The Department of Justice has some doubts about a novel merger arrangement between Canadian Pacific (CP 2.06%) and Kansas City Southern (KSU), calling into question whether Kansas City Southern shareholders will get their payout this summer as hoped.
Canadian Pacific (CP) and Kansas City Southern (KCS) last month announced plans to combine in a deal worth more than $29 billion, including debt. With a long, drawn out regulatory approval process expected, CP came up with a plan to put KCS into an independent voting trust ahead of full deal completion.
But in a letter to the Surface Transportation Board filed April 12, a top DOJ official cautioned against the railroad regulator accepting the trust plan without close scrutiny.
"It is the duty of the Board to determine whether a merger of two railroads would harm competition," Richard Powers, the DOJ's acting assistant attorney general for antitrust, wrote. "Allowing the parties to combine their ownership before the Board has reached a determination as to the merits makes a mockery of the Board's authority."
This was never going to be easy
The STB essentially prohibited large-scale railroad consolidation in 2001, and the two parties knew going in it would likely take until mid-2022 to win approval for this combination. That's a long time for KCS shareholders to be left waiting for an uncertain payout, and could be enough to discourage any merger attempt.
Canadian Pacific, mindful of the long wait, structured the deal in such a way to alleviate most of the risk for KCS holders. CP intends to establish an independent voting trust that will acquire the shares once KCS holders approve the deal, and before regulators have sounded off. That's likely to happen as soon as this summer, and at that point, holders of KCS shares would get the $90 in cash and 0.489 shares of Canadian Pacific as outlined in the merger agreement, even though CP will not yet officially own Kansas City Southern.
Image source: Kansas City Southern.
Assuming the STB eventually does sign off on the deal, Canadian Pacific would then merge with the trust. If regulators block the merger, the trust would likely go public.
It's a clever trick; perhaps too clever for the DOJ's liking. Powers in his letter said the DOJ believes the trust would "undermine the Board's ability to conduct a meaningful review."
Even if KCS is technically independent from CP, the DOJ questions what incentive the two parties would have to compete against each other if they believe they will eventually merge. And a technically independent KCS would have little incentive to pick a business strategy that could eventually be redundant to a CP operation should the deal win approval.
Does size matter at Kansas City Southern?
The deal would combine the two smallest of the seven major North American railroads in terms of revenue, and create a company that would still be smaller than fifth-place Norfolk Southern. And KCS is technically small enough that in 2001 it was granted an STB waiver to avoid the rigorous review standards that led to the merger moratorium.
But the DOJ argues in its letter that the STB should apply all the review standards written back in 2001 to this transaction. "As the first major rail merger in over two decades, this proposed transaction presents important and novel competition issues that have the potential to significantly reshape the industry," Powers wrote.
The railroads, unsurprisingly, disagree. In a response filed with the STB, the railroads say applying the strict moratorium rules to this transaction "would unnecessarily complicate and prolong the Board's review of the proposed combination."
The railroads are rallying all the support they can, and more than 375 customers, ports, and other stakeholders have filed statements of support. The railroads also quote William Clyburn Jr., who approved the KCS exemption 20 years ago as a former STB member, as saying the reasons for excluding Kansas City Southern from the moratorium "are just as valid today as they were back then."
Image source: Canadian Pacific.
What does this mean for KCS shareholders?
Powers emphasized that the DOJ does not yet have a formal position on the merits of the deal, but it seems clear the regulatory battle will, as expected, be long and arduous.
I believe the deal will eventually win approval. But the status of the trust structure is a lot more questionable, and if that goes away, any chance of a quick payout for KCS shareholders disappears with it.
Kansas City Southern shareholders face a difficult choice. If one has no interest in holding the CP shares that are part of the payout, I would be tempted to sell now instead of remaining on board for what figures to be a prolonged review.
But if you want those CP shares, it's probably best to hold tight. Just be warned that the promise of a midsummer payout seems much less certain now than it did the day the deal was announced.
