Suppose you’re a feudal serf in Medieval Europe. You clock in for work, go about your day working some lord’s land for him, pay him some amount of grain or chickens, and then head over to the tavern to blow some steam off all the while hoping you don’t die of the plague. Not a lot of bright prospects. The rich dude does well enough, but not a lot of upside for anyone else.
The Feudal system in Medieval Europe was the organizing principle that defined the relationship between the king, the lords, and the workers. The king granted land to the lords in exchange for their loyalty and resources such as military aid. The lords employed the peasantry as working labor, wholly obligated to their lord with output from working the lord’s lands extracted as rents or taxes.
Now suppose you’re a Class 2 or 3 rail operator in North America. Your shortline was likely created post-Staggers from the bankruptcy or abandonment of a line by a Class 1. You don’t have the cash to buy the line outright, so it was leased in some decades-old agreement locked away in a dusty filing cabinet somewhere. As part of that agreement, the Class 1 that leased the line to you required certain “obligations” for the pleasure of using their abandoned line. Some of these may be:
You’re required to provide a certain volume of carloads to the Class 1 landlord or suffer severe penalties.
Your Class 1 landlord has to approve new business you want to bring on your line.
You’re just flat out banned from interchanging with any other railroad.
You get the idea.
This arrangement, of course, is not great if you may actually want to grow your shortline in ways that your host Class 1 can’t help with. Suppose one of your customers is expanding and wants to ship to a new destination by rail that would require you interchanging with a railroad that isn’t your lease holder. Even if you aren’t explicitly prevented from doing so, there are about a million other tripwires preventing you from growing your business because of this landlord. Your frustrated customer gives up and shifts production to a different location, moves it by truck, or has to forgo the opportunity altogether.
What do you do? As a peasant farming your lord’s lands, what recourse do you have? Petition the king that granted the lords their lands in the first place?
That’s exactly what happened in 1998 when the Western Coal Transportation League petitioned the STB to review paper barriers created by the post-Staggers industry consolidation and line divestment bonanza. In response to the petition, I believe, STB Chairwoman Linda Morgan told the industry to figure it out or have the STB figure it out for them.
Thus, the Railroad Industry Agreement (RIA) was created as a grand bargain between Large (Class 1) and Small (Class 2 and 3) railroads. Although, “bargain” is a bit of a generous word. Even after it was amended in 2005, the RIA reads more like a ransom note than the Magna Carta.
Consider these key provisions in the RIA:
“[Paper] barriers should not restrict the Short Line's ability to develop New Traffic with another carrier if the selling or leasing Large Railroad can not or will not participate in the New Traffic.”
“‘New Traffic’ means traffic that (1) is not now moving by rail (except for reasons of seasonality or unusual disruptions of shipping patterns outside the control of the Large Railroad, such as plant shutdowns) and (2) does not unreasonably negatively impact the Large Railroad.”
“A Large Railroad seller/lessor should not be able to block a Short Line's reasonable attempts to gain New Traffic that the Large Railroad cannot handle or for which it cannot offer a competitive package. The Short Line's attempt to gain New Traffic is not reasonable, however, if … the traffic of the Large Railroad is negatively impacted by such action.”
You can probably see where I’m going with this. If a Class 1 can claim that New Traffic from the shortline would negatively impact its traffic in any way, it can kill the traffic. That is a ton of latitude for a Class 1 legal department to come in and nix any deal it wants if it may benefit a competitor.
Consider two anonymized examples of how this is constricting growth today:
Example #1 - A shortline interchanges with two Class 1’s. As part of their agreement with their host Class 1, the shortline has to interchange a certain share of of volume with that Class 1. If they don’t meet that requirement, because they’re shuffling more volume to the non-host Class 1 they interchange with, for example, they may be subject to penalties from the host Class 1. Pricing in these penalties kills the opportunity.
Example #2 - A Class 1 (along with the shortline feeding it the traffic) wanted to interchange at a new point with another shortline. The receiving shortline wasn’t allowed to do this new interchange unless it got approval from its host Class 1, which, of course, wasn’t granted.
These are only two that I’ve heard of recently. I’m sure there are many more.
That’s not all. Some of these agreements even having a poison pill. From the STB’s decision (Ex Parte 575, Oct 29, 2007),
“According to ASLRRA, many short line sale or lease agreements include clauses allowing the entire transaction to be rescinded if the Board were to find the interchange limiting provision unlawful.”
What we have here is a good old Mexican standoff.
The Argument for Paper Barriers
Why keep these in place at all? According to the AAR, paper barriers were “necessary consideration” to prevent the Class 1’s from just abandoning the lines altogether and sacrificing the captive traffic. From a filing with the STB on March 8, 2006,
“At the time of some transactions creating the new short lines, the parties involved negotiated a lower sales price or lease rate in exchange for an agreement by the new railroad to interchange future traffic solely or predominantly with the selling/leasing Class I railroad. These "paper barriers" were part of the consideration for the sale or lease of the line in the first instance and often were the only economic basis upon which a short line railroad operator could afford to take over the line.”
My brother-in-law described my nephew as being in his element when he was the “benevolent dictator.” This description of the need for paper barriers from the AAR certainly reads like that.
Sure, Class 1’s would need some consideration to avoid abandoning the line altogether. I get that. Low volume lines aren’t profitable in a business that runs on scale. But interchanging future traffic “solely or predominantly with the selling/leasing Class 1 railroad” isn’t that. That’s using your leverage to extract as much value from the deal as possible.
Theoretically, if a shortline operator offered any amount of cash consideration, let alone the potential for enough future traffic to not only justify the cost of service but also provide a profit to the host Class 1, that should be economic justification enough to avoid outright line abandonment. The Class 1 gets to shed the cost of operating the line, collects some amount of rent that it wasn’t getting before, and it gets almost all the upside from traffic growth? I don’t think that sounds like “the only economic basis” for an agreement. Adding unnecessary interchange restrictions on top of that is more like extortion than benevolence.
So, no, I’m not buying the poor, beleaguered Class 1 offering a lease as a handout for the greater good. The economic justification for paper barriers is nonsense. It’s strictly an anticompetitive tactic used by a one party with all the leverage to preserve pricing power.
I’m sure there are cases where increasing traffic from a shortline onto a Class 1 would result in negative operational impacts or costs. These obviously have to be treated pragmatically; You can’t kill the Class 1’s service reliability or you both go down. However, it would be nice for the industry to approach these challenges from a “how can we make this work” mindset rather than a “defend and litigate” mindset that is all too natural for monopolies.
Why This Matters
The frustrating aspect of all this Feudal warfare between the Class 1’s is that it unnecessarily restricts industry growth. Or, to put it more bluntly, it’s yet one more example of the strategic imperative by Class 1’s to sacrifice growth in the name of greater profitability.
If a Class 1 truly wanted to pursue greater carload growth, it would actively look for ways to reduce constraints on channel partners so that they can maximize the traffic they drive towards that Class 1. Paper barriers put a millstone around the neck of an underutilized channel partner (shortlines) that restricts their ability to grow traffic for their Class 1 overlords. In the past, I’ve called for Class 1 sales and marketing departments to be cut loose and run rampant in finding new business. Do that for the shortlines!!
Returning to the Medieval European analogy, war after war plagued the continent for centuries. This did not stop (generally) until the Treaty of Westphalia in the mid-17th century which created a sustainable balance of power among European nations. Otto von Bismarck in the 19th century was also able to balance the now greater powers of France, Russia, the UK and Germany through a series of agreements and geopolitical chess moves.
The Class 1’s need a Bismarck - someone who can rise above commercially destructive mechanisms and zero sum mentality of the past to show the industry there’s a better way. This is how a “Rail Bismarck” would go about doing things:
Create a task force with key decision makers from whatever type of shortline development group you have, operations, sales & marketing, and legal. No more than 5 people or nothing will ever get accomplished. Direct reporting line to the CEO.
Start asking the major holding companies a simple question: What opportunities are we overlooking from working with you?
Take the holding company responses (specific shortlines, commodities, geographies, customers, etc.) and feed it to the task force. Quantify each shortline railroad on your network by its ability to deliver carload volume growth.
Identify the roadblocks - Existing paper barriers, capital, personnel, regulatory, etc. of the top 5-10 opportunities.
Create a matrix and plot these opportunities based on path to execution (low barriers) and potential incremental carloads.
Undoubtedly, paper barriers will come up at some point. Now you have specific obstacles thrown up by other Class 1’s.
Take that stack and call up your counterpart at your regional competitor Class 1. The phone call should go something like this, “I’m sitting here with a stack of opportunities to grow my railroad. X of them are being prevented because of paper barriers with shortlines. I bet you’ve got the same stack, whether you know it or not. There’s a lot that’s changed in the past 40 years since our predecessors signed these agreements. I’m game to revisit them in ways that benefit both of us, if you are. Let’s make a deal.”
For non-paper barrier issues, I would also set up incentive programs to reward shortlines who attract more volume to the network. Replace the stick with the carrot. For example, you could set aside a honey pot of even just $25-50m available for shortlines who drive volume to you and give them access to capital that can improve their operations in ways that creates more traffic for you. Class 1’s have the balance sheet - you could even set up financing and loans for shortlines for capital improvements. Class 1’s should be able to effectively underwrite the risk of rail operations and rail CAPEX projects and make a profit on lending.
If Class 1 CEOs can get together to unwind some of these paper barriers, the whole industry would benefit. Yes, they would invite more competition and reduce profitability. Yes, some of that business may find its way on to a competing line. But if done right, it would unlock new freight that is currently going over the road or hasn’t yet been created because these barriers exist. You can generate greater profits by driving higher volumes despite potentially lowering ARPU.
At the end of the day, the true competitor for rail is trucking. We are missing out on so much freight because of artificial roadblocks like paper barriers where folks are more intent on preserving their shrinking slice of the pie rather than try and take a slice of a far larger one. Rail is a network business. Growing one part of the network can cascade across the rest of the network. By that same token, cutting off one node reduces the overall volumes that the industry would have prospered from. It’s time for rail to break down its fiefdoms and start working together to compete for freight that doesn’t touch the rails.
Or we could just continue to throw up more barriers around our castles until there’s nothing left to protect in the end.