Kansas City Southern is now Canadian Pacific Railway Ltd.’s takeover target to lose.

One of the hottest bidding wars of the pandemic entered a new phase on Tuesday after the U.S. Surface Transportation Board issued a long-awaited ruling on the proceedings and derailed Canadian National Railway Co.’s plan to buy Kansas City Southern. The target is the smallest of the major North American carriers, and any deal would mark the first successful consolidation of the industry since the STB adopted tougher merger rules in 2001. That made Kansas City Southern a hot commodity. The railroad initially agreed to sell itself to Canadian Pacific in March for about $29 billion. But Canadian National’s bigger balance sheet allowed it to offer a much higher valuation — about $34 billion including debt. Kansas City Southern’s board has consistently followed the money. Even when Canadian Pacific upped its offer earlier this month, Kansas City Southern stuck by Canadian National because its bid was still materially higher. 

This deal drama was never just about dollars and cents, though. Kansas City Southern made clear that a voting-trust structure was a requirement for any transaction. The arcane structure is used rarely outside of the rail industry and has been criticized by the Justice Department with good reason, but it effectively allows shareholders to get their money ahead of official regulatory sign-off, which could take years. On Tuesday, the STB denied Canadian National’s application to use a voting trust in a Kansas City Southern takeover. The key sticking point is a requirement under the tougher 2001 rules that the parties prove both the ultimate combination and any voting trust would serve the public interest. The STB was unconvinced by Canadian National’s arguments.

According to the STB, Canadian National and Kansas City Southern sought a “narrow” definition of public interest based on protecting the integrity of the target’s choice of a higher-paying acquirer and assessing the financial ramifications of any required divestitures. The would-be merger partners also said voting-trust approval was necessary to create a level playing field with Canadian Pacific, which has already received approval to use a voting trust (more on this in a moment). This didn’t sit well with the STB: “Applicants essentially claim that there is a public benefit in allowing them to use a voting trust because they should be able to make merger decisions unfettered by regulatory requirements or uncertainty,” the regulator said in its ruling. “The Board disagrees.” It went on to underscore that Canadian National and Kansas City Southern chose to pursue a deal under these conditions and that “negotiation choices by private parties cannot control agency decision-making.”

The irritation on the part of the STB is palpable from the complaint, which I’d encourage you to read in full here. It’s not entirely fair, though, to criticize Canadian National and Kansas City Southern for misreading the room. Until now, the public-interest standard had never been tested in a formal merger application. No one really knew what it meant. Now we do: The STB is applying a broader standard that includes the effects of a rail merger on public transportation, the impact on employees and the possible ramifications for competition with other rail carriers. Amtrak, labor unions and Canadian Pacific are among those that wrote letters to the STB expressing concerns about the takeover. The bottom line is that Canadian National and Kansas City Southern failed to convince the regulator that these issues aren’t worth deeper consideration and should be swept aside when it comes to the voting trust proposal. 

Canadian National can appeal the STB’s decision, but it’s not clear its own shareholders will back it in that campaign. TCI Fund Management recently became one of Canadian National’s largest shareholders, and the head of that firm has called on the railroad to abandon its pursuit of Kansas City Southern and oust its CEO, according to the Financial Times. Canadian Pacific, on the other hand, now has a fairly clear path to close the deal it initially inked in March. The STB has already said that because its own tracks don’t overlap with those of Kansas City Southern, the acquirer can take advantage of a loophole that exempts the smaller railroad from the tougher 2001 merger rules under certain circumstances. The STB approved Canadian Pacific’s voting trust proposal under the older, easier standard in May.

The railroad’s latest offer — worth about $288 a share based on Tuesday’s closing prices — may look much more attractive to Kansas City Southern shareholders in the wake of this latest regulatory decision. That’s roughly a 30% premium to where Kansas City Southern traded before the Canadian Pacific deal was first announced and nearly 40% higher than the bids the railroad reportedly rejected around this time last year from a pair of private equity firms. There will likely be some rumblings about whether Canadian Pacific needs to boost its bid further. But at this point, it’s the only bidder left standing. The company has been vindicated in its decision not to match Canadian National’s bid dollar for dollar. Why would it start now? 

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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