TRANSPORTATION CONTRACTS SMALL RAILROAD PERSPECTIVE [Association of Transportation Law Professionals, paper presented June 2003 (Newport, RI)]

Transcription

1 TRANSPORTATION CONTRACTS SMALL RAILROAD PERSPECTIVE [Association of Transportation Law Professionals, paper presented June 2003 (Newport, RI)] By: Mark H. Sidman Weiner Brodsky Sidman Kider PC Washington DC Shippers routinely enter into transportation contracts for the movement of goods by rail. In many instances, more than one railroad is involved in the handling of the freight. And those multi-carrier moves often include one or more short line or regional railroads (together, small railroads ) 1 as participants, usually at the origin or destination of the shipment. But, despite the participation of small railroads in transportation services covered by transportation contracts, small railroads rarely participate in the negotiation of the terms of these arrangements. In the end, that can disadvantage the shipper as well as the small railroad. This paper will address three issues. First, we will look at why small railroads are frequently invisible in transportation contract negotiations. Second, we will examine why shippers should care that a small railroad participant in transportation services is absent from the table. Finally, we will suggest some steps shippers can take to increase the likelihood that transportation contracts involving small railroads meet the needs of all parties to those contracts. 1. Not All Small Railroads Were Created Equally 1 The Surface Transportation defines class II carriers as those with annual carrier operating revenues of less than $250 million but in excess of $20 million after applying the railroad revenue deflator formula shown in Note A. Class III carriers are those with annual carrier operating revenues that do not exceed $20 million following the application of the revenue deflator formula. See 49 C.F.R The deflator formula is necessary because these revenue thresholds are in 1991 dollars. Thus, before a railroad determines if its annual operating revenue exceeds these thresholds, the railroad s revenue must be adjusted for inflation by applying the deflator formula.

2 In the context of transportation contracts, it is useful to divide the small railroad universe into two general categories: old-line companies that existed prior to the passage of the Staggers Rail Act of ( Staggers Act ), and new companies that were created after the passage of that landmark piece of deregulatory legislation. There are important differences between these two groups of carriers. The old-line companies, in many cases, constructed their own rail lines long ago. These small railroads generally have an arms length commercial relationship with their Class I connections. They negotiate divisions of revenue on a move-by-move basis. They also deal directly with their customers in negotiating service terms and pricing. From time to time, these pre-staggers Act companies will be signatories to transportation contracts that involve multiple carriers. The small railroads formed after 1980, on the other hand, did not construct their rail facilities. Instead, following the passage of the Staggers Act, which eased regulatory burdens associated with the transfer of branch lines, these small railroads were formed as spin-offs from Class I carrier line sales. 3 In general, the post-staggers Act small railroads purchased or leased low density branch lines 4 that the owning Class I carriers determined could be operated more efficiently by a new carrier. 5 2 Pub. L. No , 94 Stat See FRVR Corporation Exemption Acquisition and Operation Certain Lines of Chicago and North Western Transportation Company Petition for Clarification, Finance Docket No , 1988 WL (Jan. 28, 1988) (noting that [t]he trend away from abandonment and towards the formation of short-line and regional carriers developed in response to the new business environment created by the Staggers Act ). 4 Some post-staggers Act spin-offs, such as Montana Rail Link, Inc. and MidSouth Rail Corporation, were not low density branch line systems. These larger, higher density systems were the exception, not the rule. 5 The new small railroads, for the most part, were non-union carriers or were unioned under voluntary, innovative collective bargaining agreements that permitted cross-training and cross-utilization of personnel and did away with costly and burdensome payments and work rules. This allowed the small carriers to operate with two-man crews instead of the five-man crews required under Class I collective bargaining agreements that were still in place in the early 1980 s. These labor savings, along with lower overhead, enabled small railroads to provide service at significantly less cost than Class I carriers. 2

3 As a condition to the sale or lease transaction that created a new small railroad, the selling Class I carrier almost always required that the purchaser enter into a long-term marketing agreement. 6 Under the terms of a marketing agreement, the small railroad typically (i) granted power of attorney to the seller for the setting of rates and service terms in tariffs, rate quotes and contracts, with respect to interline traffic to be handled between the buyer and seller, (ii) agreed to be compensated on a per car allowance basis for interline traffic, without regard to the rate charged to the customer by the Class I carrier, and (iii) agreed to some form of contractual restriction -- now commonly referred to as a paper barrier -- that effectively precluded the small railroad from interchanging all or certain traffic with one or more connecting carriers. 7 These marketing agreements made perfect sense at the time of the small railroad s acquisition of its system. By retaining the right to price all interline traffic handled by the Class I carrier and the purchaser, the Class I carrier eliminated the risk of losing the business as a result of reckless pricing decisions by an upstart company. Moreover, by fixing the per carload allowance paid by the Class I carrier to the small railroad for its share of the work (subject only to annual inflation adjustments based on an industry standard cost index such as the Rail Cost Adjustment Factor), the Class I carrier was able 6 Many marketing agreements purport to be of perpetual duration. 7 There are several types of paper barriers. The simple ones provide for a fee to be paid by the buyer to the selling Class I carrier for each car of traffic interchanged by the buyer with one or more third party connections. In some cases, certain traffic e.g., traffic to or from markets not served by the selling Class I carrier is excluded from the scope of the paper barrier. Other, more creative paper barriers impose easement fees for the new railroad s use of a rail segment over which the new railroad obtained only an easement, with the easement fee based upon the number of carloads of restricted traffic interchanged by the new railroad with third parties. In lease transactions, a common structure is for the rental to be stated at a large amount, with rent credits given to the new railroad for each carload interchanged with the selling Class I carrier. If all of the anticipated traffic were interchanged with the seller, the rent credits would reduce the rent to a relatively modest level; if traffic were diverted to a third party connection, the rent credits would be reduced and the rent due increased by a concomitant amount. In their various iterations, the amount of the penalty for interchanging restricted traffic with third parties is greater than the 3

4 to fix its expense for the small railroad segment of the move without having the risk of extraordinary capital expense or any other unanticipated cost spike that could occur if the Class I carrier continued to own the line. 8 The sellers also found they could eliminate diversion of traffic handled by the small railroads by entering into contractual arrangements that built in financial disincentives to the small railroad s interchanging traffic with third party connections. As icing on the cake, the small railroad would improve service and be more responsive to customers because its low density line was the sole focus of its attention. Marketing agreements also had considerable appeal for the small railroads. Because the agreements effectively eliminated the risk that the sellers would lose all or a portion of the traffic attributable to a branch line due to bad pricing decisions by the small railroad or diversion of traffic to third party connection, and because the per car allowance structure effectively fixed the selling Class I carrier s cost structure for the portion of the move over the line being sold, the purchase prices of the properties acquired by small railroads were significantly less than the prices would have been in the absence of such arrangements. In the days before the advent of publicly traded small railroad groups such as RailAmerica, Inc. and Genesee & Wyoming Inc., the use of a marketing agreement in a line sale allowed an entrepreneur with limited access to capital contribution of the traffic to the small railroad. As a result, the small railroad rarely if ever chooses to divert the traffic and pay the penalty. 8 From the Class I carrier perspective, the allowance levels established in the 1980 s seemed like bargains at the time because those amounts were computed based on the cost structure of a small carrier using two-man crews when the Class I carriers were incurring the costs associated with five-man crews. This cost advantage has dissipated over time as Class I carriers negotiated crew consist agreements and began operating with two-man crews. At the same time, the unit cost for labor has steadily risen for small railroads, especially for certified engineers. In addition, the increased cost of handling 286,000-pound rail cars has increased the capital spending requirements for these carriers. The allowance levels that looked good to the small railroad 10 years ago may look considerably less attractive today (depending in large measure on the inflation index used to adjust the allowance). 4

5 the opportunity to acquire fairly significant rail properties at a relatively modest price. A case could be made that marketing agreements were the critical component of the transactions that formed hundreds of new small railroads in the post-staggers Act era. As the foregoing indicates, when it comes to transportation contracts, small railroads are not all similarly situated. The vast majority of old-line companies are not parties to sweeping, long-term marketing agreements and generally are in a position to participate, directly or indirectly, in the negotiation of a deal with a customer. The post- Staggers Act companies, however, generally are parties to marketing agreements that effectively remove them entirely from the give and take of contract negotiation. It is in cases involving these newer carriers that shippers and Class I carriers have to take care in order to produce a deal that works well for all of the involved parties. 2. The Degree of Control There are now more than 500 small railroads that are part of the national rail network. Virtually all of these railroad have at least one Class I connection, and virtually all of these railroads handle interline traffic under transportation contracts. When a shipper wants to enter into a transportation contract for traffic that involves both a Class I carrier and a small railroad, it is useful to understand the vintage of the small railroad. The likelihood is that the old-line small railroad has a certain degree of control over the revenue it requires, the services it is willing to provide and the performance incentives and disincentives it is willing to build into the deal. Even in instances in which an old-line small railroad has given one of the participating Class I carriers power of attorney to enter into contracts on its behalf and thus is not directly participating in contract negotiations it is likely that the power is circumscribed in terms of scope and 5

6 duration. That small railroad is a real player in the transaction, even if it is not at the table. In these cases, the shipper can have a reasonable degree of confidence that the small railroad is connected to the terms of the deal and will conduct itself accordingly. At the very least, if the old-line small railroad is unhappy with terms agreed to by the Class I carrier to which it gave power of attorney, it can take steps to rectify the situation when the contract expires and a new one is negotiated. If the small railroad, on the other hand, is a post-staggers Act spin-off, the likelihood is that it will be completely passive in structuring the transaction. It likely has given the Class I carrier carte blanche to market interline traffic handled by both companies. Depending on how aggressively it negotiated the terms of its marketing agreement, the small railroad may not even have the right to approve contracts that would obligate it to provide equipment, handle dimensional loads, provide in-transit services or expose it to service-related penalties. Many (if not most) marketing agreements do not include such an approval right and the small railroad truly is at the mercy of the Class I carrier. Moreover, the per carload allowance that the small railroad will receive likely was negotiated years ago (subject to an inflation index). It may well be an all commodities allowance i.e., the small railroad receives a fixed, per carload allowance without regard to the commodity being handled which means that for any particular move the allowance may be a good deal or a bad deal for the small railroad, either as compared to the rate paid by the shipper, or as compared to the complexity or risk of the service to be provided by the small railroad. For example, on a highly rated commodity that moves for $3,000 per carload for a 100-mile move, the small railroad may well be receiving 6

7 $200 for originating and handling the car for 40 of those miles. This clearly would be a bad deal for the small railroad. Under these circumstances, the small railroad may not give the level of attention the shipper expects on a high-value move. A variation of the single allowance structure is the multiple commodity allowance structure. In these agreements, certain commodities and/or geographic zones are identified and priced. For example, if the customers on a small railroad ship wood chips, chemicals and agricultural products, those commodities would each be assigned a per carload allowance amount, and then an allowance would be set for all other commodities. In a geographic zone arrangement, the allowances may vary by the proximity of the customer to the interchange between the small railroad and the Class I connection. A multiple commodity and/or geographic zone allowance structure makes it significantly more likely that the compensation to the small railroad for the services it provides under a transportation contract will be reasonably related to the value of those services. In some spin-offs, particularly those done by Conrail in the 1990 s and some being done by Norfolk Southern more recently, the marketing agreement permits the small railroad to establish its own revenue factor for various categories of traffic. The Class I carrier holds power of attorney to establish the through rate, but the small railroad can price its own services and change that price with prior notice to its Class I connection. 9 These arrangements allow the small railroad to engage in market-based pricing. Even in these cases, however, the Class I carrier may have broad authority to commit the small railroad to service requirements. 9 In these arrangements, the small railroad cannot change its revenue requirements during the term of a transportation contract. 7

8 3. Benefit of Bargain Elusive for Small Railroads As the foregoing discussion points out, the allowance received by the small railroad may be unrelated to the rate paid by the shipper. Thus, the allowance structure that is in place between the small railroad and the Class I carrier will have a significant effect on how the small carrier views the traffic. Small railroads with an all commodities allowance structure are not motivated by the price paid by the shipper, even if that price is extraordinarily high, while small railroads that establish their own revenue factors are affected by the rate paid by the shipper. A shipper who understands this phenomenon is in a position to negotiate provisions that will motivate the otherwise unmotivated small railroad participant in the traffic at issue. The small railroad may get cut out of the benefit of the bargain struck between the Class I carrier and the shipper, other than the allowance it receives. For example, the shipper may agree to allow the Class I carrier to impose a fuel surcharge when fuel prices exceed certain levels. If and when the surcharge is imposed, the likelihood is that the Class I carrier has no contractual obligation under its marketing agreement to share the surcharge with the small railroad, whose fuel costs also have increased. The shipper presumably agreed to the surcharge provision because it is fair and because service would suffer if the carrier is not getting adequate contribution from the traffic. However, the shipper s agenda is partially thwarted if one of the participants in the transportation service does not get the benefit of the surcharge provision. Another example in which a smaller railroad can be cut out of the benefit of the bargain is demurrage. The Class I carrier negotiating the contract may be a bridge carrier in the move, and thus would not receive demurrage for detained cars delivered to the 8

9 shipper. If the Class I carrier agrees to generous, non-standard demurrage terms for the shipper in exchange for a higher rate, the originating or terminating small railroad loses demurrage and likely will not share in the increased rate (because it receives a contractual allowance amount under its marketing agreement). Once again, the shipper ends up with an unhappy, disenfranchised carrier handling its traffic. Perhaps the most problematic area is performance incentives and penalties that might be built into a contract. It is entirely possible that the small railroad s compensation is unaffected by these types of provisions. 10 Thus, those provisions may not motivate the desired conduct by one of the participating carriers. This is especially important if the small railroad is the originating or terminating carrier and is going to be responsible for performing duties that are crucial to the shipper. 4. Conclusion A transportation contract is a good contract if it meets the needs of the shipper, on the one hand, and the participating carriers, on the other. In a transportation move involving several carriers, the shipper has not negotiated a good deal if one or more of the carriers feels that the contract is non-compensatory or is otherwise unhappy with the agreed-upon service terms. This is particularly true if the unhappy carrier is performing crucial services in originating or terminating the move. When a Class I carrier shows up at the bargaining table with a small railroad s power of attorney in hand, the shipper should take the time to figure out where the absent small railroad fits into the deal. If the small railroad is an old-line company formed prior 10 As a general matter, Class I carriers do not attempt to subject small railroads to penalty/incentive clauses without the agreement of the small railroad. However, in cases in which incentives and penalties apply only to the Class I carrier, the shipper will not get the result it was looking for. 9

10 to 1980, the likelihood is that the small railroad can take care of itself. But even with an old-line small railroad, it still makes sense to clarify how that carrier will be treated in the context of performance incentives and penalties; sharing of permitted surcharges; reduction of demurrage (especially if the small railroad is the originating or terminating railroad); and the like. If the participating small railroad is a post-staggers Act creation, the situation is much trickier. If the contract involves highly rated commodities; hazardous materials; intransit services; special service requirements; special demurrage arrangements; or performance incentives and disincentives, the shipper would be well-advised to try to determine how the small railroad will be compensated. (If the contract involves low- or medium-rated commodities and garden-variety service, the likelihood is that the small railroad will be adequately compensated under the terms of its marketing agreement.) The Class I carrier may not be receptive to a shipper s effort to make sure that a small railroad is being treated fairly in a contract. But from the shipper s perspective, it makes sense to balance risk and rewards for all of the carriers who will be handling the lading. It is not likely that the Class I carrier will gratuitously agree to increase the allowance to be paid to the small railroad. But, the Class I carrier may agree to provide for the small railroad to be at least a partial beneficiary of various carrier reward provisions that it otherwise would not pass along. 10