Canadian Pacific Railway (CP) yesterday unveiled its third proposal to acquire Norfolk Southern Corp. (NS), with the Calgary-based railroad and its largest investor, hedge fund Pershing Square Capital, hinting a proxy fight for NS shares would be the next step if the U.S. railroad's board rejected the offer. However, CP's biggest potential obstacle isn't NS' board or its shareholders, but Daniel R. Elliott III, Ann D. Begeman, and Deb Miller, the three members of the Surface Transportation Board, the agency that must rule on all mergers involving a U.S. railroad.
CP's latest offer sounds much like its second proposal, which was announced Dec. 8. It would pay NS shareholders US$32.86 a share in mid-May, a month after shareholders purportedly approve the merger, and, as CP maps it out, the Board approves the Canadian road's proposal to place itself in a voting trust. The trust would be overseen by a trustee who would insulate CP from taking unlawful control of NS during the 19- to 22-month period when the board evaluates the combination before ruling on it. CP's current CEO, E. Hunter Harrison, would run NS, while his second in command, Keith Creel, would head CP. In addition, NS shareholders would receive about 45 percent of a newly formed company, a percentage unchanged from the prior offer.
The difference in the latest bid is the emergence of a "contingent value right," an instrument of liquidity that CP said NS shareholders could convert to cash at their discretion. Each right would provide its owner with a cash payment from CP equal to the difference between the average share price of a CP-NS combination from April 20 to August 20, 2017, and US$175/share, up to a maximum of US$25 for each right. There would be no payment if the combined entity's share price exceeded $175 a share. CP said yesterday the rights would deliver up to $3.4 billion in additional value to NS shareholders, and would demonstrate CP's ability to improve NS' operating metrics, which have lagged CP's since Harrison became CEO in 2012 following an insurrection led by Pershing's head, the activist investor William A. Ackman, which resulted in the departures of CP's former CEO and five board members.
NS' board, which unanimously rejected CP's prior two proposals, said in a statement yesterday that it would review the latest offer. However, the Norfolk, Va.-based company hardly issued a ringing endorsement. Other than the new wrinkle, CP's latest proposal was no different from its prior offer, which actually offered NS' shareholders less money than the first proposal, the company said. Yesterday's bid also "did not address the substantial regulatory risks and uncertainties inherent in the proposed combination," NS said.
NS threw down the gauntlet to CP, saying it could seek an immediate declaratory order from the Board on its proposed voting-trust structure. The board has "clear, statutorily established authority to issue declaratory orders to remove uncertainty" and it can do so in this instance, NS said.
Fritz Kahn, who was a transportation attorney for 60 years—including a five-year stint in the early 1970s as general counsel of the Interstate Commerce Commission, the Board's forerunner agency—said in an interview that the Board has a wide berth under the 1995 law that sunset the ICC and created the successor agency. For example, the agency has the power to block Harrison from jumping to NS on grounds it would represent a de facto control grab, he added.
In years past, the Board—and the ICC before it—routinely allowed a carrier to use a voting trust to acquire a controlling stake in another as long as it could prove the trustee was independent and preventing undue operating control. Under tougher merger and voting-trust approval guidelines imposed in 2001, following an 15-month moratorium on all merger activity, the Board ruled that a voting trust be shown to be in the public interest, while still acting to prevent premature and unlawful control by one carrier over another.
Kahn said that even if CP wins a proxy fight and can establish its voting trust, it would have a hard time winning merger approval. With only five large, so-called Class I railroads remaining in the U.S., the Board would be rightfully concerned about reduced competition, Kahn said. A CP-NS combination would compel one of the two western roads, Union Pacific Corp. and BNSF Railway Co., to make a bid for CSX Corp., the lone large Eastern railroad, Kahn said. That would leave just two independent U.S. Class I roads—one of the two western carriers and the Kansas City Southern Railway Co., which operates vertically through the U.S. midsection and into Mexico. At that point, an alarmed Congress could step in and reregulate the industry, a nightmare scenario for carrier interests, he said.
Kahn said there would be "covert or public" opposition to the CP-NS combination. He didn't specify who the opponents would be. However, it is easy to conceive that pushback would come from rival railroads, labor, public interest groups, and shippers who have spent the past decade griping about rising freight rates and inconsistent service—especially coming out of the brutal winter of 2014, which led to the virtual shutdown of the Chicago hub where six large North American railroads converge. The bottleneck in the Midwest radiated out to create network paralysis that took carriers about a year to recover from.
Two former STB chairmen, Francis P. Mulvey and Charles D. Nottingham, also took a dim view of CP's prospects before the Board. In comments published Dec. 7 on Norfolk Southern's web site, Mulvey and Nottingham said the deal would be the first big merger proposal to come before the Board since it imposed the tougher guidelines. The proposal, they said, fails to clear the higher bar, principally due to CP's reported desire to use the trust to execute a business plan for NS during the merger review process and before the Board rules. This would be a violation of the law, and would anger the Board, which might feel that CP is usurping its authority.
"CP cannot assume control of NS, by any means, until the STB approves the merger—even if a voting trust is used," Mulvey and Nottingham wrote. No matter how CP structures NS' organization chart—and its proposal calls for Harrison to sever all financial ties with CP—the Board "likely would not be fooled into thinking that CP and NS are operating independently," they said. The biggest risk to the public interest would be NS sitting in "voting-trust limbo" for nearly two years, during which time its investments in network and infrastructure could be curtailed and its service reliability could suffer, they said.
CP hit back Tuesday, saying that Mulvey and Nottingham made their comments before its second and revised proposal, and assumed NS would be put in trust rather than CP. CP added that the comments are "based largely on inaccurate assumptions, rumor, speculation, and conclusions that are unsupported by fact or by law." CP said it believed its proposal will get a fair and impartial hearing before the Board, and affirmed its confidence that the voting trust will be approved.
Even if the Board ultimately rejects the merger and the railroads go their separate ways, NS shareholders will benefit by receiving an upfront cash payment for their shares, as well as enormous value creation as Harrison, considered the industry's best operator, dramatically improves NS' standing, CP has said.