ON APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE EASTERN DISTRICT OF PENNSYLVANIA (D.C. No. B-70-347 In Bankruptcy)
Before Aldisert, Gibbons and Higginbotham, Circuit Judges.
We have before us numerous appeals from the Penn Central Transportation Company reorganization court's orders of approval, confirmation and consummation of a Plan of Reorganization. Satisfied that the Plan is fair and equitable as to these appellants, we affirm.
Plans of reorganization for Penn Central and for fifteen secondary debtors (collectively, The Plan) have been approved by the reorganization court, and upon submission to claimants for a vote, have been accepted by an overwhelming majority of claimants. Related appeals also decided this day are In the Matter of Penn Central Transportation Company, Debtor, (Irving Trust and Bank of New York Appeals), 596 F.2d 1102 (3d Cir. 1979). In the Matter of Penn Central Transportation Company, Debtor, (Stockholder Appeals), 596 F.2d 1155 (3d Cir. 1979). These appeals present issues which require us to review the basic framework of the monumental plan designed to resolve what may be the most complex set of interrelated and conflicting claims ever addressed under Section 77 of the Bankruptcy Act, 11 U.S.C. § 205.
The questions for decision are:
1. Whether the Plan, in providing Series A preference stock to certain bondholders whose mortgage liens were recognized by the reorganization court to have somewhat superior coverage (the so-called "super-secured" creditors), adequately provides for them.
2. Whether the Plan properly excludes certain bond issues from that "super-secured" class.
3. Whether the Plan adequately protects the interests of the Erie and Kalamazoo Railroad Company, a non-bankrupt leased line of Penn Central.
The history of this reorganization proceeding and the characteristics of the Plan are set forth in an extensive opinion by the Honorable John P. Fullam, judge of the reorganization court, 458 F. Supp. 1234 (E.D.Pa.1978). To put in proper perspective the nature of these appeals, it is necessary to understand the theory of the Plan, and to understand this theory it is first necessary to review the history which forms the backdrop for this mammoth reorganization.
Penn Central Transportation Company (PCTC), the debtor, was formed in 1968 by the merger of the Pennsylvania Railroad Company and the New York Central Railroad Company. The "Pennsy" and the New York Central can be traced almost to the beginning of railroad transportation in the United States. By the 1870's they had created, by construction and purchase, railroad systems extending from the eastern seaboard to the Mississippi River. In spite of the difficulties facing the rail industry in the 1930's, both railroads, because of their financial strength, were able to function as viable, successful companies. Both systems had been created in large part through lease or purchase of stock of a large number of separate railroad companies, many of which had substantial amounts of their own securities outstanding. Both legal and financial obstacles made it difficult to change the original relationships and subsequently added to the complexity of the Penn Central reorganization.
The Interstate Commerce Commission conditioned its approval of the merger between the Pennsylvania and New York Central railroads on the acquisition of the New York, New Haven and Hartford Railroad Company (New Haven) by the newly formed Penn Central. The New Haven, a system in southern New England with many operating relationships to the merged companies, had been in reorganization proceedings under Section 77 of the Bankruptcy Act since 1961.
There is some suggestion in The Financial Collapse of the Penn Central Company, Staff Report of the Securities and Exchange Commission to the Special Subcommittee on Investigations (August 1972) (SEC Report), that the Pennsylvania-New York Central merger may not have been realistically planned:
No consideration was given in connection with this merger to the broad question of realignment of the Eastern roads or whether this was the best merger for the two roads. They were, in effect, the leftovers, after other combinations had been individually arranged. Furthermore, little consideration appears to have been given to the question of whether this particular merger would work at all. Certainly the combination of two already ailing and financially weak roads raises questions as to feasibility and in this situation the possibility also existed that the size and complexity of the merged company would preclude manageability.
SEC Report, Supra, at 17. Additionally, whatever flaws were inherent in the plan to merge were exacerbated by ICC requirements and labor difficulties:
By the time ICC's approval was obtained, two decisions had been made which many people have suggested sealed the doom of the company. Neither had been contemplated at the time of the original proposal. First, in May 1964, the two roads reached an accord with labor, the Merger Protective Agreement, whereby they, in effect, bought the cooperation of the unions, which had been opposing the merger. The result of this agreement would be to cause the company to incur costs far above those anticipated in the Patchell report and thus limit the savings projected. The second factor was the decision of the ICC to force the New Haven Railroad on the Penn Central, adding still a third financially and operationally weak road to the group.
Id., at 18. When merger was completed, the initial expectation that increased size would bring with it increased efficiency and profits began to fade into the dismal reality of misrouted cars, management problems, uncertainty of internal procedures, deterioration of the physical plant, and high-level in-fighting. An officer of the company, in a speech to a group of shippers in March 1969, described one aspect of the operations problem as follows:
This period of transition from two railroads to one harmonious system has not been easy. One of the reasons for our difficulty can be found in the size of the plant itself. While our lines paralleled each other in a number of areas and we shared many common points, the Pennsylvania and New York Central systems were not complementary. Our separate yards did not have the individual capacity to handle the combined business of the two railroads, and we have had to keep several yards in operation until combined facilities can be built.
Our separate communications systems were not compatible and this complicated some of the service problems created by the merger. This situation has been aggravated by confusing routing symbols, particularly from off-line sources. For example, a car routed Penn Central-Cincinnati that should have gone to the former Central yard in Cincinnati often has ended up in the old Pennsylvania yard and frequently its waybill papers went astray as well. In addition, employees of the former Pennsylvania were not familiar with the properties and procedures of the former New York Central, and vice versa. A great deal of cross-pollination had to take place in the process of finding the most efficient way to handle traffic.
An internal memorandum prepared about the same time and intended for use by top-level management personnel as a basis for response to numerous press inquiries about the road's "lousy" freight service relates the following:
From the beginning of merger discussions it was recognized that it would be necessary to continue parallel operations over the lines of the two former railroads until terminals could be integrated, connections constructed, and yards expanded along principal routes. Before the merger was consummated, arrangements were made with our principal connecting carriers that blocking of traffic and interchange would continue as before merger, with gradual changes to be made as construction and operational arrangements were completed to permit integration on an orderly basis. For a while following merger, operations were maintained in accordance with this plan, and deterioration set in only when there was a relaxation in the preclassification and delivery arrangements at major gateways, such as St. Louis and Chicago. The problem was unintentionally compounded when shippers began to route their freight "PC" rather than via "PNYC(P)" or "PNYC(N)" thereby failing to direct their traffic to one or the other of the former railroads.
The principal effect of these changes was to create congestion and confusion at major gateways and to shift the classification functions of those terminals to internal yards, thus spreading the congestion eastward. This initial disruption triggered a number of collateral effects: it widened the margin for error by clerical personnel who were unfamiliar with stations and consignees to which they were routing traffic; it disrupted the cycling of locomotives and thereby produced sporadic power shortages; it placed an unmanageable tracing demand upon a data processing system already beset with the problems in incompatibility; it caused separation of cars from billing as emergency steps were taken to clear congested yards; it prompted short-hauling of Penn Central, thereby increasing the switching burden at interchange points with other eastern carriers and as these adversities snowballed one after another the speed and reliability of our service deteriorated steadily.
Id., at 21-22 (footnote omitted). In sum, the merged railroad faced operational, financial and management problems which, in large part, were not anticipated and which ultimately led to its collapse.
Notwithstanding these difficulties, the annual reports for 1968, 1969 and 1970 were misleadingly optimistic, according to the SEC Report:
As we review the disclosure history of Penn Central, we get a picture of high euphoria and inflated prospects about the savings to be achieved by the merger with the manifest difficulties ignored or overlooked. When these difficulties emerged as painful realities, they were inadequately disclosed. The annual reports put out for 1968, 1969, and 1970 obscured the railroad's further movement into debt amid mounting operating losses. Instead they emphasized that efficiencies, improvement in service, and new exciting revenue sources were just around the corner.
The staff report shows that as both the operating and liquidity condition of Penn Central deteriorated, its management made increasingly strenuous efforts to make a bad situation look better by maximizing reported income. An elaborate and ingenious series of steps was concocted to create or accelerate income, frequently by rearranging holdings and disposing of assets, and to avoid or defer transactions which would require reporting of loss. Accounting personnel testified that they were constantly under intense pressure from top management to accrue revenue optimistically and underaccrue expenses, losses, and reserves, to realize gain by disposing of assets and to charge losses to a merger reserve which would not take them through the income statement. Gains were reported on real estate transactions in which the realization of benefits to the company depended on operating results far into the future and in which there was little if any real change in the character or amount of assets owned by Penn Central.
Id. at ix-x. An already complex situation was further complicated in 1969 by a second merger: the Penn Central Company, which had operated the merged Pennsylvania and New York railroads, was renamed Penn Central Transportation Company and became a wholly owned subsidiary of a new holding company, the Penn Central Company. In other words, the old Penn Central Company was renamed Penn Central Transportation Company and the new holding company took over the subsidiary's old name, Penn Central Company. The purpose of the reorganization was to facilitate diversification and consolidation of the railroad business.
By 1970, PCTC had reached the point where it could no longer raise the money to pay the escalating cash losses incurred in its operations. In retrospect, it had been relying upon use of short term credit to pay its cash deficits in the expectation that the projected merger savings would restore its financial health. The short term borrowings were about at the half billion dollar level; the immediate fruit of the merger was expensive new problems, well publicized; and its 1969 financial statements, once analyzed, indicated that the financial results of operations were rapidly deteriorating rather than improving. After an unsuccessful attempt to secure government financing, PCTC sought relief under the Bankruptcy Act. The 1968 and 1969 mergers, the inclusion of the New Haven, already in reorganization, and the complex capital structures of the merged railroads has required the reorganization court to deal with a bewildering number of companies and security issues.
On June 21, 1970, two years after the merger of the Pennsylvania and New York Central railroads, Penn Central filed a petition for reorganization under Section 77 of the Bankruptcy Act. At that time, the merged system had approximately 40,000 miles of track in sixteen states, the District of Columbia and two Canadian provinces. Since its inception, the bankruptcy of the Penn Central and the subsequent reorganization proceeding have been different from all prior railroad reorganizations. In re Penn Central Transportation Co., 384 F. Supp. 895, 902 (Sp.Ct.1974) (180-Day Appeals). Whereas earlier railroad insolvencies had typically been caused by inability to meet fixed charges or debt maturities, the bankruptcies of the Penn Central and the other northeast railroads were precipitated by their inability to meet the operating expenses and taxes of their railroad business. Id. at 903. The collapse of their capacity to provide rail service in turn precipitated a "rail transportation crisis seriously threatening the national welfare." See Regional Rail Reorganization Act Cases, 419 U.S. 102, 108, 95 S. Ct. 335, 341, 42 L. Ed. 2d 320 (1974) ("Rail Act Cases "). And this crisis in turn prompted a public response unprecedented in the long history of railroad reorganization.
For more than two years the trustees tried to reorganize the Penn Central by pressing for the realization of the conditions they deemed essential to its viability. By 1972, however, the ICC had recognized that the trustees' most recent report had constituted "a public notice that a successful reorganization of Penn Central could not be accomplished wholly within the means provided by Section 77 of the Bankruptcy Act."*fn1 It was becoming clear that congressional intervention would be necessary to solve the complex problems affecting Penn Central and a number of other eastern railroad systems.*fn2
Various reports in February 1971, September 1971, and April 1972, by the trustees attempted to show that the system was a viable, private economic entity. The reorganization court reported:
In February of 1973, the trustees again, eschewing nationalization, but apparently reconciled to the inevitability of delay before the conditions of viability could be achieved, concluded that plant improvement in the range of $600 to $800 million would be necessary and that the only source of this financing was the United States. Absent such capital investment, even a sharply reduced freight system would not be viable.
The dilemma facing the trustees was that each day the estate operated additional deferred charges were accruing. Time was expensive. High administration expenses gave rise to two concerns: first, the potential economic viability of any railroad which might emerge was diminished by each increase in high-priority obligations; second, the continued accrual of administrative expenses would soon reach the point of being an unconstitutional impairment of the rights of the estate's creditors.*fn3
With mounting opposition from creditors who feared the continued erosion of the estate in deficit rail operations, the trustees acknowledged in 1973 the impossibility of reorganizing the railroad without federal aid of massive proportions.*fn4
Pursuant to an order of the reorganization court, the trustees filed with the ICC on July 2, 1973 a plan of reorganization for Penn Central. The New Haven trustee and Penn Central Company also filed plans.*fn5 The ICC held hearings on those plans over the summer; it reported on September 28, 1973,*fn6 holding that because the plan of the trustees did not provide concretely for the continuation of rail services, it did not constitute a "plan of reorganization" under Section 77 of the Bankruptcy Act. Accordingly, approval of this and the other two plans was withheld. As creditors moved to dismiss the reorganization*fn7 or to halt rail operations,*fn8 Congress enacted the Regional Rail Reorganization Act of 1973 (RRRA).*fn9
The RRRA created the United States Railway Association (USRA), a federal agency, to develop plans for revitalizing railroad services in the region and to administer various grant and loan funds. Among other things, USRA was to decide which lines or parts of lines were necessary to federal reorganization. The Act also directed creation of Consolidated Rail Corporation (Conrail), a railroad company and successor to some of the routes served by the bankrupt Penn Central. The Act required the conveyance of major portions of Penn Central's rail assets to Conrail free of encumbrances, and the continuation by Penn Central of its rail operations in the interim. Although the Act contemplated that Conrail would be a corporation owned by investors rather than a federal agency, at present it is financed by the United States. Further, the Act provided that a Special Court would have original and exclusive jurisdiction to dispose of all disputes arising from implementation of the reorganization. The Supreme Court sustained the Act against constitutional challenge,*fn10 recognizing it as a unique extension of the bankruptcy powers of Congress.*fn11 The Court upheld the unconventional central provision of the Act mandatory conveyance of the estate's rail assets before judicial approval of the terms of the transfer in light of the assurance found in the Tucker Act, 28 U.S.C. § 1491, that full compensation for those assets would be paid.*fn12
In April 1976, pursuant to court order but prior to a valuation, Conrail acquired certain of the railroad property of Penn Central. In general Conrail did not acquire lines or parts of lines which USRA considered unnecessary. Properties not acquired by Conrail were divided into two categories: lines authorized by the Act to be abandoned or scrapped, or lines which could be operated if state or local authorities provided for continued service, backed by a subsidy sufficient to ensure the owner against loss. It was not intended that Penn Central would resume any railroad operations.
Conveyance to USRA took place in 1976. But before the conveyance took place, Congress made a number of important amendments to the RRRA including Section 306 of the Act, which authorized the issuance of Certificates of Value, and the Section 211(h) loan program. Section 306 Certificates of Value are interest-bearing USRA securities redeemable on December 31, 1987, constituting a pledge of the United States to make up with cash any difference between the net liquidation value of the assets conveyed by Penn Central and other northeast bankrupt railroads and the value of Conrail stock and other benefits conferred on the estates by the RRRA.
The reason for the enactment of the Section 211(h) loan program was that as the time for conveyance approached, it was apparent that Penn Central's payables were in excess of its receivables. The situation was potentially tantamount to a second bankruptcy since Conrail was not to assume any liability for Penn Central's pre-conveyance obligations. Section 211(h) created a mechanism by which Conrail borrowed from USRA in order to pay certain classes of the debtor's payables. In turn, the estate was obligated to recognize as a current cost of administration the amount of 211(h) funds expended by Conrail on the estate's behalf.
An understanding of the Plan also necessarily involves consideration of the non-rail business of the estate. These substantial and profitable non-rail operations and assets held out the promise that Penn Central could function as a non-rail enterprise. Principally, these assets included non-rail businesses operated through Pennsylvania Company (Pennco), a wholly-owned subsidiary of PCTC, and various income-producing real properties in New York City and elsewhere. In the income statements filed by the trustees for the years 1970-75, a total of $244,462,000 of non-rail income was reported.*fn13
In developing a plan of reorganization which took account of these considerations, the trustees could derive guidance from two significant events involving major non-rail assets that had occurred during the course of reorganization.
Having previously announced their intention to sell all of the Park Avenue properties in New York City, in March 1972 the trustees petitioned to sell six of them at prices aggregating $59.5 million.*fn14 Various creditors raised objections to that sale, arguing that the proceeds of the sale would inevitably and improperly be used directly or indirectly to support hopelessly losing rail operations, and that the possibility of an ultimate plan of reorganization for Penn Central was threatened by the divestiture of those earning assets. At that time, those assets were producing $4.4 million annually, In re Penn Central Transportation Co. ("Park Avenue Properties"), 354 F. Supp. 717, 750-51 (E.D.Pa.1972), Aff'd in part and rev'd in part, 484 F.2d 323 (3d Cir.), Cert. denied, 414 U.S. 1079, 94 S. Ct. 598, 38 L. Ed. 2d 485 (1973), and with other non-rail properties were properly regarded as constituting the key to any attempt to formulate a plan of reorganization. The district court denied the petition in part, but approved the sale of four parcels for an aggregate of $14 million. 354 F. Supp. at 746-51. On appeal, the creditor interests urged that a reorganization court could not approve piecemeal disposition of such non-rail assets in the context of a program to divest all major non-rail assets, and that, apart from extraordinary circumstances, no such program for divestiture of non-rail assets could be pursued except in the context of a plan of reorganization. In June 1973 this court sustained that view, holding:
In the context of this case, if such sales are to take place, they must be made as part of a reorganization plan, approved pursuant to the provisions of sections 77(d) and 77(e).
In re Penn Central Transportation Co., supra, 484 F.2d at 334.
The second major controversy involved Penn Central's ownership and pledge of the common stock of Pennco. That stock had been pledged to the Secured Bank Creditors as collateral for a $300 million pre-bankruptcy loan. In July 1972 the trustees petitioned the court to approve a settlement of the claims of the Secured Bank Creditors which provided that the common stock of Pennco would be transferred to the banks subject to conditional provisions permitting Penn Central to share in certain appreciation in value of that stock.*fn15 That petition was opposed upon the ground that the common stock of Pennco was essential to an ultimate reorganization and that a settlement of the kind proposed could not be carried out except in the context of a complete plan. The appropriate value of Pennco to Penn Central was also put in issue. In April 1973 the reorganization court denied the petition stating:
In a straight bankruptcy, the relevant consideration presumably would be the price which Pennco could be sold for; that is, whether there is any "equity" over and above the banks' claims, and whether the Trustees should "disclaim." In a railroad reorganization context, however, the potential value of Pennco to the reorganized company must also be considered.
Opinion and Order No. 1189, 1011 Corp.Reorg.Rep. (Penn Cent.) 4609, 4616 (April 16, 1973).
In light of the conveyance of the rail assets and the judicial insistence that the non-rail assets should not be disposed of except as part of a plan of reorganization that would contribute the value of these assets to the entire enterprise, fresh efforts to formulate a fair and equitable plan were undertaken. These efforts were focused on an attempt to construct a plan that would take account of (1) the income-producing continuing businesses owned and managed by Pennco; (2) the cash to be generated through liquidation of non-essential remaining assets (the "asset disposition program"); and (3) the constitutionally assured expectation that a significant award would be made in the Valuation Case, understanding all the while that both the time and the amount of the award were unforeseeable. The alternative to such a plan, it was believed, would be to embark on decades of litigation, with the concomitant waste of valuable and productive assets and accrual of increasing claims. Any plan, in order to ...