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In re Lehigh and New England Railway Co.

August 3, 1981



Author: Garth

Before: GIBBONS, HUNTER and GARTH, Circuit Judges

GARTH, Circuit Judge :

This appeal requires us to determine a question of first impression: once a railroad has gone into receivership and has expended all of its general funds, may the balance of unpaid interline claims be paid out of mortgaged assets prior to the satisfaction of the mortgage bondholder's secured claims?*fn1

This issue was presented to the United States District Court for the District of New Jersey on motion of the Receiver of The Lehigh and New England Railway Company ("L&NE") for an order approving a plan of liquidation. The court initially approved certain modifications to the Plan, but reserved its decision on the issue which constitutes the heart of this appeal: the priority, as between the interline claimants and the L&NE bondholder, with respect to the proceeds to be recovered in currently pending valuation proceedings. The district court by Order dated September 16, 1980, granted the railroad interline claimants, represented by appellees Committee of Interline Railroads ("Committee") and the Trustees of the Erie Lackawanna Railway Co.*fn2 ("Erie"), first priority in the valuation proceeds. Central Jersey Industries, Inc. ("CJI"), owner of all of L&NE's bonds, appeals from this order. We reverse.


L&NE was formed in 1961 as a wholly-owned subsidiary of the Central Railroad Co. of New Jersey ("CNJ"). Following a default by CNJ of certain loans guaranteed by the ICC, all L&NE stock, bonds and equipment were transferred to, and registered in the name of, the United States. When CNJ was reorganized in 1979 as CJI, the claims of the United States were satisfied and the reorganized corporation regained full ownership of the L&NE bonds. These bonds, in a principal amount of $2,500,000, are secured by an indenture, dated July 1, 1961, to which virtually all of L&NE's real property in subject.

On April 1, 1976, during the period when the United States owned all of L&NE's stock, bonds and equipment, some of L&NE's rail properties were transferred to Consolidated Rail Corp. ("Conrail"), pursuant to the Regional Rail Reorganization Act of 1973, 45 U.S.C. ยง 701 et seq . L&NE presently has a claim outstanding against the United States for the value of those assets conveyed to Conrail. This claim is currently in litigation to determine the amount of the "valuation proceeds." The interline claimants seek to be paid their balances from these valuation proceeds.*fn3

The L&NE went into receivership on September 26, 1977.*fn4 On February 9, 1979, the Committee of Interline Railroads, a group of railroads with interline claims against L&NE, petitioned the district court for a declaratory order stating that pre-receivership interline freight revenues collected by L&NE should be held in trust by L&NE, and that the interline railroads should be permitted to set off all pre-receivership accounts and debts owed to L&NE against the trust funds owed to them. In an Order dated June 6, 1979, the district court ordered that:

1. Pre-receivership freight revenues collected by Lehigh on behalf of the Interlines are held in trust by Lehigh on behalf of the Interlines.

2. The Interlines are entitled to recovery of such revenues, after first setting off all pre-receivership accounts or debts owed by the Interlines to Lehigh.

3. Lehigh shall not pay any resulting balances due to the Interlines until further order of this Court.

App. at 65.

On June 15, 1979, the Receiver notified the court that there were in sufficient funds in the general account of the L&NE estate to pay all interline claims and all administration expenses. See App. at 66.

At that time, the assets of L&NE fell into three separate categories: a trust account containing $444,171.63, maintained at the Security National Bank (the general trust account); an account containing $118,644.71 which represents proceeds from the sale of property subject to the 1961 indenture (the mortgaged release account); and a claim against the United States for the value of the rail assets of the L&NE which were conveyed to Conrail in April, 1976 (the valuation proceeds). The net book value of these latter assets is $3,054,407.00. See App. at 77-78, 156.

In September, 1979, the Committee filed a motion for payment of the trust funds. While this motion was pending, the Receiver filed a petition for the approval of a plan of liquidation. This plan provided that the balance of the interline claims would be paid from the valuation case proceeds before such proceeds were made available to CJI as bondholder. See App. at 81. The Receiver interpreeted the June 6, 1979 Order of the court to mean that all of the assets in his hands, "regardless of their origin, [were] impressed with a trust on behalf of the interline freight creditors." See App. at 80.

The Receiver subsequently modified his plan. Under the modified plan, interline freight claimants were to receive substantially all of the monies in the general trust account and to share pari passu with the bondholder in the valuation proceeds. In addition to its share of the valuation proceeds, the bondholder would receive immediate payment of the funds in the mortgaged release account,*fn5 less a sum for administration expenses incurred by the estate. Objections to this plan were filed by the Committee and the Erie trustees.

After a hearing, the district court issued an opinion and order in which it determined that $37,500 in the general trust account should be set aside for administrative expenses and the balance paid over to interline claimants on a pro rata basis. The court also accepted CJI's offer to make a substantial contribution from the mortgaged release account toward administration expenses, and determined that the balance of funds in that account should be disbursed to CJI as sole owner of the L&NE bonds. In its order, the court reserved judgment as to the priorities to be accorded to creditors with regard to the valuation proceeds.

On March 25, 1980, the Receiver distributed, in accordance with the District Court's decision, $433,789.13 to interline freight claimants from the general trust account. This represented a distribution to each interline claimant of approximately 55% of its claim. App. at 163.

By on Order dated September 16, 1980, the District Court awarded "a first priority" in the valuation proceeds to the interline creditors, "a second priority" to CJI, and "a third priority" to general creditors. This appeal followed.

As indicated above, the sole issue presented by this appeal concerns the district court's determination of priorities in the valuation proceeds. Before addressing this matter, however, we must decide a preliminary issue which surfaced during the oral argument: whether the instant action, an equity receivership in which jurisdiction is based on diversity of citizenship, is governed by federal or state law. It is to this inquiry that we now turn.


CJI contends that under the choice of law rule announced in Erie Railroad Co. v. Tompkins, 304 U.S. 64 (1938), the law of New Jersey, the forum state, governs this action. If we were to accept this position, we would then have to determine which state's substantive laws a New Jersey court would apply in an action such as this.*fn6 We need not reach this choice of law question, however, for we are satisfied that federal law should govern the instant matter.

Under Erie, supra, we are instructed that a federal court sitting in a diversity case must apply the substantive law of the forum in which it is sitting. In so holding, the court declared: "[t]here is no federal general common law." 304 U.S. at 78. Nevertheless, the Supreme Court has observed that, notwithstanding the rule of Erie, supra, federal common law may govern, even in diversity cases, where a uniform national rule is necessary to protect or further the interests of the federal government. Texas Industries, Inc. v. Radcliff Materials, Inc ., 49 U.S.L.W. 4537, 4540-41 (May 26, 1981); City of Milwaukee v. Illinois, 49 U.S.L.W. 4445, 4447-48, 4453-54 (April 28, 1981); Miree v. DeKalb County, 433 U.S. 25, 28-29 (1977); Clearfield Trust Co. v. United States, 318 U.S. 363 (1943). The Supreme Court, therefore, "has applied federal common law where federally created substantive rights and obligations are at stake." Milwaukee, supra, 49 U.S.L.W. at 4454 (Blackmun, J., dissenting). See, e.g., Banco Nacional de Cuba v. Sabbatino, 376 U.S. 398, 426 (1964) (scope of the act of state doctrine determined according to federal law); Textile Workers Union v. Lincoln Mills, 353 U.S. 448, 456-57 (1957) (federal substantive law applied ...

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