Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

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On May 27^th, Schering-Plough and Merck provided an “update” on the status of their dispute with Johnson & Johnson over the valuable Remicade distribution agreement between J&J’s Centocor subsidiary and Schering-Plough.  We previously wrote about this dispute, which centers on whether J&J has the right to terminate the distribution agreement under a “change of control” provision, and thereby capture sole rights over the international distribution of Remicade.  The press release confirmed that J&J instituted arbitration proceedings under the distribution agreement, which could go on for 9 to 12 months.  The deal will go ahead despite the outcome of the arbitration, as the possible termination of the distribution agreement was excluded from the “material adverse effect” condition in the merger agreement.

 As others have noted, the complex reverse merger structure adopted by Schering-Plough and Merck seems specifically designed to escape one of the two competing definitions of “change of control” in the distribution agreement.  Despite the merger parties’ insistence that J&J’s case “is contradicted by the clear language of the Remicade distribution agreement”, the outcome was uncertain enough to warrant a prominent risk factor in the Form S-4 registration statement filed by Schering-Plough. That disclosure includes the not-so-subtle suggestion that a settlement is likely: 

“[D]ue to the uncertainty surrounding the outcome of any threatened or actual proceeding, the parties may choose to settle a dispute under mutually agreeable terms.  Any agreement reached with Centocor to resolve a dispute under the distribution agreement may result in the terms of the distribution agreement being modified in a manner that may reduce the benefits of the distribution agreement to the combined company.”

Given the amount at stake ($2.1 billion annual revenue), the strangely ambiguous language of the distribution agreement, and the conciliatory nature of arbitration, it seems that a negotiated settlement is the most likely outcome.

Related Posts: Merck-Schering’s Reverse Merger: Change of Control Provisions in Material Contracts

                         Can Merck-Schering’s Deal Structure Avert a Change of Control?

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We were recently quoted in the online version of the Wall Street Journal in a piece about Merck's pending merger with Schering-Plough.  You can read the article here.  Thanks to reporter Peter Loftus for the mention!

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Shareholders of closely held, privately owned companies often worry that their voting and economic rights may be diluted if the company were to issue new securities. An issuance of new securities could diminish a shareholder’s proportionate share of profits, dividends, and other distributions. These concerns may be especially acute when a company is just starting up and its owners anticipate future rounds of equity or debt financing. To prevent these undesirable consequences, shareholders may seek preemptive rights in offerings of new securities.  

Some states provide shareholders preemptive rights as a matter of law, while others require that preemptive rights be expressly granted in a company’s state filings or its organizational documents. Delaware’s general corporation law, for example, requires that preemptive rights be granted to shareholders in a company’s certificate of incorporation. Although there is some variance among state corporation laws, a company usually spells out the terms and conditions of any preemptive rights in its shareholders’ agreement.

Preemptive Rights: Determining a Shareholder’s Ownership Percentage

Preemptive rights entitle shareholders of a company to maintain their proportionate beneficial ownership interests by allowing them to participate in offerings of new securities on a pro rata basis. When a company issues new securities, each shareholder has a right to purchase a percentage of the new securities equal to the shareholder’s ownership percentage of the company’s outstanding stock prior to the offering. Each shareholder’s ownership percentage is calculated by dividing the number of the shareholder’s shares by the total outstanding shares of the company. One of the key differences among preemptive rights provisions is the way that the amount of total outstanding stock is determined. 

Preemptive rights may be offered either on an “as converted” or “as converted, fully diluted” basis. If the preemptive rights are offered on an “as converted” basis, then a company’s total outstanding stock prior to a new securities issuance includes both the total outstanding stock of the company and the outstanding stock there would be if its convertible preferred stock and convertible debt were to convert. If the preemptive rights are offered on an “as converted, fully diluted” basis, then a company’s total outstanding stock prior to a new securities issuance includes the company’s total outstanding stock on an “as converted basis,” plus the outstanding stock there would be if all options and warrants were exercised.

When a company plans to issue new securities that are subject to shareholders’ preemptive rights, the company commonly sends each shareholder a subscription warrant notifying him of the number of shares he is entitled to purchase.

Limitations on Preemptive Rights

Whether preemptive rights are offered on an “as converted” or “as converted, fully diluted” basis, they are customarily subject to certain limitations. Shareholder agreements restrict preemptive rights by excluding, or carving out, specific securities offerings from the definition of “new securities.” Securities offerings that may be carved out from the definition of new securities include those related to:

Equity Incentive Plans. Shareholders generally do not have preemptive rights in any new securities issued as part of a board approved employee equity incentive plan or other benefit program where the primary purpose is not to raise additional capital for the company. This exception allows the company’s board to incentivize management by offering them stock options and other interests in securities, while at the same time shielding the company from the prospect of a management buyout.  

Strategic Acquisitions. Where new securities are issued as consideration for the acquisition of another business entity, shareholders’ preemptive rights typically don’t apply. This exception enables the company to enter into transactions like stock-for-stock exchange mergers, or B reorganizations, in which an acquiring company issues new securities to the target company’s shareholders in return for a controlling interest in the target, and asset-for-stock exchange mergers, or C reorganizations, in which a company issues new securities to a target company’s shareholders in exchange for substantially all of the assets of the target. By affording the company an opportunity to grow through strategic acquisitions, this exception allows the company’s business operations to benefit from synergies and economies of scale and scope. 

Equity Kickers. So-called “equity kickers,” or equity interests attached to corporate debt, issued in connection with arm’s-length debt financing transactions are often excluded from a shareholder agreement’s definition of new securities. Banks may want to couple their rights as senior lenders with an equity position in the borrowing company and purchasers of corporate debt securities may prefer bonds issued with convertible features like options and warrants. In return, the issuing company receives lower interest rates on its senior and subordinated financing.

Stock Splits and Dividends. Another exception to the definition of new securities is the issuance of common stock resulting from a share dividend, share split, or similar event that is made on a pro rata basis. In shareholder agreements involving venture capitalists, this exception is generally not included. As primary capital contributors to a business, venture capitalists have considerable bargaining power and negotiate for additional anti-dilution protections by having their respective ownership percentages preserved after stock splits.

Public Offerings. Often, there is an exception for an initial public offering or listing of the company’s shares on a nationally or internationally recognized stock exchange. Usually, the exception only pertains to certain public offerings in which the new securities represent a specified percentage of the company’s total outstanding stock or raise proceeds above a defined threshold. The qualified public offering exception is commonly included in shareholder agreements among private equity firms when the sponsors anticipate a partial or total exit from their investment by means of an initial public offering.  

In practice, shareholder preemptive rights only benefit those shareholders with enough capital to participate in new securities offerings on a pro rata basis with their fellow investors. Shareholders with limited cash reserves may find themselves unable to exercise their preemptive rights in qualified offerings of new securities and consequently discover that their voting and economic rights have been diluted. 

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Does Merck-Schering’s reverse merger structure avoid triggering the change of control provision in Schering’s distribution agreement with Centocor? Only time will tell. But The Wall Street Journal reports that William Weldon, CEO of Centocor’s parent company Johnson & Johnson, admitted his company was “analyzing the situation” and “was not sitting back and doing nothing.” In our previous post, we summarized the Merck-Schering reverse merger deal structure. Today, we’ll review the Schering-Centocor distribution agreement’s change of control definition and inquire whether imprecise contract drafting may benefit Johnson & Johnson.

Ambiguity of “Change of Control” in the Schering-Centocor Distribution Agreement

The Schering-Centocor distribution agreement appears to offer two competing definitions of what would constitute a change of control. Section 8.2(c) of the agreement provides that either party may terminate the agreement if the other party suffers a “change of control.” The section begins by stating that if Schering or Centocor is “acquired by a third party or otherwise comes under Control of a third party,” then the “party not subject to such change of control” has the right to terminate the distribution agreement. The first two clauses of Section 8.2(c) indicate that Schering would suffer “such a change of control” if: (i) a third party were to acquire it or (ii) a third-party, directly or indirectly, were to own more than 50% of its voting rights, have the right to receive more than 50% of its profits, or otherwise control its management decisions. But at this point Section 8.2(c) continues in an unexpected way: it offers another competing definition of change of control.        

Without any reference to the first two clauses of Section 8.2(c), the remainder of the section purports to define the elements that constitute a “Change of Control.” According to this definition, a change of control under Section 8.2(c) would occur upon (i) a merger or other reorganization in which Schering was not the surviving corporation, (ii) any non-affiliate of Schering’s becoming a beneficial owner of more than 50% of Schering’s outstanding common stock or the combined voting power of Schering’s outstanding securities, (iii) certain extraordinary changes to Schering’s board of directors, or (iv) Schering’s liquidation or dissolution. What are we to make of this second definition?   

A court would most likely determine that the meaning of a “change of control” under the distribution agreement is ambiguous because the two definitions offered are susceptible to different reasonable interpretations and may have two separate meanings.  Unless a court determined that both the first definition and the second definition were coextensive, it would likely rule that the two change of control definitions are irreconcilable. In that case, the court may have to resort to extrinsic evidence of the parties’ intent at the time of contract to resolve the ambiguity. 

Effect of Contractual Ambiguity on Reverse Merger Structure

Given the distribution agreement’s ambiguity, what effect does this have on the ostensible protections afforded by the Merck-Schering deal structure?

First, as Robert Willens at CFO.com points out, although legally Schering will become the parent corporation of Merck, from a financial accounting perspective Schering will be the acquired entity. Generally, in a business combination involving the exchange of equity interests, the acquiring company is usually the one that issues the securities. But the Financial Accounting Standard Board’s SFAS No. 141, which provides accounting guidance for business combinations, notes that in reverse acquisitions, the company issuing equity securities is often the target. SFAS No. 141 states that the acquiring company in a merger will usually be:

• the merging entity whose owners as a group receive the largest portion of the voting rights of the combined entity,
• the merging entity whose owners have the ability to elect, appoint, or remove a majority of the members of the combined entity’s board of directors,
• the company whose former managers dominate management of the combined entity, and
• the entity that pays a premium over the pre-merger fair value of the equity interests of the combined entity. 

Merck, as Willens points out, seems to fit these criteria perfectly. If the dispute over which definition controls comes down to the intent of Schering and Centocor at the time they entered into the agreement, then Johnson & Johnson could argue that the broad “acquired by” language in the first definition was meant to cover transactions like the Merck-Schering merger. Although Merck will be a wholly owned subsidiary of Schering after the merger, Merck will have effectively acquired control over Schering’s operations. 

Second, as we discussed in our previous post, before Merck merges with Schering’s subsidiary, Schering must cause its board of directors to resign and appoint Merck’s directors to Schering’s board. Interestingly, the second change of control definition in the distribution agreement precludes certain extraordinary changes in Schering’s board of directors. While the definition allows changes in Schering’s board of directors that occur as a result of ordinary course shareholder and board actions, such as the periodic nomination and election of directors, it explicitly excludes directors whose initial assumption of office results from (i) an election contest or (ii) “other actual or threatened solicitation proxies or consents by or on behalf of a person other than the [board of directors]” (emphasis added). 

The drafters of this clause probably intended it to prohibit extraordinary changes to Schering’s board of directors resulting from tender offers or other hostile takeover techniques. Nevertheless, we do not know the content of pre-merger negotiations between Merck and Schering. It’s possible that the record would show that Merck’s conduct towards Schering arguably violated this provision by seeking to place its directors on Schering’s board. Remember, Schering has agreed to put Merck’s board of directors in control of the surviving Schering corporation before Merck becomes Schering’s subsidiary in the second and final step of the merger. 

The inevitable negotiations between Schering’s and Johnson & Johnson’s lawyers about the distribution agreement will depend on which side thinks the contract’s ambiguity gives it an upper hand.

Related Posts: Merck-Schering's Reverse Merger: Change of Control Provisions in Material Contracts

           A Duty to be Forthright: Negotiators Beware!

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Merck & Co. structured its acquisition of Schering-Plough Corp. as a reverse merger to avoid tripping a change of control provision in an important distribution agreement. This has received a lot of attention, not surprisingly. The distribution agreement (for the rheumatoid arthritis drug Remicade^®) brought in $518 million for Schering in the first quarter of 2009, constituting 18% of the company’s sales. In today’s post on the deal’s structure, we’ll summarize some of the terms of the Merck-Schering merger agreement and consider the importance to the M&A process of getting consents to change of control provisions in a target company’s material contracts.

Change of Control Provisions in Material Contracts

Generally, receiving consents or waivers to change of control provisions in material contracts is set out as a closing condition to an acquisition or merger. Indeed, determining which of a target’s contracts contain change of control provisions constitutes an important part of the pre-acquisition legal due diligence process. For some transactions, failure to obtain the appropriate consents may materially affect the value of the target company or may interrupt the target’s business operations if the deal were to go through. 

Take the case of a company whose sole assets comprise a group of television broadcasting stations. These stations rely on programming contracts they have with national network and cable television producers in order to provide most of their viewing content to their audiences. If the acquisition of the company by another corporation were to allow the television producers to terminate the programming agreements, the company’s broadcast stations may go off the air once the transaction is completed.     

Many counterparties insist on change of control provisions in important contracts on the grounds that they are reaching an agreement with a specific company and do not think it reasonable that they should later be bound to an unknown third party by the same terms. That’s the most likely rationale behind the change of control provision in Schering’s distribution agreement with Centocor, a subsidiary of Johnson & Johnson. As the creator and developer of the lucrative Remicade^® and other arthritis medications, Centocor agreed to share profits from international sales of some of its drugs with Schering in exchange for Schering’s distribution of the drugs outside of the United States. But if Schering suffers a change of control, the distribution agreement allows Centocor to terminate the agreement, causing all rights to profits from worldwide sales of the drugs to revert to Centocor. 

Last year, Remicade^® alone generated over $21.1 billion in sales for Schering. A great deal of money is at stake here. Merck, the potential acquirer of Schering, is a major pharmaceutical rival of Johnson & Johnson. The normal M&A process of procuring waivers to change of control provisions in material contracts does not seem to have worked. Instead, Merck and Schering decided to use the business reorganization technique known as a reverse merger for an unusual purpose: to avoid a change of control.          

The Reverse Merger Deal Structure

The Merck-Schering merger agreement contemplates a two-step transaction involving Merck, Schering, and Schering’s two special purpose, subsidiary holding companies, Blue, Inc. and Purple, Inc. In step one of the merger, Blue will merge into Schering and each share of Schering will be converted into the right to receive (i) 0.5767 shares of the surviving Schering corporation and (ii) $10.50 in cash. In step two of the merger, Purple will merge into Merck and each share of Merck will be converted into 1 share of the surviving Schering corporation. 

After the completion of these two steps, the surviving Merck corporation will be a wholly owned subsidiary of the surviving Schering corporation. Yet, the shareholders of pre-merger Merck will own approximately 68% of the surviving Schering corporation and shareholders of pre-merger Schering will own around 32% of the surviving Schering corporation. Although Merck will become a subsidiary of Schering, Merck’s pre-merger shareholders will together possess a supermajority of the voting and economic rights (or beneficial ownership) of Merck’s new parent company, Schering. 

One peculiarity of the Merck-Schering reverse merger transaction structure is that between steps one and two Merck finds itself in a slightly precarious situation. After the completion of step one, Schering’s pre-merger shareholders will have received shares of the surviving Schering corporation and a cash payout, but Merck’s pre-merger shareholders will not yet have seized control over the management of the surviving Schering corporation.  

The merger agreement has come up with a way to protect Merck’s shareholders during this governance gap. Simultaneously with the completion of step one of the merger, Schering has agreed that its board will cause all of its directors (other than 3 specified exceptions) to resign and to elect the members of pre-merger Merck’s board of directors as the directors of the surviving Schering corporation. Even before pre-merger Merck’s shareholders acquire their supermajority share of the beneficial ownership of the surviving Schering corporation after step two, they indirectly will have already taken the helm of the surviving Schering corporation through the election of their own directors to the new parent company’s board.        

In our next post on the deal, we’ll analyze the change of control provision in the Schering-Centocor distribution agreement and assess whether Johnson & Johnson has any colorable arguments that Schering will indeed undergo a change of control if the Merck-Schering reverse merger closes.

Related Post:  Can Merck-Shering's Deal Structure Avert a Change of Control?

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A recent opinion issued by the Delaware Court of Chancery serves as a cautionary tale to entrepreneurs, venture capitalists, and others entering into LLC operating agreements in connection with start-up companies. A minority investor with a substantial stake in a company sought to dissolve the company on the grounds it had abandoned its original business plan. However, because the purposes of the LLC were worded quite broadly in the operating agreement, the court ruled against the dissolution, much to the frustration of the minority investor. Thanks go to Francis Pileggi for bringing the case of In re: Arrow Investment Advisors, LLC to my attention and providing, as usual, an excellent summary and analysis of the court’s opinion on his blog. 

 Along with two others, Noah Hamman co-founded Arrow Investment with the intention of offering advisory services to investment funds. Hamman, who held a 30% membership interest in the company, had been its CEO until he was removed by his two fellow founders as a result of disagreements over management decisions. Like many other financial services firms, Arrow’s prospects began to sink with the market’s. In response, Arrow’s management committee decided to explore other investment opportunities and sent out a notice to the company’s members requesting capital contributions to fund their new programs. Hamman disagreed with this approach and brought a petition before the Court of Chancery seeking dissolution of the LLC under §18-208 of the Delaware LLC Act, alleging that Arrow had departed from the business strategy set out in its original business plan.  

 The court noted that Arrow’s LLC operating agreement, and not its business plan, was the controlling document for determining the company’s purpose. Arrow’s operating agreement clearly stated it was formed “for the purpose of acting as an investment adviser to certain investment funds and for such other lawful business as the Management Committee chooses to pursue.” Given the broad formation clause of the operating agreement, the court ruled that Arrow’s management had not violated the purpose for which the company had been formed simply by choosing to pursue new business strategies. In the words of Vice Chancellor Strine:

Dissolution of an entity chartered for a broad business purpose remains possible upon a strong showing that a confluence of situationally specific adverse financial, market, product, managerial, or corporate governance circumstances make it nihilistic for the entity to continue. 

A company suffering disappointing financial returns resulting from a downturn in general economic conditions did not meet this standard.    

For most companies, including a broad purpose of formation clause in the operating agreement makes sense because it provides management with flexibility to adapt to changing business conditions. But founders of start-up companies should accept that the company’s eventual trajectory may not follow the one they initially conceived. 

To address this unknown and unknowable future, LLC operating agreements can institute appropriate governance procedures and potential exit provisions that would allow management and the company’s members to resolve significant disputes, or, if necessary, to part ways. Members of LLCs with substantial minority stakes, for example, may be given veto rights over certain material managerial decisions (such as when capital calls may be made to fund new business ventures) or exit rights that would allow a withdrawal from the LLC under narrowly specified conditions.        

Nobody won in the case of Arrow Investment Advisors. Hamman remains bound to a company he no longer wants to be a part of, management must continue to deal with a contrary minority investor, and the LLC itself has lost valuable time and money in defending this lawsuit. 

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In our third and final post today on noteworthy deal protection provisions in the KKR-Sum Total merger agreement, we review Sum Total’s remedies for a breach or termination of the agreement by KKR. (Our first post covered the agreement’s “go shop” and “no shop” provisions and KKR’s break-up fee; our second post discussed the absence of a “financing out” for KKR.)

No Reverse Break-Up Fee

Sum Total is not entitled to a reverse break-up fee if KKR breaches or terminates the agreement under any circumstances.     

Specific Performance

The merger agreement pointedly provides that specific performance constitutes Sun Total’s “sole and exclusive remedy” for breaches of the merger agreement by the KKR merger vehicle or of the guarantee by Accel-KKR Fund III, L.P. Sum Total’s only recourse, in other words, is to get a court order compelling KKR to complete the merger. Sum Total has even agreed that if a court declines to enforce the specific performance remedy and awards monetary damages instead, the company may only collect its court ordered award if KKR is no longer willing to go ahead with the merger. 

The remedies section of the merger agreement appears to have been drafted in the shadow of the Delaware Chancery Court’s ruling in United Rentals v. Ram Holdings. In that case, the target company United Rentals moved for summary judgment on its claim that it was entitled to specific performance from a Cerberus-led private equity fund consortium under the terms of their merger agreement. The court, however, found that the priority of the two remedies provided to United Rentals under the merger agreement -  a reverse break-up fee and a right to specific performance - was ambiguous. Determining that neither United Rentals nor Cerberus was able to demonstrate that its proposed interpretation of the merger agreement was the only one that would be reasonable as a matter of law, the court resorted to extrinsic evidence by applying the forthright negotiator principle to divine the parties’ intent at the time of contract. The remedies section of the KKR-Sum Total merger agreement appears to be closely drafted to memorialize the parties’ intent that Sum Total’s only remedy is specific performance and that KKR’s right to specific performance does not preclude it from seeking its break-up fees.     

NB: The merger agreement also gives Sum Total the right to force the shell holding company serving as KKR's merger vehicle to compel Accel-KKR Fund III, L.P. to finance the purchase price of the merger.

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Following our post earlier today in which we reviewed KKR's break-up fees and the "go shop" and "no shop" provisions in the KKR-Sum Total merger agreement, we now examine the absence of a “financing out” in the agreement.

No Financing Out

In private equity buyouts, the acquisition vehicle tends to be a shell holding company with no assets. At the closing of highly leveraged cash-for-stock mergers, the holding company is funded by an equity investment from the funds participating in the merger and by senior and mezzanine, or “bridge,” loans from a syndicate of banks. Upon receipt, the holding company immediately transfers these funds to the target company for distribution to the target’s shareholders to complete the merger.   (The movement of these funds as they’re wired from entity to entity is mapped out in painstaking detail beforehand by the accounting firms in a chart dubbed the “funds flow.”) 

Although private equity firms usually have obtained signed letters from the banks committing their funds to the transaction before they enter into a merger agreement, firms always face the danger that, at some point between signing the merger agreement and closing, their lenders renege on their financing commitments or increase the costs of borrowing. To protect themselves against the possible loss of debt financing on acceptable terms, private equity funds in years past have negotiated a “financing out” in merger agreements by setting the continued availability of financing from their bank syndicates as a condition to closing the deal. 

The merger agreement does not have a “financing out” for KKR because the firm is financing the Sum Total merger solely with an equity investment from Accel-KKR Fund III, L.P., a fund dedicated to investing in mid-market technology companies. With no fear of a third-party’s failure to make good on its loan promises, KKR faces very little risk that it will not be able to come up with the cash to complete the transaction. 

Guarantee from KKR Fund

In fact, it is Sum Total who bears some risk that the KKR fund may fail to contribute cash to the shell holding company serving as KKR’s merger vehicle. The merger agreement gives Sum Total additional comfort by having the right to force the merger vehicle to compel the KKR fund to finance the purchase price. Sum Total also has a direct guarantee from Accel-KKR Fund III, L.P. for the holding company’s (and its subsidiary’s) obligations under the merger agreement. In effect, Sum Total’s contractual right to force the KKR fund to finance the transaction serves as an alternative, extra-judicial means of enforcing its right to specific performance under the agreement.

Sum Total’s right to specific performance will be the subject of our third and final post on the deal protection terms in the KKR-Sum Total merger agreement.

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