Armchair Legal Analysis of Schering-J&J Distribution Agreement: The $41 Billion Deal Hinges on This?

Sorry guys, this is a little longer than most posts. As mentioned in my previous entry, the Merck-Schering Plough merger is structured as a reverse merger with Schering surviving even though it is the target. This is being done because the parties believe it will not trigger a change in control provision in Schering’s distribution arrangement with Johnson & Johnson relating to two products, Remicade and Golumumab. I don’t follow these issues but presumably these are important not to lose.

We took a look at the agreement, as it is publicly available. Technically J&J entered into the agreement in 1998 through its subsidiary Centocor, Inc. In addition, Schering entered into the agreement originally through a Swiss subsidiary. In 2007 an amendment to the agreement (which extended the period of the agreement to end 15 years after production starts on the products) noted that Schering’s Ireland subsidiary succeeded to the rights of the Swiss subsidiary. So we now have a deal between Centocor, a subsidiary of J&J, and Schering’s Irish subsidiary. You will see why this matters in a minute.

The agreement indeed contains a change in control provision that lets either party terminate the deal if the other one is “acquired by a third party or otherwise comes under Control (as defined in Section 1.4 above) of a third party.” From here on you kind of need a scorecard to follow what appears to be pretty faulty drafting (we tried but could not easily determine what law firms were involved at the time).

You would think we would go right to the definition of Control and see what happens, but we will go there next. First, right after the language above there is a sentence that begins, “As used herein ‘Change of Control’ shall mean…” What follows is the definition of a term that is never actually used as a defined term in the termination provision (Section 8.2 of the agreement). That defined term indeed limits change of control to events happening directly to the parties to the agreement, namely the various subsidiaries mentioned above. Thus looking at the actual language of this definition, as presumably Merck and Schering believe, no “Change of Control” will occur if all that happens is the ownership of the parties’ parent company changes.

Now let’s go back to the actual operative language of the provision. Remember it says a party can terminate if the other is “acquired by a third party or otherwise comes under Control…of a third party.” Nowhere does it say, as maybe it should have, you can terminate if the other suffers a Change of Control, as defined above. Can Schering-Merck argue that this is what was intended, otherwise why would the definition be in there? Absolutely. But J&J can say if they wanted that definition to apply they would have used it.

Therefore, J&J could go in and say, basically, ignore the definition of Change of Control, which would have helped Schering, and go to the operative language above. What happens there? Not good for Schering. Let’s go through it.

You can terminate if the other party is “acquired by a third party.” The word acquired can mean many things, but one can certainly see an argument that a change in control of a party’s parent is effectively an acquisition. As structured, the current shareholders of Merck will end up with about 68% of the combined company. Sounds like an acquisition to me.

You can also terminate if the other party comes under “Control” of a third party. Well here the Schering guys have a big problem. The definition of Control, in Section 1.4 of the Agreement, is short enough to quote almost entirely:

“‘Control’ means the ability of any entity (the ‘Controlling’ entity), directly or indirectly, through ownership of securities, by agreement or by any other method, to direct the manner in which more than fifty percent (50%) of the outstanding voting rights of any other entity (the ‘Controlled’ entity)…shall be cast…[emphasis added]”

So will Schering “come under Control of a third party” as a result of this transaction? There appears to be a strong argument that it will. Can you argue that there is no one single party taking “Control,” but rather all the shareholders of Merck? I suppose.  But it does say “directly or indirectly,” which takes away an argument that the only changes are not happening at the level of the parties that actually signed the contract.

Are you following this? So bottom line: If Schering can convince a court that the definition of Change of Control, which works in their favor, is actually what they meant to apply, even though they didn’t, in the operative language, they might be ok. If they cannot, it appears the operative language works against them and J&J might indeed be able to terminate their very important deal. 

Let’s all stay tuned.

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