MS. VIGARS: I think we'll go ahead and get started if everybody could take their seats. MR. CANTER: Take your seats, please.

MS. VIGARS: Okay. We'll go ahead and get started here. And we have two more speakers before we have our lunch activities. And the first, Mr. Frank Pergolizzi, received his BA from Villanova University and his JD from Wake Forest University School of Law. Prior to joining Slover & Loftus, he served as a Visiting Fellow at the Columbus School of Law at the Catholic University of America.

Frank practices at Slover & Loftus and his focus has been on the litigation of rail transportation and coal supply contract disputes before the federal and state courts and commercial arbitration panels. This litigation has covered a variety of matters, including disputes relating to price renegotiations and price reopener provisions, compliance with service standards, liability for federal coal royalty, and utility bankruptcy.

Frank also maintains an active regulatory practice before the Surface Transportation Board. All of these issues, Frank's going to cover with us today; Western Rail Service crisis and its impact on contract rate shippers. Please join me in welcoming Frank.

MR. PERGOLIZZI: It's a pleasure to be here today to talk to you about a subject that has affected most of you over the last several years, and particularly in the last 18 months. It's also a subject that we believe is going to continue to affect you in the next several years.

Over the last five years, UP and, to a lesser extent, BNSF have experienced significant service disruptions. The situation began first with the Midwestern floods in 1993 and continued throughout '94 and 1995. UP service was also impacted for periods in 1995 and 1996 by UP's efforts to integrate the CNW after that merger took place.

More recently, and more to the point of today's discussion, the UP service crisis that began in the late summer of 1997 has presented many of you with inadequate service levels that have caused you to experience substantial deficits, increased costs and reliability concerns. In December of 1998, the Surface Transportation Board lifted its Emergency Service Order and declared that Up's service crisis was essentially over, stating, quote, "The UP service situation, although still not perfect, has improved considerably. And all indications are that it will continue to improve."

Well, we agree that the situation still is not perfect. We do not agree that all indications are that you can expect continued improvement. In fact, we believe that there's cause for concern. My comments are going to focus on those concerns.

Before doing that, I'd like to talk about how we got to the point the crisis has become the norm, rather than the exception. If we could turn to our first slide.

Back in the mid-1980s when competition was first introduced to the Powder River Basin, there was far greater capacity than demand. Throughout the '80s and into the 1990s, UP/CNW marketed their services aggressively in order to attract revenues to service their investment in the basin. That effort was largely successful. They've gone from moving 2.4 million tons out of the basin in 1984 to approximately 112 million tons in 1998. This increase has been caused in part by an increased demand for PRB coal. It's also been caused by increase in competition between BNSF and UP.

BNSF has also remained an active participant in the market. BNSF has seen their market share grow, although not nearly at the same pace as the UP traffic base. Total production out of the basin has grown from about 76 million tons in 1984 to approximately 250 million tons in the past year, 1998.

At the same time, there's been tremendous growth in all other commodities being moved by the railroads. If we could go to our next slide. As an example, while UP has increased its revenue-ton miles per mile of track from 1990 to 1998 by about 60 percent, UP's increased its train miles per mile of track by about 40 percent. At the same time, their miles of road have decreased by about 15 percent.

If we could go to the next slide. Along similar lines, BNSF's revenue ton-miles per mile have gone up by about 35 percent; train miles per mile have gone up by about 25 percent; and overall miles of road went down for '90 through '94 and currently are about the same level where they were in 1990. What these two charts reflect is that while the railroads have been cutting back the size of their systems, they've been moving greater volumes of traffic over the remaining lines.

We believe there's a direct correlation between the traffic growth, the levels of congestion that you've experienced since '93, in particular, and the poor service that you've experienced over that same period of time. We also believe that this type of growth is what has made the railroads far more vulnerable to service crises.

The railroads are no longer in a state of excess capacity. Indeed, despite substantial capital improvements throughout the 1990s, UP has not been able to match its capacity to demand in the recent years. UP recently summed up this problem when it said, "It was like we had a 20-seat restaurant and 40 people were reserved to eat." Along similar lines, Dick Davidson recently said, "We have assumed too often that the product was there, when capacity, whether measured as people, equipment, track or facilities, was not. Best intentions aside, we failed our customers."

This is not to say that there haven't been substantial capital improvements. UP recently issued an annual report in which it touts substantial construction projects in and around the Powder River Basin and along the major coal routes. The problem is that notwithstanding those significant capital investments, UP still hasn't caught up with its demand. In essence, by the time they've expanded the restaurant to accommodate the 40 people they committed to, they've got another 25 customers ready to come on in.

What has become apparent through the railroads' attempts to deal with recent rail crises is that coal service has been among the hardest hit in these times of crisis. One of the factors contributing to that, we believe, has been the manner in which the railroads prioritize traffic normally, as well as during times of crisis.

If we could go to our next slide. UP maintains a set of prioritization rules that assist it in dispatching its trains throughout its system. The number one priority is passenger trains or Amtrak trains. Number two is priority intermodal. Number three/four is other intermodal and automotive. Five is manifest traffic. And last is bulk trains, which include, of course, your coal trains. What's interesting about this prioritization schedule is it appears to be in inverse proportion to the profitability of the traffic listed. Priority intermodal typically has razor-thin margins as compared to coal traffic, which is among the most profitable on the system for the railroads.

The other interesting thing about the prioritization scheme is it appears to be in order of competition. The priority intermodal traffic is certainly more competitive traffic; it's subject to competition between the railroads, as well as competition from other modes. We believe that this prioritization scheme hurts you, particularly when you're in a time of crisis. The manner in which it hurts you can be seen by what happened to you right at the beginning of the UP service crisis last year.

In the fall of 1997, one of the first things that UP did was to remove locomotives from service to coal. It capped the number of train sets in service to coal. It laid down sets of equipment for coal, in part, to free up its capacity to serve other traffic commodity groups.

With that background in mind, I'd like to review just briefly where we stand currently on service. Through 1998, UP continued to experience high-cycle times, in terms of how those times related to contract service commitments.

If we could look at the Texas experience as an example. Throughout the November '97 to October '98 period, the Texas PUC and the Texas Railroad Commission monitored service provided by UP and BNSF and prepared various periodic reports. What these reports reflect is that UP was able to only deliver 74 percent of its targeted tonnage during that period to Texas. It also reflects that UP's actual cycle times exceeded the target cycle times by about 152 percent. There have been reports that service has been improving on UP in the first quarter of 1999.

While we have seen that improvement and have heard of that improvement from some of you, the fact remains that service still remains well above contract standards. And again, while it's fair to say there's been some improvement, I think we're a long way from saying that service has returned to normal. What "normal" means to the railroad is something that Diane touched on before. It does not mean our contract standard; it means some level of pre-crisis service, which puts you back somewhere in 1993. It does not, however, necessarily mean the standard you bargained for in your contracts.

BNSF reformed significantly better during this same period, in November '97 to October '98. While BNSF was only able to deliver 94 percent of the tonnage to Texas, its cycle times were 113 percent of targeted times, which is substantially better than the UP performance. The BNSF experience for 1999 to date appears to be continuing on this trend.

The bad news is that many of you are not seeing your contracts complied with in terms of cycle times standards. Even more concerning is what appears to be happening up in the basin in terms of congestion at the mines. There is, as Chuck said earlier, a great deal of finger pointing going on. The railroads have been primarily trying to put the blame on everybody other than themselves for congestion in the Basin. They've been accusing each other. UP has been claiming that BNSF has been favoring its own trains, allowing them to run around certain trains to get into certain mines.

UP and BNSF have also pointed the finger at the producers claiming that the load-out capabilities are not what they should be and that additional capacity is needed at the mines.

There are indications that production for '99 is up by approximately 10 percent of what was shipped over the first few months of '98. There are also indications that trains are sitting for anywhere between 24 and 36 hours waiting to get into the various mines.

Producers certainly have not agreed with the railroads that the congestion at the mines is their fault. They've pointed at a number of things, including an increase in the number of train sets in service from the same point in time last year. A couple of reasons exist for why there were more train sets in service. One theory is that there are more trains in service because UP is attempting to make up the substantial deficits that it created in 1998. Also, many utilities are trying to rebuild inventory to account for the poor service that they received in 1997 and 1998. And some utilities may be concerned that they've finally gotten some sets in service and that there's a risk in allowing those sets to come out of service because of fear that the service will take a downturn.

These continuing service difficulties -- and I don't mean to suggest just in the last 18 months -- but since 1993, have put an increasing strain on contract relationships. This strain is most apparent in the way that the railroads have treated shippers in connection with the delivery of declared tons, in connection with making up their failure to deliver all declared tons, and in their efforts to make up deficit tons.

A prime example of this strain is the litigation between Entergy Services, Entergy Arkansas and the Union Pacific Railroad. Before addressing that litigation in detail, I should point out that our firm, Slover & Loftus, is representing Entergy in that dispute. I've spent a great part of the last 18 months working on that case. Entergy is aware that we're going to be talking about the case. We have not only the confidentiality restrictions of the contract to deal with, but also a rather stringent protective order entered by the district court. My comments will be limited to what's available from the public record.

With that in mind, the Entergy/UP relationship is a relationship that dates back to 1983. Entergy, as many of you know, was UP's first significant customer in the basin. They ship -- if they could get the service -- approximately 13 million tons a year of PRB coal to their two Arkansas plants, the White Bluff station and the Independence Station.

In 1991, Entergy entered what's known as the Interim Rail Transportation Agreement, which provides for the transportation of 100 percent of Entergy's Powder River Basin tonnage to the two Arkansas plants. Under that agreement, Entergy has an obligation to provide UP with a declared quarterly volume commitment, as well as a declared monthly volume commitment. Entergy provides enough equipment to move that tonnage on the assumption that UP will meet its specified contract service standards. Those service standards include a quarterly average elapsed transit time. For the White Bluff plant, that standard is 160 hours; for the Independence Plant, it's 133 hours.

The agreement also specifies that if UP is unable to deliver all the declared tonnage within those transit times in a given quarter, they can make up deficit tons that are created in the subsequent quarter. UP has to supply the equipment necessary for the movement of the makeup tons. In the event that UP fails to make up tons, they are then obligated to pay liquidated damages specified as a percentage of the contract rate.

Finally, and we believe significantly, the contract includes an express provision that specifies that UP must act in good faith to avoid the creation of deficit tonnages in the first place.

Over the last several years, Entergy has experienced substantial deficits under its rail transportation contract. In 1994 the deficits that were not made up totalled 2.7 million tons. In '95, there were another half million tons of unmade-up deficits. And during the recent crisis, Entergy has alleged that for the period of '97 through the second quarter of '98, UP failed to make up approximately 3 million tons. There are additional deficits for the period from second quarter of '98 to the present. Those figures are not public.

Because of the deficits, Entergy has had periods where they've curtailed generation at the two Arkansas plants, including in 1997 and 1998. As a result of these service problems Entergy filed a complaint in October of 1997 claiming that UP had breached the contract by failing to meet the service standards, by not making up deficits in timely fashion, and by failing to act in good faith to avoid creating the deficits in the first place.

Entergy is seeking two independent, though not exclusive, remedies. First, Entergy is claiming that the breaches of the contract are material and therefore that they should be excused from their performance obligations under the agreement. In other words, that the contract should be terminated and they should be free to go out and contract for new service. They've also sought actual damages in lieu of the liquidated damages that are specified in the agreement.

The case was initially filed in a federal district court in Baton Rouge, Louisiana, but was transferred last summer to a district court in Omaha, Nebraska. Before being transferred, the magistrate in Louisiana bifurcated the proceeding into two phases. The first phase deals with the issue of whether or not UP had breached the contract by failing to meet the performance standard in the contract. The second phase is designed to encompass the issue of whether that breach, if any, was a material breach and whether Entergy can terminate the agreement, as well as the appropriate level of damages.

The parties have engaged in a great deal of discovery on the phase one issues. In the fall of 1998, both sides filed motions for summary judgment. The motions raised a number of issues. The key issues were: (1) whether UP had, in fact, breached the agreement; and (2), whether the liquidated damage provision in the agreement was the exclusive remedy available to Entergy.

There were certain facts that were not in dispute in connection with those motions, including the fact that UP had failed to meet the transit times and the fact that UP had created and failed to make up deficit tonnage. There is a dispute as to the degree to which UP failed to make up those tonnages and the level of the deficiency on the transit time side, but the basic fact that there was a violation of the service standard and that deficits have not been made up was not disputed.

Entergy argued that the failure to meet the elapsed transit time, in and of itself, constituted breach of the contract. In essence, Entergy argued that it bargained for service in accordance with a contract service commitment and it had a reasonable expectation that UP would deliver its tonnage in accordance with that service commitment.

Entergy also argued that the makeup and liquidated damage provisions were remedial provisions. They were not intended to supplant the performance obligation.

Entergy argued that UP could not alternatively perform the agreement by substituting the payment of liquidated damages for delivery of the coal in accordance with the service standards. Entergy argued that it was entitled to recover actual damages and/or that it could terminate the agreement if the breach was found to be material.

In presenting those arguments, Entergy noted a difference that existed between the minimum volume obligation for Entergy and the deficit service payment provisions on the railroad obligation. In Entergy's contract, the liquidated damage provision applying to the failure to meet the minimum volume commitment specifies that those damages would be in full settlement of any controversy over the failure to ship minimum tonnage. On the other hand, the provision governing the payment by the railroad of liquidated damages for failure to make up deficits did not contain such language of exclusivity.

UP filed its own motion. It argued that its failure to meet the transit time standard was not a breach of the agreement; that the service standards did not consist solely of the transit time standard, but that you had to read the entire section together. Under UP's theory, there is no breach until it incurs a deficit, until the deficit isn't made up, and until it doesn't pay liquidated damages. UP also argued, in essence, that it can substitute the payment of liquidated damages for performance.

On January 28th, 1999, Judge Lyle Strom of the U.S. District Court for the District of Nebraska entered an order granting Entergy's motion for summary judgment in part and denying the UP motion. In that order, Judge Strom held several things that we believe will be a benefit to shippers in dealing with railroads on service standards in the future. Among them was the first point listed on the overhead here, "From the language and structure of the contract, UP must have understood that its primary performance obligation was to deliver the coal to Entergy."

That seems like a pretty obvious point. But, as many of you may have learned in the last 18 months, that has not been UP's position. You, effectively, have handed over the keys to your plants. UP will get you the coal if they can. And if not, they'll make it up at some other point, whether it's when you need it or not. But the very beneficial holding here is that the judge affirmed the fact that the primary obligation is to transport coal.

Judge Strom also held, as reflected in the second bullet, that "UP breached the interim agreement by failing to transport all coal tendered by plaintiff, therefore creating deficits and in failing to make up deficit tonnage within the succeeding calendar quarter." The Court denied UP's motion for summary judgment that liquidated damages should be the sole and exclusive remedy, and stated that the liquidated damage provision contains no words of exclusivity.

As reflected in the third bullet, the judge concluded that "the liquidated damages provisions does not preclude Entergy's common law right not to perform if UP's breach amounts to a material breach." Again, if Entergy is successful in the next phase of the litigation and shows that the UP service failures were material, then it has a right to cease performance and to terminate the long-term contract.

The Court did note, however, that the liquidated damage provision could be exclusive as to one type of harm but not as to others. In the liquidated damage provision dealing with the deficit makeup in the Entergy case, there is a provision that notes that the intent was for compensation for obtaining alternate fuel supply. The Court noted that Entergy could not recover actual damages related to those specific types of costs, although it left open the question of what exactly those costs entail. It did not address, for example, whether those costs include the costs of substituting purchase power for lost generation.

In any event, we believe that the key aspect of the decision is the notion that the failure to meet a transit time and the failure to make up deficits could provide a basis for you to potentially terminate a contract for material breach.

There are many issues that are still left in the case including, of course, whether or not the breach is material. Essentially, that involves a determination of whether or not Entergy's been deprived of reasonably expected benefits as a result of UP's failure to comply with the service standards.

Other issues that still need to be dealt with include the level of damages and whether or not any of Entergy's damages fall outside of that one specific exclusionary clause on the alternate fuel supplies. Also, another issue which was raised by Entergy, but not addressed, was whether or not Entergy could recover actual damages because of the gross disparity between the liquidated damage amount and the actual damages that it experienced to date. The Court decided not to address this issue in its phase one ruling, but instead has deferred that issue to phase two.

This is a potentially significant issue to the extent that there may be others out there who are in a position where the railroad owes them liquidated damages and those liquidated damages may not match up to the actual damages experienced. Again, the Entergy opinion leaves hope that you'll be able to take some action that would entitle you to damages beyond the liquidated damage amount.

We believe that the Entergy decision, as well as the general experience that you've all had, is going to have a significant impact in the way you deal with the railroads in the future in terms of not only day-to-day activity, but especially in terms of dealing with them in times of crisis. The railroads are already showing signs of the impacts of this litigation and, again, the crisis, through various steps and actions that you're seeing. Among those are that we have seen that UP has been taking a more aggressive approach to administering coal transportation contracts.

In 1998, UP made several claims of force majeure relating to weather. There were some snowstorms in early '98 and then some flooding in October. It's unclear to us whether these force majeure claims were consistently applied to all PRB shippers or just a select few. BN, despite serving some of the same mines in the same basin, did not make similar claims of force majeure on all of its customers.

Other than a very limited time frame in connection with the 1993 floods, this represent a significant change in the way the railroads have approached administering their contracts. Our experience has been that other than for a very limited time in September of '93, there have been no weather-related force majeures claimed by UP in '94 through 1998.

Also, the issue of congestion at the mines is another example of where the railroads are being more aggressive in the way they administer their contracts. There have been some reports of constructive placement of trains in the basin to account for the delays of trains getting into the mines. Constructively placing a train enables the railroad to avoid including the time the train is held in the cycle time calculation. This will decrease the level of deficit that they would owe you in makeup service and would make it easier for them to comply with the cycle time standard.

Again, constructive placement is a tactic that has rarely been used by the railroads in recent memory. It's a practice that may not be consistent with contracts, depending on the terms of your contract. This gets, again, back to the issue of the finger pointing that we may already be seeing, but it certainly does not appear to us that the problems that are being experienced at the mine are the product of any activity on the part of shippers.

In any event, both the force majeure and constructive placement issues are examples of the railroads taking a much more aggressive approach to dealing with shippers than they have in the past. And we submit that this aggressiveness is inconsistent with an assumption that the UP rail crisis is over. Rather it reflects the recognition that the crisis is still very real and that the railroads, and particularly UP, have to be very careful to minimize exposure to any delays. Rather than acknowledge the delay and take responsibility for the time, they're looking for more aggressive ways to pass that burden on to the shipper.

We also think that you're going to see a change in the way that the railroads deal with you in negotiating service standards. Some of you may already be experiencing this. We believe that the service standards will have a greater focus in negotiations. You may find that there is less willingness to commit to transit time standards, and generally you may find more resistance to imposing strict requirements on performance.

We think it's important that you be careful to clearly define the rights and obligations, not only with regard to transit time commitment, but with regard to the makeup obligation, with regard to equipment commitments, and expect that you will see greater resistance on these points. For those of you with competition, it may be a point of change in focus in the competitiveness of terms between the BNSF and the UP. It's unclear whether the railroads will try to compete with each other on service terms, but it's certainly an issue that you should keep in mind as you're proceeding with negotiations on such issues.

We also expect that the liquidated damages provisions will be of greater focus in future negotiations. The Entergy decision is, we believe, quite significant in that regard.

We also believe -- and this is a point that I think has been touched on by Diane and Bob -- that the service experience and the Entergy decision confirm the need for competition. A UP attorney recently told the board in opposing the CN/IC merger, "Genuine competition is about rate decreases and service improvements. Only the introduction of an independent second competitor can ensure continued genuine competition."

We agree with that statement. Competition is your best protection from the type of service disruptions that many of you have experienced. For those of you who have competitive alternatives, you need to be conscious of protecting yourself. If you're going to commit volume to a particular railroad, you need to protect yourself with provisions that will enable you to be relieved of the volume commitment in the event that there are significant service disruptions. We believe the railroad is going to try to cut that off to counter some of these rulings in the Entergy case. But if you can effectively define materiality in your service provisions to allow for termination, or at least a partial relief of volume commitment, you'll be able to assure that you have competition at the time when you most need it, which is at a time when you're going to be looking to assure the reliability of your system.

For those of you without competition, you're going to have to be more creative. Reliability issues that have come up through this most recent crisis confirm that you can't rely on one railroad, necessarily, to assure that you're going to be able to provide reliable service in the midst of a rail service crisis. One method would be through construction of spurs. That may be something that you'll have to look at more carefully where that is feasible. The other, of course, is the legislative front. And hopefully, that will yield some type of bottleneck relief that can be utilized to protect you from being in a situation, not unlike Entergy was in, where UP could not provide the service, yet refused to allow a competitor to provide alternate service.

Since that time, the board has adopted new emergency service rules which offer some hope for contract shippers. I'll let Craig address those more directly. There is, however, some issue as to whether or not those rules, in fact, apply to contract shippers. In the course of the rule-making relating to those rules, the AAR argued that the board lacked jurisdiction over contract movements. WCTL and others argued otherwise. The STB, in their final promulgation of the rules, did not preclude exercise of jurisdiction to award emergency service relief for contract moves, but rather left that issue to be decided on a case-by-case basis.

Recently, the AAR filed an appeal of the emergency service rules to the D.C. Circuit Court of Appeals. We assumed that one of the focuses of that effort was going to be to attack the board's treatment of the contract issue. A couple weeks ago, however, the board moved to dismiss that appeal and the AAR has consented to that dismissal. We believe that the appeal will be dismissed and that the issue of the scope of those rules will have to be dealt with in the context of whoever the poor shipper is that decides to be the first to try to get emergency relief.

In sum, tomorrow you're going to be hearing from the railroads that your service problems are over and that things are back to normal. We do not believe that you should be so optimistic. We think it remains to be seen whether the latest crisis is truly over and whether, when and where the next one may arise. Thank you.

MS. VIGARS: Great. Thank you very much, Frank. We'll hold off the questions and answers until the end, until we've heard from Craig. 
  back to top
  Please click here for the Publications and Presentations Archive