STB Rejects CN-KCS Voting Trust

The future of Canadian National’s bid to buy Kansas City Southern was cast into doubt Tuesday after the U.S. Surface Transportation Board unanimously rejected a CN plan to place KCS into a voting trust while regulators reviewed the merger.

In the wake of that development, an activist hedge fund that on Monday increased its share of CN stock to 5.2 percent, called for the resignations of CN CEO J.J. Ruest and Chairman Robert Pace.

Some industry analysts said the STB decision signals that it doesn’t favor the CN-KCS combination.

The developments also prompted Canadian Pacific, which earlier failed in its own bid to buy KCS, to renew its efforts to merge with KCS.

The CN-KCS merger would have been the first combination of Class 1 railroads in two decades.

STB members decided that CN’s plan to place KCS into a voting trust was not in the public interest.

CN had proposed buying KCS in May in a $33.6 billion deal that it said would create the first railroad linking Canada, the United States and Mexico.

One sticking point for the STB about the voting trust was whether it would insulate KCS from unlawful control by CN during the merger review process.

The 33-page decision said the voting trust could hinder competition between CN and KCS while the merger is under review. Further harm could occur if CN is forced to sell KCS if federal regulators rejected the merger.

The STB decision also said the establishment of a voting trust is not essential as part of a merger proceeding and that CN and KCS could still seek to merge under different terms.

Earlier this year when CP and KCS were courting each other for a merger, the STB had approved the terms of a voting trust that CP had proposed as part of the merger.

The KCS board of directors had approved CP’s $29 billion offer in March, but two months later did an about face after CN submitted what the KCS board termed a “superior offer.”

CP has since offered to increase what it will pay for KCS, but that bid is still less than what CN is offering.

The STB decision this week in effect rejected a CN argument that it’s proposed KCS voting trust was the same as what CP proposed and the STB approved.

In its decision, the STB said the CN-KCS merger would be judged under tougher new merger rules, while CP-KCS would have been reviewed under rules that existed before being changed in 2001.

The STB also said approval of a CN-KCS voting trust arrangement could lead to further consolidation among Class I railroads.

“A simple geographic analysis of the rail network would suggest that a carrier in CP’s position, i.e., one that would be the smallest carrier by far after a CN-KCS combination, might need to look for potential strategic alliances, which might in turn trigger yet more strategic responses by other rail carriers,” the STB said. “Approval of a CN-KCS voting trust could speed up downstream consolidation movements prior to the Board even having had an opportunity to assess them based on the record yet to be developed in this proceeding.”

It remains unclear if KCS will proceed with a meeting of its shareholders on Friday to vote on the CN merger proposal.

The CN-KCS merger agreement remains in force until February 2022.

Industry analyst Anthony Hatch told Trains magazine the STB decision this week sends a “clear signal about potential downstream impacts of a merger involving two Class I systems.”

Analysts at Wolfe Research said in a note to investors said CN could increase its offer to KCS as a way of enticing it to ride out the process.

However, it said that if the STB rejected the voting trust proposal it was likely that KCS shareholders would vote against the CN bid, which would mean KCS would owe CN a $700 million breakup fee.

The day before the STB decision came down TCI Fund Management increased its ownership of CN stock to 5.2 percent.

Shortly after federal regulators spurned the CN voting trust proposal, TCI issued a statement calling on CN to end its bid for KCS.

TCI also called for Jim Vena – a former CN chief operating officer who most recently worked in operations at Union Pacific – to be named CN’s chief executive.

The activist hedge fund also wants Gil Lamphere, a former CN board member and an early supporter of E. Hunter Harrison’s precision scheduled railroading operating model, to be named to the CN board of directors.

In seeking the resignation of CN CEO Ruest and board chairman Pace, TCI said the CN-KCS merger faced regulatory risk.

It acknowledged that if CN backs away from the merger that it would be liable for paying a

$1 billion breakup fee to KCS.

CN previously paid KCS $700 million to cover a breakup fee it owed CP when it broke its merger plans with that company.

 “The opinion of the STB is clear: it does not want Canadian National to buy KCS, so persisting in the face of explicit opposition from the STB would be hugely damaging to the reputation of CN and potentially financially disastrous because it would expose the company to the risk of forced divestment and damaging remedies,” TCI’s Chris Hohn and Ben Walker wrote in a letter to CN.

They said any attempt to salvage the KCS merger would be futile.

“From the start, it has been clear and obvious the bid would fail. That the Board sanctioned the bid, together with potential fees of C$2 billion, is an egregious failure of oversight and there must be accountability. CN needs a change of senior management,” TCI said.

Late Tuesday night CN issued a statement expressing disappointment in the STB decision.

“We are evaluating the options available to us in light of the STB’s decision,” CN said.

“We remain confident that our pro-competitive, end-to-end combination is in the public interest and that it would offer unparalleled opportunities and benefits for customers, employees, the environment and the North American economy.”

CP also issued a statement calling on KCS to merge with it.

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