Canadian Pacific’s pursuit of Norfolk Southern has taken on the tone of a rough-and-tumble yet well-intentioned star athlete pulling out all the stops to capture the heart of his dream woman, a relationship-shy political science major who continues to resist her suitor’s advances with perfectly logical yet unemotional reasons why the two aren’t right for each other.
On Dec. 8, 2015, CP sent a revised offer letter to Norfolk Southern proposing a sweetened deal that is “financially more attractive and dramatically reduces the regulatory uncertainty for NS shareholders.” NS once again said no, calling CP’s latest proposal “less than the prior proposal, which the NS board unanimously determined was grossly inadequate, creates substantial regulatory risks and uncertainties that are highly unlikely to be overcome, and is not in the best interest of the company and its shareholders.” NS backed up its response with a so-called “white paper” by former Surface Transportation Board Commissioners Frank Mulvey and Charles Nottingham stating numerous reasons why the STB would not approve a voting trust and a merger transaction.
In a letter to NS Chairman and CEO Jim Squires, CP CEO Hunter Harrison and Board Chairman Andy Reardon attempted to address NS’s “publicly expressed concerns” by improving upon its prior offer. CP’s newest deal is sweeter because it “dramatically reduces the regulatory risk for NS shareholders,” is “substantially more financially attractive, increasing NS shareholders’ ownership of the pro forma company from 41% to 47%,” and includes “agreeing to complete due diligence in no more than three weeks while contemporaneously negotiating definitive documentation.”
CP is sticking to its voting-trust approach, which it continues to stress should alleviate any regulatory concerns that NS shareholders might have: “By utilizing a voting trust, NS shareholders will receive a substantial cash payment and shares in a new investment-grade company that would be listed on both the New York Stock Exchange and Toronto Stock Exchange. Based on extensive work done by our lead transaction counsel, Simpson Thacher, and our U.S. and Canadian regulatory counsel, Stinson Leonard Street and Bennett Jones, we anticipate the closing and listing of shares to occur on May 1, 2016.” CP is proposing putting itself in trust, and having Hunter Harrison resign from CP, severing all ties (including retirement benefits) and becoming CEO of NS. This approach, CP said, is similar to that taken by CN when it acquired Illinois Central (though IC was placed in trust).
CP also placed more money on the table. “At the closing of the transaction, NS shareholders will receive $32.86 in cash and 0.451 shares of stock in a new company that will own NS and Canadian Pacific,” CP said. “We estimate the total value of the stock and cash consideration to NS shareholders to be worth $125 to $140 per share at the closing of the transaction in May 2016. The revised transaction offers a 37% to 53% premium to [NS’s Dec. 7] closing price of $91.52 and a 58% to 77% premium to the unaffected price of $79.14 per share.”
“We remain ready to work with you and your team immediately on this transformational opportunity,” concluded Harrison and Reardon. “This offer has received the unanimous support of our Board of Directors.”
NS, which some industry observers are saying is “purposely playing hard to get,” says Mulvey and Nottingham have “carefully reviewed voting trust issues and the merger transaction proposed by Canadian Pacific and agree with the NS board of directors that both would be highly unlikely to be approved by the STB” as “neither would be in the public interest. The NS board remains confident that the continued execution of its strategic plan is superior to Canadian Pacific’s grossly inadequate and high-risk proposal.”
Following is the complete text of the Mulvey-Nottingham white paper:
Regulatory Review of Proposed CP+NS Merger
Having formerly served as Chairmen of the Surface Transportation Board, we have unique insights regarding how the STB would review the proposed CP+NS merger and any related voting trust mechanism. We publish this white paper to share these insights.
Out of respect for the independent professional judgment of the current members of the STB, we are not attempting to speak on behalf of our former agency. Rather, having been confronted with much misinformation about how the STB is likely to review the proposed voting trust and merger, we feel compelled to correct the record.
As simple background, rail carriers cannot assume control of another carrier without prior STB approval. The STB’s approval process can last between 19 and 22 months. Current STB regulations, adopted in 2001, set a high bar for approval of a proposed major merger and related voting trust based on an untested public interest standard. In our expert opinions, the STB is not likely to approve CP’s proposed voting trust or the CP+NS merger.
Voting Trust Approval
STB voting trust regulations have become far more stringent. In the past, the STB routinely and informally permitted carriers to acquire controlling stakes in other carriers using a voting trust, provided that the trustee was independent. This is no longer the case under current STB regulations. A voting trust to be used in conjunction with a proposed major merger (such as CP+NS) now must receive formal STB approval before it is implemented. The STB approval process includes a public comment period where interested stakeholders can object to the proposed use of a voting trust. And, the STB’s current approval standard is quite demanding. As was true under the old regulations, the trustee must be independent and the trust must prevent premature, unlawful control; but now under the new regulations, use of the trust also must be in the public interest. CP’s voting trust would be the first trust reviewed under the STB’s new regulations.
If the reports we have read are correct, CP seems to think it can use a voting trust to begin implementing its business plan for NS (“Plan”) during the STB’s merger review process and prior to formal STB approval of the merger. This would directly violate the express statutory bar against a premature exercise of common control. CP cannot assume control of NS, by any means, until the STB approves the merger—even if a voting trust is used. This conclusion applies regardless of the specific scheme CP might use. No matter how CP executives are put in charge of NS management before the merger is approved, the STB likely would not be fooled into thinking that CP and NS are operating independently.
Further, if CP begins to implement its Plan prior to formal STB review and approval of the merger, CP essentially would usurp and preempt the STB’s exclusive jurisdiction to review and approve that Plan and the other effects of the merger. The STB might not take kindly to this circumvention.
Even if CP does not use a voting trust to begin implementing its Plan and exercising control over NS prematurely, we have grave doubts that the STB would find any voting trust to be in the public interest. Because the public interest standard is completely new, even as former Chairmen of the STB, we cannot predict this outcome with certainty. However, we struggle to identify any public interest justifications for CP’s voting trust. It is far easier to identify the public interest harms from holding NS in voting trust limbo for nearly 2 years, which could include compromised service for shippers, reduced investments in rail infrastructure and network capacity, and disruptions for NS labor interests.
The STB also could view approval of any voting trust as triggering a domino effect. Under the current STB merger regulations, as discussed below, the Board must consider likely downstream effects as rival carriers react to a proposed merger. When the BNSF+CN merger was proposed in 1999, other Class I carriers notified the STB that they would find it necessary to respond in kind. Accordingly, the STB presumes that any major rail merger (such as CP+NS) will trigger further industry consolidation resulting in just two transcontinental carriers, with adverse effects for competition and rail service for shippers. As such, the STB could try to stop the first domino from falling—by rejecting CP’s voting trust.
Merger Approval
As with the voting trust regulations, STB merger regulations have become far more stringent. The current regulations eliminate the historical, longstanding presumption favoring rail industry consolidation. As then-Chairman Linda Morgan testified in a June 2001 Senate subcommittee hearing on the STB’s new merger rules:
The old rules said that mergers would be approved unless. The new rules say mergers will be approved only if. Our new rules clearly reflect a greater skepticism about the benefits of future mergers and a greater concern about the potential harm of further consolidation . . . And it is my hope that, in raising the bar, these rules will remind the railroads to take care of business with the systems they now have and to stop viewing mergers as the only way to go.
The proposed CP+NS merger would be the first merger reviewed under the STB’s new regulations.
As in the voting trust review process, there is substantial regulatory uncertainty and risk in the merger review process. Again, the STB approval process includes a public comment period where interested stakeholders can object to a proposed merger. And, the STB has broad discretion to determine if a proposed merger is in the public interest. Under STB regulations, mergers are in the public interest only if substantial and demonstrable gains in key benefits—such as improved service and safety, enhanced competition, and greater economic efficiency—outweigh anticompetitive effects, potential service disruptions, or other merger-related harms.
In the words of former Chairman Morgan, merger applicants have a high bar to clear, including: demonstrating how the merger would enhance competition; addressing the impacts of the merger in conjunction with potential further rail industry consolidation; providing a full-system operating plan in a cross-border merger as well as robust safety and service plans; and proposing conditions that would spring into effect if the merger benefits are not realized or if the STB approves further rail industry consolidation.
The STB can outright reject a proposed merger, or it can approve a proposed merger with conditions designed to safeguard the public interest and to stimulate effective competition. Typical conditions relate to environmental mitigation, labor protection, and safety and service.
CP+NS Merger Review
Based on our collective experience with prior STB determinations under public interest standards, the STB likely would not approve the proposed CP+NS merger. There is every reason to expect substantial opposition to the merger from other railroads, shippers, labor interests, and community and environmental groups. Especially in this context, it is hard to see any public interest justifications for the CP+NS merger, and the STB could view CP’s claims with a large grain of salt.
(1) Chicago Congestion. Based on publicly available traffic data, there are limited opportunities for CP and NS to reroute traffic away from Chicago.
(2) Terminal Access and Bottleneck Proposals. The STB currently is considering whether open access would increase competitive rail options for shippers. It appears that CP has proposed a voluntary and unilateral open access condition to attempt to show that the merger would enhance competition. Even if this were enough to entice STB approval, the STB would have to define many elements of this open access proposal to make sure that it actually enhances competition in practice. And, open access would destroy value from reduced revenues and degrade service from increased operating complexities and costs.
(3) Improved Metrics. CP claims that it can improve NS’operating ratio, but this is irrelevant to the STB’s review. Improved metrics can be achieved absent a merger, as demonstrated by CP’s own record. Further, the dramatic reductions in NS’ network and asset base that CP has proposed to improve NS’ metrics might not be in the public interest. Such reductions could disenfranchise shippers by eliminating key service products; compromise CP+NS’ ability to withstand operational or service disruptions; impair CP+NS’ ability to sustain future traffic growth; and overall, impede the national interest in a robust transportation network.
On the other side of the ledger, the STB likely would find significant harms from the CP+NS merger. Most importantly, the proposed merger would trigger a final wave of industry consolidation. As noted above, this is an entirely new consideration in the STB’s merger review. We strongly believe that the STB would be disinclined to allow railroads to merge down to just two transcontinental carriers, especially in the current climate where all of the large railroads are financially healthy, investing substantially in infrastructure, and providing generally good service.
Further, in our experience, rail mergers typically have resulted in substantial and lengthy service disruptions. The CP+NS merger would be no different. In fact, the proposed merger could create multiple stages of service disruptions—during the voting trust period, during merger implementation, during follow-on competitive responses to the merger, and during further industry consolidation.
Even if the STB were to approve the proposed merger, such approval should be expected to come with a huge price tag in the form of conditions. The merger review process provides the STB with the jurisdiction and authority to regulate carriers in ways that would otherwise exceed its authority. In addition to conditions regarding competition and potential further rail industry consolidation, the STB could impose other burdensome and expensive conditions.
(1) Environmental Mitigation Conditions. Since our tenures at the STB, community and environmental groups have become increasingly sophisticated and politicized. For example, several local municipalities in the suburbs of Chicago were successful in petitioning the STB for environmental and highway traffic congestion mitigation conditions in the CN/EJ&E transaction in 2008. In CN/EJ&E, total mitigation costs amounted to $160 million—more than 50% of the transaction price; and STB oversight continues to this day—nearly 7 years after formal STB approval. CP+NS should expect similarly burdensome and expensive environmental mitigation conditions, especially given their crude oil traffic volumes.
(2) Labor Protection Conditions. The STB would impose New York Dock labor protection, requiring payments to certain employees who lose their job as a result of the merger. If the reports we have read are correct, CP’s Plan includes extensive headcount reductions, so labor protection benefits likely would represent a huge cost for CP+NS.
(3) Service Conditions. Given historical service problems from mergers, the STB might impose conditions related to service levels, such as the frequency with which cars will be delivered to and picked up from shippers, or other conditions to address shipper concerns. Such service conditions necessarily would threaten CP+NS’ freedom to structure its operations.
Conclusion
Current STB regulations set a high bar for approval of CP’s proposed voting trust and merger based on an untested public interest standard. While no one can predict with absolute certainty what the STB will decide, we believe, based on our review of the public record, that the STB is unlikely to approve CP’s proposed voting trust and the CP+NS merger.
(Morgan Stanley & Co. LLC and Bank of America Merrill Lynch are acting as financial advisors to Norfolk Southern and Skadden, Arps, Slate, Meagher & Flom LLP, Hunton & Williams LLP and Morrison & Foerster LLP are acting as legal advisors.)
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