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TORONTO — Canadian National Railway Co.'s takeover bid for Kansas City Â鶹ÊÓƵern Railway has been thrown into doubt after a U.S. regulator denied its use of a voting trust structure.

The U.S. Surface Transportation Board said Tuesday that the trust would reduce incentives for competition between the two railways whose networks overlap, and is not consistent with the public interest standard under its merger regulations.

"Applicants have shown no benefit from the use of a voting trust to stakeholders other than KCS and CN," the regulator said in its decision.

The trust would have allowed KCS to remain independent while a full and lengthy review of the proposed takeover goes forward, while also allowing shareholders to be paid without having to wait for a final decision on the deal.

The Surface Transportation Board said that while the trust would mean CN wasn't in direct control of KCS operations, it would still be a beneficial owner and share in profits. 

"Antitrust regulators have long recognized that the sort of financial interest that CN would have in KCS is sufficient to alter a firm’s incentive to compete vigorously."

CN's proposed acquisition would be the first takeover of a major U.S. railway in two decades and the first to test stricter criteria that looks at whether a merger would enhance competition.

Canadian Pacific Railway, which already has approval for a voting trust structure, reaffirmed its offer to acquire the U.S. railway.

"The STB decision clearly shows that the CN-KCS merger proposal is illusory and not achievable," stated CP chief executive Keith Creel.

"Knowing this, we believe the August 10 CP offer to combine with KCS, which recognizes the premium value of KCS while providing regulatory certainty, ought to be deemed a superior proposal. Today, we have notified the KCS Board of Directors that our August 10 offer still stands to bring this once-in-a lifetime partnership together."

The railway's bid would also be assessed under the older merger regime after the regulator granted a waiver because a merged CP and KCS would still be the smallest of seven U.S. railways in the top tier of operators.

CN has proposed a takeover worth US$33.6 billion for the U.S. railway, while Canadian Pacific increased its offer to US$31 billion earlier in August. Both proposals include the assumption of about US$3.8 billion of KCS debt.

Canadian Pacific has maintained that while it is offering less money, its bid faces less regulatory risk.

The Surface Transportation Board said that CN could still try to move forward with its takeover, but it would have to wait until the full regulatory review of the proposal is done.

National Bank analyst Cameron Doerksen said that while CN could try to move forward with its merger, and possibly appeal the decision, KCS would likely move to re-engage CP on a potential merger.

"Practically speaking in our view, the KCS Board and shareholders are likely much better served by accepting a merger offer from CP that has a high certainty of financial close," he said in a note. 

He said the rejection of the trust potentially puts CN on the hook for a US$1-billion break fee and could have repercussions for company leadership.

"CN's fundamental misreading of the STB's rules around mergers could lead to some fallout for CN's Board and management."

CN did not respond to a request for comment. 

One of the railway's largest shareholders, U.K.-based TCI Fund, which recently increased its stake to 5.2 per cent and is also a leading CP Rail shareholder, urged CN in a letter on Tuesday to abandon its pursuit of KCS.

"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," stated the letter from founder Chris Hohn and partner Ben Walker.

They added that an appeal of the STB decision would be "an expensive and undignified charade."

"Continuing with the bid would not only be futile but, knowing it will ultimately end in failure, would also be unprofessional and disrespectful to everyone involved in the process. Instead, the company should withdraw and save billions of dollars in break fees.

"Proceeding without a voting trust would be reckless, irresponsible and massively value destructive."

TCI also reiterated its position expressed in a May letter to CN that it expects CN chairman Robert Pace and CEO Jean-Jacques Ruest to resign immediately and be replaced by Jim Vena, who was recently chief operating officer at Union Pacific Railway.

CN's shares closed up $10.17, or 7.36 per cent, at $148.40 on the Toronto Stock Exchange, while CP Rail's shares closed down $4.13, or 4.55 per cent, at $86.69. 

This report by The Canadian Press was first published Aug. 31, 2021.

Companies in this story: (TSX:CNR, TSX:CP)

Ian Bickis, The Canadian Press