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A Canadian Pacific Railway employee walks along the side of a locomotive in a marshalling yard in Calgary in 2012.

Jeff McIntosh/The Canadian Press

Takeover voting trusts proposed by Canada’s two pre-eminent railways are throwing a unique wrinkle into the battle for Kansas City Southern , putting extra pressure on the original bidder, Canadian Pacific Railway Ltd. , to boost its purchase price.

Under CP’s takeover agreement with Kansas City Southern (KCS), KCS shares will be transferred to an independent trust once both companies’ shareholders approve the deal. At that time, KCS investors will be paid in full, handing them a total of US$275 in cash and CP stock no matter what the U.S. regulator ultimately decides on the takeover’s merits.

On Tuesday, Canadian National Railway revealed its own takeover proposal for KCS, worth US$325 a share in cash and stock, and said it would also use the voting trust structure for its approach.

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Such trusts are rarely seen in other sectors, but they are common for railway deals – a vestige from a previous era when industry mergers were encouraged after American railways had been overbuilt. Using this model, after a deal is approved by shareholders, the target’s stock is transferred to a trust so that efficiencies can be identified and implemented as soon as regulators give their blessing.

Yet in hostile takeover fight, such as the one now playing out between CN and CP, the trusts add an interesting dynamic.

Often the winner of a hostile takeover in a highly regulated industry is the bidder that offers a compelling purchase price and presents the best chance of earning the relevant watchdog’s approval.

CN, though, does not have to make the regulatory argument to KCS shareholders. Instead, it can lure them with a proposal that is currently worth more than CP’s. On top of that, the cash portion of its offer will pay US$110 more a share.

KCS shareholders, then, could simply vote to get the best bang for their buck and walk away, even though the U.S. Surface Transportation Board’s (STB) review is not expected to finish until mid-2022.

Contrast that with what Air Transat shareholders just endured. After agreeing to Air Canada’s takeover proposal in 2019, they waited almost two years for regulatory approval, only to find out earlier this month the deal was killed by the European Commission.

For KCS shareholders, the importance of sidestepping the regulatory risk is not to be underestimated. Railways have some of the most stringent takeover rules in the United States.

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However, for CN, it likely will not be as simple as offering more money. First, both bidders are offering a mix of cash and shares, and KCS shareholders may prefer holding one of those stocks over the other. Both bidders also propose to tack on a large chunk of debt to finance the cash portion of their offer – CP will add US$8.6-billion, while CN will add US$19.3-billion – and the resulting burden could weigh down one company’s balance sheet more than the other.

Largely for this reason, CP’s debt rating was downgraded by Moody’s Investors Service in March. CN, meanwhile, “is clearly paying an ‘extra full’ price [31 times KCS’s 2022 estimated earnings] and layering on a significant amount of debt in the process,” Raymond James analysts wrote in a note to clients.

It also is not clear if the trusts will be approved by the STB. (A ruling is expected in the next few weeks.) Although these trusts are common in railway deals, including in CP’s 2019 acquisition of Central Maine & Quebec Railway US Inc., last week the Department of Justice asked the STB to deny CP’s request.

Finally, KCS’s board has backed the CP merger. While shareholders are free to vote however they want, of course, board support for a rival bid is yet another hurdle to clear.

In the end, CP may simply make its deal look more compelling by sweetening the pot and raising its takeover price. Even if that derails CN’s approach, it would mean CN got its rival to pay a lot more than it intended – and that is a victory in and of itself.

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