Merck-Schering's Reverse Merger: Change of Control Provisions in Material Contracts
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 $2.1 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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