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In re Montreal, Maine & Atlantic Railway, Ltd.

United States Bankruptcy Appellate Panel of the First Circuit

October 21, 2016

MONTREAL, MAINE & ATLANTIC RAILWAY, LTD., Debtor.
v.
NEW BRUNSWICK SOUTHERN RAILWAY COMPANY LIMITED and MAINE NORTHERN RAILWAY COMPANY, Appellees. ROBERT J. KEACH, Chapter 11 Trustee, Appellant,

         Appeal from the United States Bankruptcy Court for the District of Maine, BAP No. EB 16-015 (Hon. Peter G. Cary, U.S. Bankruptcy Judge)

          Robert J. Keach, Esq., and Lindsay K. Zahradka, Esq., on brief for Appellant.

          Alan R. Lepene, Esq., and Keith J. Cunningham, Esq., on brief for Appellees.

          Before Feeney, Deasy, and Harwood, United States Bankruptcy Appellate Panel Judges.

          Feeney, Chief U.S. Bankruptcy Appellate Panel Judge.

         Robert J. Keach, the former chapter 11 trustee (the "Appellant"), [1] appeals the bankruptcy court's February 26, 2016 order (the "Order") overruling in part his objections to certain proofs of claim filed by New Brunswick Southern Railway Company Limited ("NBSR") and Maine Northern Railway Company ("MNR" and, collectively with NBSR, the "Irving Railroads"). The Appellant appeals the bankruptcy court's ruling that the Irving Railroads' claims qualified as so-called "six months claims" entitled to priority under § 1171(b).[2] For the reasons set forth below, we AFFIRM.

         BACKGROUND

         I. Pre-Bankruptcy Events

         From January 2003 until May 2014, Montreal, Maine & Atlantic Railway, Ltd. ("MMA") owned and operated an integrated, international shortline freight railroad system with its wholly owned Canadian subsidiary, Montreal, Maine & Atlantic Canada Co.[3] This railroad system included 510 route miles of track in Maine, Vermont, and Québec, and was a substantial component of the rail transportation systems in northern Maine, northern New England, Québec, and New Brunswick. Among other things, it provided the shortest rail transportation route between Maine and Montreal, and was a "critical rail artery" between St. John, New Brunswick and Montreal. In order to provide freight transportation services to customers throughout the system, MMA interchanged freight traffic with other railroads, including the Irving Railroads, with which its operations were interconnected.

         A. The Interline Settlement System

         MMA, like most railroads, participated in the Interline Settlement System (the "ISS"). The ISS provides a central clearing house for all participating railroads involved in the interchange of freight traffic among multiple rail carriers to settle accounts receivable and accounts payable arising from the interchange of such traffic. Railroads participating in the ISS that originate traffic are known as "billing" or "originating" railroads and invoice the customer for all freight charges from the point of origin to the point of destination, even if the shipment is interchanged with other railroads along the route. The customer is responsible for paying the billing railroad the entire invoice, and the billing railroad is responsible for paying the other railroads involved in the shipment along the line for their share of the freight charges. Railroads participating in the ISS calculate on a monthly basis the accounts receivable and accounts payable arising from the interchange of traffic that are due and owing to each participant, and the payment of the net amount due and owing is made on the second business day of each month. One of the benefits of participating in the ISS is that billing railroads are obligated to pay the other participating railroads regardless of whether the customer pays the billing railroad.

         B. The Relationship between MMA and the Irving Railroads

         The business relationship between MMA and the Irving Railroads began in January 2003, when MMA entered into a Commercial Agreement (the "Commercial Agreement") with NBSR and one of NBSR's affiliates, Eastern Maine Railway Company ("EMR"), [4] setting forth various terms and conditions governing the interchange of freight traffic between MMA and the Irving Railroads. Pursuant to the Commercial Agreement and a separate Interchange Agreement between MMA and EMR, the Irving Railroads and MMA agreed to interchange freight traffic at MMA's Brownville Junction Yard in Maine. Section 2 of the Commercial Agreement, entitled "Performance of Transportation Services, " provided as follows:

The parties agree that from and after the Effective Date, EMR/NBS[R] shall move loaded freight cars and associated empty cars between points located on its lines or reached by it under Canadian interswitch rules and Brownville Junction at rates as set out in this Agreement. MMA shall act as the interline tariff carrier on a junction settlement basis. By "junction settlement basis" the parties mean that MMA shall negotiate through rates and make contracts and provide quotations, and shall be responsible for car supply to the extent requested by NBS[R] and reasonably available from MMA and in rail cars customarily supplied by railroad carries, all in accordance with the provisions of this Agreement. MMA shall continue to render one freight bill, and assess and collect the total amount of freight charges . . . and remit the portion pertaining to EMR/NBS[R's] transportation services to EMR/NBS[R] in accordance with the procedures in this Agreement.

         At the evidentiary hearing described below, and while addressing the freight carried by MMA to the interchange point with the Irving Railroads, Ian Simpson, general manager of the Irving Railroads, explained that the interchange of freight traffic involved the decoupling of freight cars from MMA's locomotives and connecting them to the Irving Railroads' locomotives, which then carried the freight cars to their final destination.

         The Irving Railroads did not participate in the ISS.[5] As a result, pursuant to the Commercial Agreement, MMA acted as the billing railroad when either of the Irving Railroads originated traffic and interchanged with MMA, as well as when MMA originated traffic and interchanged with either of the Irving Railroads. MMA also collected from the ISS freight revenue attributable to freight services provided by the Irving Railroads in connection with shipments originated by other carriers that were interchanged by such carriers with MMA and then by MMA with the Irving Railroads. Periodically, MMA and the Irving Railroads settled their accounts payable and receivable as between themselves. Other than certain amounts for repair of cars owned or leased by MMA, the Irving Railroads' claims, as described below, arose from MMA's collection of funds either from customers or through the ISS and its failure to pay amounts due to the Irving Railroads.

         C. The "Payment Swap" Arrangement

         At the time MMA and the Irving Railroads began doing business, Karl Hansen, general manager of Corporate Credit and Finance for the Irving Railroads and their affiliated companies, had concerns MMA would not be able to pay the Irving Railroads due to the troubled history of MMA's predecessor, Bangor & Aroostook. As a result, the Irving Railroads, together with certain of their affiliated paper companies, Irving Pulp and Paper, Limited, Irving Paper Limited, and J.D. Irving, Limited (collectively, the "Irving Paper Companies"), which were among MMA's largest customers, agreed with MMA on a process to settle their respective accounts receivable and accounts payable by concurrently exchanging payments through wire transfers of amounts owed to each other. Included in this "payment swap" arrangement[6] were: (1) accounts payable owed by the Irving Paper Companies to MMA for freight services provided by MMA to the Irving Paper Companies; (2) accounts payable owed to MMA by the Irving Railroads for interline freight services provided by MMA; and (3) accounts receivable owed by MMA to the Irving Railroads for interline freight services provided by them. Under this arrangement, the parties would determine, based upon the payment terms in effect between them, the amounts due from the Irving Railroads and the Irving Paper Companies to MMA, and the amounts due from MMA to the Irving Railroads, and then concurrently exchange cash payments in the agreed upon amounts. Initially, the amounts owed to MMA by the Irving Railroads and the Irving Paper Companies each week greatly exceeded the amounts owed by MMA to the Irving Railroads. Mr. Hansen explained the reason for entering into this arrangement as follows: "I was determined that I was not going to take a credit risk, I was not relying on their credit to [e]nsure we got paid."

         D. The Agreement Regarding Oil Shipments

         The payment swap arrangement worked well until the volume of crude oil shipments carried by MMA and interchanged with the Irving Railroads for delivery to refineries in St. John, New Brunswick began to increase significantly in 2012. In the two years leading up to the bankruptcy filing, MMA benefited from the increased use of trains to move oil from the central and western regions of the United States to refineries in the east. United States and Canadian oil drillers were producing oil faster than the new pipelines could be built, and trains were needed to transport crude oil to refineries. During this time, MMA was hauling 500, 000 barrels of oil monthly through Québec and Maine. For the majority of such oil shipments, the originating railroad was Canadian Pacific Railway Company and its affiliates ("CP"), which participated in the ISS. CP was the first railroad to haul the oil, and the shipment would then travel across the country over a number of railway lines until it eventually interchanged with MMA. MMA would haul the oil over its lines and then interchange the freight with the Irving Railroads, which delivered the oil to its final destination at the Irving Oil refinery in St. John, New Brunswick.[7]

         The payments for the oil shipments were processed through the ISS. Because the Irving Railroads were not members of the ISS, they could not collect from the ISS for their share of freight interline charges. Rather, the ISS paid MMA, and MMA paid the Irving Railroads pursuant to the terms of their payment arrangement.

         Typically, MMA did not receive payments through the ISS until 45 to 60 days following the shipments. Under the terms of payment in effect with the Irving Railroads, however, MMA was obligated to pay the Irving Railroads its share of the freight charges for oil shipments within 33 days of shipment. This was not a problem when the Irving Paper Companies owed MMA more than MMA owed them. But eventually, due to the significant increase in oil shipments carried by MMA and interchanged with the Irving Railroads for delivery to St. John, New Brunswick, the amounts owed by MMA for interline freight services provided by the Irving Railroads began to exceed the amounts owed by the Irving Paper Companies to MMA, and MMA did not have enough cash to make the simultaneous payments under the swap arrangement.

         In order to address this situation, in July 2012, the parties agreed MMA would pay the Irving Railroads for their share of freight charges earned in connection with oil shipments promptly upon MMA's receipt of payment from the ISS, and in no event later than five days thereafter. According to the Irving Railroads, the amounts owed to them for interline freight charges incurred in connection with oil shipments were "carved out of the swap arrangement, and instead, those charges would be paid to the Irving Railroads upon MMA's receipt of payment from the ISS of the amounts owed to MMA for such shipments." As to "local" shipments (those which were originated either by MMA and interchanged with the Irving Railroads, or those originated by the Irving Railroads and interchanged with MMA), the swap arrangement remained in effect.

         II. The Derailment and MMA's Bankruptcy Filing

         On July 6, 2013, an unmanned train operated by MMA containing 72 tank cars filled with crude oil derailed in Lac-Mégantic, Québec, causing several large explosions, the death of 47 people, and significant property and environmental damage. After the derailment, train activity was temporarily halted between Maine and Québec, resulting in the immediate loss of most of MMA's freight business and a drastic fall in MMA's gross revenues.

         On August 7, 2013, MMA filed a chapter 11 petition in the U.S. Bankruptcy Court for the District of Maine, and the Appellant was subsequently appointed as the chapter 11 trustee. On January 24, 2014, the bankruptcy court entered an order approving the sale of substantially all of MMA's assets as a going concern to Railroad Acquisition Holdings LLC. The sale of MMA's assets closed on May 15, 2014.

         On June 13, 2014, MNR and NBSR timely filed proofs of claim (collectively, the "Claims").[8] In Claim 259-1, NBSR asserted claims in the aggregate amount of $2, 164, 471.30 arising from "[f]reight services provided to [MMA] in connection with interline rail shipments." Of the total amount claimed, NBSR asserted not less than $1, 971, 834.67 was "secured by equitable liens against all property of [MMA] under the Six Month[s] Rule applicable in federal court receiverships, and [we]re entitled to priority pursuant to 11 U.S.C. § 1171(b), " because such claims: (1) related to current operating expenses incurred by MMA that were necessary for the on-going operation of MMA's railroad; (2) were incurred within six months prior to the commencement of MMA's bankruptcy case; and (3) were for services provided by NBSR with the expectation they would be paid out of current operating revenue and not in reliance on MMA's general credit.

         In Claim 257-1, MNR asserted claims in the aggregate amount of $355, 101.19 arising from "[f]reight services provided to [MMA] in connection with interline rail shipments." Of the total amount claimed, MNR asserted approximately $167, 228.89 was entitled to priority under § 1171(b) for the same reasons advanced by NBSR in Claim 259-1.

         On July 16, 2015, the Appellant filed the Plan and Revised First Amended Disclosure Statement ("Disclosure Statement").[9] The Irving Railroads objected to confirmation of the Plan arguing, among other things, that it failed to provide the same treatment for allowed § 1171(b) claims as it provided for administrative expense claims-i.e., payment in full following confirmation of the Plan.

         On October 9, 2015, the bankruptcy court entered an order confirming the Plan ("Confirmation Order"). The Confirmation Order provided, in relevant part:

In resolution of the [Irving Railroads'] Objection, any 1171(b) Claims of the [Irving Railroads] shall be paid in full, in Cash, on the later of the Initial Distribution date or thirty (30) days after the date such Claims become Allowed Claims. In the event the Bankruptcy Court has not determined, prior to the Initial Distribution Date, the existence of and/or the amount of any Allowed 1171(b) Claims of the [Irving Railroads], if any, as of such date, the Trustee shall set aside, and not distribute pending further order of the Bankruptcy Court making such determination, $2, 139, 063.56 to secure any payment, to the extent required, with respect to such Allowed 1171(b) Claims, when and if determined.

         On October 19, 2015, the Appellant filed an objection to the Claims (the "Claims Objection"), on the ground they were improperly asserted as priority claims and should be allowed only as general unsecured claims. Specifically, the Appellant argued, "as a matter of controlling law in this circuit, " pre-petition interline freight claims of the type asserted by the Irving Railroads are general unsecured claims and do not qualify as six months claims entitled to priority under § 1171(b), citing In re Boston & Maine Corp., 600 F.2d 307 (1st Cir. 1979) ("Boston & Maine I"). The Appellant also argued, in furnishing services to MMA, the Irving Railroads relied-not on MMA's operating revenues at the time the service was provided-but upon MMA's general credit and, as a consequence, their claims were not entitled to priority as § 1171(b) claims, citing In re Boston & Maine Corp., 634 F.2d 1359 (1st Cir. 1980) ("Boston & Maine II").

         In their response ("Irving Railroads' Response"), the Irving Railroads argued Boston & Maine I was not applicable or controlling law on the issue because the court did not decide, or even address, the issue of whether interline freight claims qualify as six months claims entitled to priority in a railroad reorganization; rather, Boston & Maine I only addressed the question of the timing of the payment of such claims. The Irving Railroads also contended the question of whether the interline freight claims asserted in Boston & Maine I were entitled to treatment as priority claims under the plan of reorganization was addressed by the U.S. Court of Appeals for the First Circuit in the subsequent case of Boston & Maine II. According to the Irving Railroads, in Boston & Maine II, the First Circuit reversed a decision of the district court ruling those claims should be treated as general unsecured claims, holding instead that per diem claims, such as those asserted by the interlining railroads, constituted six months claims entitled to priority, if such claims: (1) represented a current operating expense necessarily incurred; (2) were incurred within six months before the reorganization petition was filed; and (3) the goods or services were delivered in the expectation that they would be paid for out of current operating revenues of the railroad, and not in reliance on the railroad's general credit. And, the Irving Railroads maintained, the evidence clearly established the Claims satisfied the test articulated in Boston & Maine II.

         On November 19, 2015, the parties filed stipulations with respect to the Claims Objection, in which they stipulated to certain facts and agreed the only issue to be addressed at the hearing on the Claims Objection was whether the Claims qualified as six months claims entitled to priority under § 1171(b); the amount of such Claims would be determined at a subsequent hearing, if required.

         On November 20, 2015, the bankruptcy court held an evidentiary hearing during which Mr. Hansen and Mr. Simpson testified. Following the hearing, the bankruptcy court took the matter under advisement, and directed the parties to submit post-trial briefs. Both parties filed post-trial briefs on December 10, 2015.

         On February 5, 2016, the bankruptcy court issued oral findings of fact and conclusions of law, determining the Claims were entitled to priority as six months claims under § 1171(b). In its ruling, the bankruptcy court rejected the Appellant's contention that claims arising from interline freight services cannot, as a matter of law, qualify for priority under § 1171(b), stating:

I read Boston [&] Maine II to have reversed the decision of the District Court, which denied priority treatment of the claims of interlining railroads which sought six-month priority status for their per diem claims. . . . [A]s a matter of law, the mere fact that the claims are for interline freight services does not exclude them from possible priority consideration.

         The bankruptcy court then stated "if the claimant railways can satisfy the judicially established three elements required for the 1171(b) claims [set forth in Boston & Maine II], then they're entitled to priority treatment." Turning to the evidence, the bankruptcy court found the Claims satisfied each of the elements of the Boston & Maine II test.

         As to the "necessity of the charges, " the bankruptcy court looked at the testimony of Mr. Hansen and Mr. Simpson regarding the importance of the "critical rail artery" between St. John, New Brunswick and Montreal to MMA and found MMA's inability to interchange traffic with the Irving Railroads on that route would have had a significant adverse effect on MMA's operations, including possible loss of business with Irving Paper Companies as well as a reduction in revenue. As to this prong, the bankruptcy court concluded:

Based upon this and the other evidence adduced at the hearing, I conclude that the claimant railways satisfied their burden on the necessity issue. I don't ascribe to the narrow view of what a necessity is. I find that [ ] sufficient claims are for a current expense, goods and services and [ ] ordinary operation of the rail.

         As to the second prong-whether the Claims were incurred within six months before the petition was filed-the bankruptcy court determined there had been "no meaningful challenge" to this asserted element.

         As to the third prong-whether the goods or services were delivered in the expectation that they be paid for out of MMA's current operating revenues and not in reliance on MMA's general credit-the bankruptcy court concluded:

Based on testimony . . . as well as other evidence presented at the hearing, I conclude that the claimant railways met their burden as to the third element of the 1171(b) claims. Testimony shows that, in order to keep the interchange of services going between the parties, claimant railways agreed to wait for the ISS system to process payment and then to pay . . . them to MMA before MMA would pay the claimant railways. I do not conclude that this was reliance on MMA's credit, nor do I conclude that this was some sort of special security arrangement which excepts the claimant railways from the protection of the six-months rule. I didn't find anything in that deal or that arrangement that had incorporated common conditions of the commercial credit, security interests, and the like.
I do not find that the existence of the Wheeling line of credit changes my conclusion. Mr. Hansen was not aware that MMA had a line of credit with Wheeling, he so testified. Mr. Simpson admitted he was aware of it "anecdotally, " but had no knowledge of how it "worked, " and was not familiar with it. Nobody, according to the testimony, ever advised Mr. Hansen or Mr. Simpson that MMA's ability to pay claimant railroads was dependent on MMA being able to draw on the Wheeling line of credit.
So based upon the unique facts and my analysis of the equities asserted by MMA, on one hand, and [t]he claimant railroads, on the other, I conclude that the claimant railways have met their burden. The claims shall be allowed as 1171(b) claims.

         Thereafter, the bankruptcy court entered the Order, which memorialized its ruling as follows:

Based upon the unique facts of this matter and the Court's analysis of the equities asserted by MMA, on the one hand, and the [Irving Railroads], on the other, the [Irving Railroads] met their burden of establishing that the Asserted 1171(b) Claims qualify as claims that are entitled to priority under § 1171(b) of the Code because:
(1) the Asserted 1171(b) Claims represent current operating expenses that were necessarily incurred by MMA in connection with its on-going operations;
(2) the Asserted 1171(b) Claims were incurred within six months prior to the commencement of this case; and
(3) the services that are the subject of the Asserted 1171(b) Claims were provided to MMA with the expectation that they would be paid for out of the current operating revenues of MMA, and ...

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