A $29 Billion Rail Deal Is Too Big to Skirt Scrutiny

(Bloomberg Opinion) -- Pushback from the U.S. Justice Department complicates the proposed railroad megamerger between Canadian Pacific Railway Ltd. and Kansas City Southern, but the regulator has a point. 

Canadian Pacific agreed last month to acquire Kansas City Southern for about $29 billion including the assumption of debt. The primary regulator for the railroad industry is the Surface Transportation Board, which has the final say over whether any deal can go ahead. But in a letter Monday, the Justice Department asserted a “statutory right to intervene” and outlined its thoughts on how the railroad regulator should go about reviewing what would be the largest ever merger between two major North American carriers.

While the Justice Department doesn’t yet have a view on the merits or competitive impact of the transaction itself, it advocates for the deal to be assessed according to tougher merger rules adopted in 2001 that require railroads to prove a transaction is in the public interest and enhances competition. Kansas City Southern had been granted an exemption from those rules when they were announced because of its relative size. In a filing late Monday, the companies argued that pulling that waiver “would unnecessarily complicate the review process.” At the same time, they’ve been pushing the argument that the streamlined network created by the merged entity will create new service options for shippers and help lure freight traffic away from the more carbon-intensive trucking industry. Translation: The deal does meet the higher standards for public interest and enhanced competition but the companies shouldn't have to prove it under the new rules because that would be time-consuming.

It's a bit weird. Either the deal passes muster or it doesn’t — and if the companies are confident in the benefits, they should welcome the extra scrutiny. Some rivals and large shipping groups have also asked that the exemption be revoked, arguing the sheer scale of the tie-up and the growth of Kansas City Southern’s operations in the past two decades warrant a tougher standard. 

But a long-winded process is problematic for the companies because the Justice Department also takes a dim view of the arcane voting trust structure that Canadian Pacific wants to use to close the Kansas City Southern takeover on a financial basis ahead of antitrust approval. Under that proposal, Canadian Pacific would buy Kansas City Southern shareholders’ stock and put those shares into a trust that would be overseen by former Kansas City Southern CEO Dave Starling. Current Kansas City Southern management would continue to operate the business until the merger is approved, which is expected to happen in mid-2022. This structure is less galling than what Canadian Pacific proposed in late 2015 when it tried to acquire Norfolk Southern Corp.; in that scenario, Canadian Pacific wanted to put itself into a trust and send its then-CEO Hunter Harrison to run Norfolk Southern and start making operational changes. Bill Baer, the head of the Justice Department’s antitrust division at the time, accused Canadian Pacific of “scrambling the eggs” and said the proposed voting trust “makes no sense."

The Justice Department acknowledges the Kansas City Southern voting trust structure is less egregious, but the setup still “makes a mockery of the Board’s authority,” Richard Powers, the acting assistant attorney general for the antitrust division, wrote in Monday’s letter. Whatever protestations of independence the companies make, the looming merger will change how they run their businesses. The regulator gives the example of an operating decision that would entail Kansas City Southern’s cooperation with either Canadian Pacific or another railroad partner; it’s obviously going to be motivated to collaborate with Canadian Pacific over the alternative. Such decisions could make Kansas City Southern less competitive if regulators end up blocking a merger and require Canadian Pacific to divest the asset out of the voting trust. 

This kind of dynamic arguably exists at any company with a signed merger agreement that's waiting for antitrust sign-off. The difference is that unlike the railroads, which have a designated regulator in the STB, the vast majority of companies are subject to the Hart-Scott-Rodino Antitrust Improvements Act. That law requires companies to wait a certain amount of time before closing their deal to avoid any premature scrambling of the eggs, to use the Justice Department’s term. So rather than use voting trusts, other companies mitigate the risks of a long antitrust review with breakup fees, divestiture agreements and “hell or high water” commitments to see a deal through no matter the demands of regulators. And it works for them. It’s not uncommon in other highly consolidated industries for antitrust reviews to stretch for a year or more.

While the railroads have good reason to argue that the merger itself is in the public interest, the 2001 merger rules would require Canadian Pacific and Kansas City Southern to prove that the voting trust is, too. That’s a trickier argument. Really, the voting trust is in Canadian Pacific's interest. If Kansas City Southern shareholders have to wait until 2022 to receive compensation under the merger, they may be more tempted to consider other offers. Blackstone Group Inc. and Global Infrastructure Partners reportedly made repeated offers for Kansas City Southern last year but were rebuffed. Canadian Pacific’s offer of $275 a share is a substantial premium to the last reported bid of $208 a share from the private equity firms, but Blackstone and Global Infrastructure Partners don’t necessarily have to match Canadian Pacific’s offer on a dollar basis if the voting trust structure isn’t allowed. The private equity firms don’t own a railroad now, so they would face a less onerous antitrust review and could entice shareholders that way. In a letter Tuesday responding to the DOJ, Canadian Pacific said it's better for competition if another railroad buys Kansas City Southern and that the voting trust enables that. But as compelling as the Canadian Pacific tie-up is, some Kansas City Southern investors may prefer a faster, guaranteed close over more money. 

Canadian Pacific then pulled its offer and the STB never had to make an official decision on that transaction.

The Justice Department says it has no knowledge of other specialized regulators such as the Federal Communications Commission or the Federal Energy Regulatory Commission allowing the use of voting trusts, either.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brooke Sutherland is a Bloomberg Opinion columnist covering deals and industrial companies. She previously wrote an M&A column for Bloomberg News.

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