did not rely on any provision of the Bankruptcy Act or state law. It relied, instead, on In re Penn Central Transportation Co., 486 F.2d 519, 531-33 (3d Cir. 1973) (en banc) (Adams, J., concurring), in which Judge Adams -- rejecting the majority's conclusion that interline balances are trust funds only to the extent state law so characterizes them -- concluded that interline creditors are entitled to a preference because of "Congress' interest in creating and maintaining a viable interline rail system". Id. at 533. Judge Adams believed that a preference in bankruptcy is essential to ensure that railroads participate in a system in which carrier collects the entire cost of the movement; the abolition of this single-bill system, Judge Adams feared, "would greatly impede the smooth and efficient functioning of the through-route network." Id. at 532. The district court in this case added: "Principles of common sense and elemental justice require that the railroad which earned this money be declared to be its owner."


We may dispose summarily of the argument from "common sense and elemental justice". The railroads that moved the freight are entitled to be paid -- but so are the people who supplied it with diesel fuel, and its other creditors. All of these persons contributed essential ingredients of the movement of the freight and earned their right to payment. That the interline creditors have been short changed by the Iowa does not imply that the other creditors should get nothing. Justice in a bankruptcy case is decision according to law. If the Iowa's general creditors have the same sort of property interest as the interline creditors, then justice requires courts to recognize both interests. As we said in Boston & Maine Corp. v. Chicago Pacific Corp., 785 F.2d 562, 566 (7th Cir. 1986), another case involving interline balances:

[The district court thought] that considerations of equity overrode the law. But equity in law is the consistent application of legal rules. The definition of inequity is unequal application of norms. Federated Department Stores v. Moitie, 452 U.S. 394, 401, 69 L. Ed. 2d 103, 101 S. Ct. 2424 (1981). The bankruptcy law treats all pre-bankruptcy claims of the same class equally. When one claimant gets treatment that is denied to others, they have been treated inequitably.

See also, e.g., Bonded Financial Services, Inc. v. European American Bank, 838 F.2d 890 (7th Cir. 1988), slip op. at 9; In re Chicago, Milwaukee, St. Paul & Pacific R.R., 791 F.2d 524, 528 (7th Cir. 1986); Guerin v. Weil, Gotshal & Manges, 205 F.2d 302, 304 (2d Cir. 1953) (A. Hand, J.). The decision in this case turns on property rights, not notions of equity.


Unless a specific provision of the Bankruptcy Code requires a different result, the function of bankruptcy law is to marshal the debtor's assets and distribute them according to the property rights of the creditors. (We put to one side managerial tasks such as maintaining the firm during a reorganization.) These property rights are defined in most cases by state law. When they are so defined, the bankruptcy court must implement rather than alter them. Butner v. United States, 440 U.S. 48, 54-57, 59 L. Ed. 2d 136, 99 S. Ct. 914 (1979); In re American Reserve Corp., 840 F.2d 487 (7th Cir. 1988); Boston & Maine, 785 F.2d at 565-66. We said in Boston & Maine that interline creditors do not get special treatment. It remains to be seen, however, just what the ordinary treatment may be. State law is the principal but not the only source of property rights; federal law, too, may supply these rights, and the pervasive federal regulation of the rail business requires us to scrutinize federal law with some care. The survey is animated, however, by the principle that we are looking for legal entitlements rather than for the arrangements that seem to us best.

We start with the question whether the Bankruptcy Code settles the subject. The trustee says that it does, in his favor. Since the trustee believes that the 1978 Code disposes of the subject by not discussing it, the appreciation of the argument requires a bit of background.

Railroads have been turning belly up with great frequency ever since Stephenson's "Rocket". Interline operations have been common since the founding of American roads, so the treatment of interline balances also is an old subject. See Miltenberger v. Logansport Ry., 106 U.S. 286, 293, 27 L. Ed. 117, 1 S. Ct. 140 (1882). Until 1933, when Congress added § 77 to the old Code, 11 U.S.C. § 205 (1976), all railroad bankruptcies were handled as equity receiverships; under § 77 the ICC acquired a principal role in reorganizations but the principles of the common law continued to govern most relations among creditors. The rules for equity receiverships permitted courts to enhance the priority of debts incurred as operating expenses within the six months prior to insolvency or necessary to the continued operation of the debtor. See Miltenberger, 106 U.S. at 311. Courts applied these principles, without extended discussion, to interline balances. E.g., Gregg v. Metropolitan Trust Co., 197 U.S. 183, 49 L. Ed. 717, 25 S. Ct. 415 (1905); Southern Ry. v. Flournoy, 301 F.2d 847, 850-53 (4th Cir. 1962); Southern Ry. v. United States, 306 F.2d 119 (5th Cir. 1962); In re Tennessee Central Ry., 316 F. Supp. 1103, 1110-12 (M.D. Tenn. 1970), vacated on other grounds, 463 F.2d 73 (6th Cir. 1972). This approach asssumed that interline balances are general, unsecured debts. Not until 1967 did any interline creditor argue that the balances are "trust funds" or otherwise entitled to priority exceeding that available to other operating expenses. In re Central Railroad Co. of New Jersey, 273 F. Supp. 282, 288 (D.N.J. 1967), affirmed by adoption, 392 F.2d 589 (3d Cir. 1968), brusquely replied: "That they are not trust funds is clear. The relationship among the several carriers engaged in an interline freight movement is that of debtor and creditor."

The Third Circuit took a different path in its en banc decision of 1972. It distinguished among kinds of interline balances. Those for freight and passenger transportation, it concluded, are collected by one carrier and held in trust for others. 486 F.2d at 523-27. (We discuss in Part V the court's grounds for this conclusion.) Other interline balances -- per diem car charges (rental of of one line's cars being used by another pending their return), switching charges, and several other categories -- the court thought were general unsecured debts, largely because the debtor did not collect a specific charge from customers for these balances and so did not generate a fund. Id. at 527-29. The trust funds for pre-bankruptcy balances must be turned over immediately, the court held, regardless of the claims of competing creditors. The other balances, however, could be retained pending final reckoning. In 1976 we took still a different approach, holding that ICC rules required the immediate payment in full of pre-bankruptcy interline per diem balances, whether or not they were trust funds. In re Chicago, Rock Island & Pacific R.R., 537 F.2d 906 (7th Cir. 1976). Interline freight and passenger balances were current operating expenditures to be paid as they arose. Other pre-bankruptcy balances would be treated as unsecured debt. The Third Circuit promptly rejected this holding, reiterating its position that per diem car charge balances are general, unsecured debts. In re Penn Central Transportation Co., 553 F.2d 12 (3d Cir. 1977).

When Congress overhauled bankruptcy law in 1978, then, the Third Circuit treated passenger and freight balances (but no others) as trust funds; this court treated passenger and freight balances as current operating expenses and per diem accounts as trust funds; other courts had been silent since 1963. The rules in force in the Third and Seventh Circuits had two effects: priority for certain debts, and immediate payout (rather than payment with other secured creditors at the end of the case).

Lobbyists for solvent (creditor) railroads tried to consolidate and extend these gains. The House passed a bankruptcy bill first, including nothing on the subject. The principal bill pending in the Senate, S. 2266, 95th Cong., 1st Sess. (1977), contained a provision (§ 1169) authorizing a railroad's trustee to pay in full all pre-bankruptcy interline balances without waiting for a court to approve the payment. Witnesses for creditor railroads objected to this on the ground that it did not require the trustee to pay these claims. Hearings on S. 2266 and H.R. 8200 Before the Subcommittee on Improvements in Judicial Machinery of the Senate Committee on the Judiciary, 95th Cong., 1st Sess. 759-71 (1977) (testimony on behalf of the Association of American Railroads and the Union Pacific Railroad). The Committee then reported, and the Senate passed, a bill providing:

[T]he debtors under this chapter shall pay in cash pursuant to statutory, [ICC], or recognized rail industry settlement procedures, or Commission orders of general applicability, the current net balances owed by the debtor to other carriers on its interline freight, passenger and per diem . . . accounts for the periods both prior and ...

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