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CHICAGO (Reuters) - Canadian Pacific Railway Ltd's (CP.TO) $27 billion bid for Norfolk Southern Corp (NSC.N) risks coming unstuck due to regulatory scrutiny of its impact on the U.S. rail market, in particular the possibility it could spark competition-crushing rival deals, according to former regulators and analysts.
Led by enigmatic, septuagenarian railroad legend Hunter Harrison, Canadian Pacific has assured investors that what it proposes - especially putting the transaction in a voting trust - has been approved in the past.
Canadian Pacific made its first bid for Norfolk Southern last month, arguing that it would improve competition and boost its target's performance that has flagged recently due to declining coal volumes.
But assuming the hostile bid makes it through a long and nasty proxy fight - "If this is going to be a street fight, so be it," Harrison said on Wednesday - the Canadian railroad would be in uncharted territory.
This would the first deal judged by the Surface Transportation Board, the U.S. rail regulator, since the regulator rewrote the merger rules in 2001.
That followed major mergers in the 1990s resulting in severe service disruptions that "caused a great deal of heartburn," former STB vice chairman William Clyburn told Reuters. Clyburn was on the board from 1998 to 2001.
STB's chief concern at that time was that the number of major railroads in North America had dwindled to just seven from 35. The most controversial part of the new rules was the board had to "look around the corner" at what any proposed merger would mean for whole sector, Clyburn said.
No. 1 U.S. railroad Union Pacific Corp (UNP.N) has said in regard to Canadian Pacific's bid that it will act in the "best interests of our customers and our shareholders."
According to several former STB commissioners, that could be seen as an implication that Union Pacific could get involved in a merger frenzy, but would not be firm enough for the STB to take notice.
But a red flag for the STB would be comments from Matt Rose, chairman of No. 2 U.S. railroad BNSF, owned by Warren Buffett's Berkshire Hathaway Inc (BRKa.N), that BNSF could bid for Norfolk Southern or for No. 3 U.S. railroad CSX Corp CSX.N rather than be left at a competitive disadvantage.
"We believe that if a combination of any of the major railroads in North America were to occur, it would trigger the final round of consolidations and BNSF would be actively involved," Rose said in a statement this week.
This is the key stumbling block for Canadian Pacific's bid, according to analysts, railroad executives and former regulators. The main concern is that a series of mega-mergers would result in just two railroads and leave customers stuck with no competition.
Clyburn, who did not wish to discuss individual cases, said any major railroad threatening further consolidation "is very significant news and the STB would pay very close attention to what the next move may be."
An STB spokesman said the board could not comment on Canadian Pacific and Norfolk Southern because there was no case before it.
There are a number of other potential pitfalls.
Chief among them is the voting trust Canadian Pacific proposes, which the STB would need to approve before beginning the merger review process.
Canadian Pacific proposes sending CEO Harrison to run Norfolk Southern as part of that trust. But the STB's rules stipulate there can be no "common control" of the railroads during the review process - meaning they have to run independently of each other and not according to a joint plan. Skeptics have said that having Harrison run the railroad he has worked to acquire would not pass the STB's "smell test."
"You don't want a situation where you have Railroad A acquiring Railroad B with a voting trust and you have somebody from Railroad A running Railroad B," Clyburn said.
Norfolk Southern declined to comment for this story.
During merger reviews in the 1990s, significant space was given to labor groups and railroad customers. Under the new rules where "public interest" is paramount, Clyburn said they would be allotted a lot of time at public hearings.
In a survey published Dec. 7, Cowen & Co found 71 percent of shippers opposed a merger of Canadian Pacific and Norfolk Southern.
Input from elected officials will also matter. Democratic U.S. Senator Dick Durbin and Democratic House members from Illinois - the two railroads meet in Chicago - have written to the STB stressing concern over a possible merger.
And because Norfolk Southern handles traffic for the U.S. military, a potential takeover by a foreign entity is expected to garner attention from the Department of Defense.
Canadian Pacific says a deal would reduce congestion in Chicago as it could reroute traffic through the merged railroads' networks - a debatable claim as the two railroads interchange little traffic in Chicago.
But rerouting traffic would be subject to an environmental review that could last years. Towns along the proposed routes could object. The STB could approve a merger with conditions mandating infrastructure investments to mitigate the effect of rerouting traffic - which could involve large sums of money.
Stacked up, all these issues - above all the probable consolidation of the entire industry - have many analysts and observers believing a deal will not win approval.
"My view is the STB will not let this go through," said Jim Corridore, an equity analyst at S&P Capital IQ. "What we're likely to see is a costly proxy battle that will ultimately prove futile."
Additional reporting by Allison Lampert in Montreal and Euan Rocha in Toronto; Editing by Matthew Lewis