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

Attorneys for Biogen Idec Inc. and Elan Corporation finally faced off in a Manhattan federal court earlier this month. The two companies had adopted increasingly antagonistic postures towards one another as elements of Elan’s cooperation and financing agreements with a Johnson & Johnson subsidiary became public. Shane Cooke, Elan’s CFO, told the Wall Street Journal in July that its arrangements with J&J contemplated the possibility of the two companies working together to buy Biogen’s Tysabri stake if Biogen is acquired by a third party. Biogen protested that Elan’s proposed deal ran afoul of the companies’ collaboration agreement for the multiple sclerosis drug Tysabri. A defiant Elan filed a complaint in federal court requesting a declaratory judgment that it had not violated the collaboration agreement and a permanent injunction prohibiting Biogen from terminating their partnership. After five hours of oral argument, U.S. District Court Judge Deborah Batts ruled that the Elan-J&J partnership infringed the Tysabri agreement. 

As we explained last month, the Tysabri collaboration agreement provides that if either Biogen or Elan is acquired by a third party, then the non-acquired party has the option to purchase its stake in Tysabri. The agreement also contains a customary provision prohibiting the assignment of any rights or obligations to an unaffiliated third party without the other party’s written consent. At the hearing, Biogen’s attorneys cited a confidential clause in one of the Elan-J&J agreements giving Johnson & Johnson the option to finance an Elan change of control purchase of Biogen’s share in Tysabri. The clause requires Elan to take instructions from Johnson & Johnson if it ever enters into negotiations to purchase Biogen’s stake. By granting this option to J&J, Biogen argued, Elan effectively transferred its rights under the agreement to Johnson & Johnson.   As Biogen’s attorney Michael Gruenglas put it, Elan "is no longer in the driver's seat, Johnson & Johnson is driving the car."     

Although Judge Batts concluded that “it would seem there has been a breach of the Biogen-Elan collaboration agreement,” she saw the legal issues differently. Contrary to Biogen’s characterization of the Elan-J&J pact, Judge Batts declared that Elan had not assigned any of its rights to Johnson & Johnson. Instead, Batts explained: "It appears to the court that Elan has designated an obligation it has to Johnson & Johnson by taking direction from Johnson & Johnson on the purchase price negotiations.”

Judge Batts appears to have based the rationale for her decision on redacted portions of the Tysabri agreement’s “change of control” provision. The version of the collaboration agreement filed with the SEC details Biogen’s and Tysabri’s acquisition rights upon a change of control in the other party. But the publicly available version of the contract omits important clauses relating to the conduct of negotiations once the non-acquired party exercises its acquisition rights.   This version of the contract reads: “[i]n the event the Non-Acquired Party exercises its election [sic] to purchase the interest of the Acquired Party under this Agreement, the Parties shall…”, but then expunges the next 36 lines of the change of control provision. Significantly, the excised portions address how the companies are to proceed in the event that the non-acquired party decides to acquire the other party’s Tysabri stake. From Judge Batt’s justification for her ruling, it appears that these omitted clauses specify how pricing and other negotiations should be conducted.   

By putting the power of the purse strings in J&J’s hands, Judge Batts determined that Elan had effectively delegated its negotiating power to Johnson & Johnson.   Under the Tysabri agreement, Elan has a right to exercise its change of control purchase option, but it also has a corresponding obligation to negotiate with Biogen on such matters as the valuation of Biogen’s stake in the drug. According to Judge Batts, when Elan agreed to let J&J dictate the terms of those negotiations, it violated the “no assignment” provision of the collaboration agreement by transferring this obligation to Johnson & Johnson.       

As part of her ruling, Judge Batts remarked that Biogen was within its rights under the Tysabri agreement to give Elan a chance to rectify its breach and noted that Elan had 23 days left in the agreement’s 60-day cure period. The Wall Street Journal reports that Johnson & Johnson and Elan have been discussing ways to amend their cooperation agreement so as to avoid violating the Elan-Biogen Tysabri partnership.   Proposals by Johnson & Johnson include reducing their investment in Elan by as much as $100 million.   

Related Post: Pharma Contractual Dispute: Biogen and Elan to See Each Other in Court

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A billion dollar drug. A change of control. A collaboration agreement. And Johnson & Johnson. Sound familiar? No, we’re not talking about the Schering-Plough and J&J dispute over whether the Merck-Schering merger violates the Remicade distribution agreement. This time, Johnson & Johnson may have gone into the breach, rather than having alleged it. The case involves Massachusetts-based Biogen Idec, the Irish drug company Elan Pharma, the multiple sclerosis drug Tsyabri, and around a billion dollars in annual revenue. The question is whether Johnson & Johnson’s purchase of a minority interest in Elan violates Biogen’s and Elan’s agreement to jointly develop and market Tsyabri. 

In July, a Johnson & Johnson subsidiary entered into a set of financing and cooperation agreements with Elan worth around $1.5 billion. The agreements (which are not publicly available) would give J&J a 14.8% stake in Elan along with the option to finance Elan’s purchase of Biogen’s 50% interest in the multiple sclerosis drug Tsyabri. Under the terms of a development and marketing collaboration agreement signed by Biogen and Elan in 2000, if one of the parties to the agreement is acquired by a third-party, then the other party has the option to purchase the acquired party’s rights to Tsyabri. So why has Elan offered Johnson & Johnson this option to finance a purchase that may not ever happen?   

Elan, it seems, has been keeping a watchful eye on Biogen’s shareholders. Back in June, Carl Icahn – who has a 5.6% stake in Biogen – succeeded in getting two of his four nominees on Biogen’s board of directors. Icahn’s victory came after a fierce proxy battle waged over the course of six months. Although Icahn’s broader platform, which included moving the company’s state of incorporation to North Dakota, did not receive support from the board, there are no signs that the activist shareholder plans on relenting any time soon. On the contrary, Icahn has indicated that he intends to promote a sale of the company. By cozying up to Johnson & Johnson, Elan can ensure it has quick access to capital should Biogen suffer a change of control.   

Biogen was clearly troubled by the prospect of a big pharma player getting too close to its Tsyabri partner. If Biogen were to lose its rights to Tsyabri under the collaboration agreement’s change of control provision, the company’s value would sink. In what can only be a signal that communication channels between Biogen and Elan have broken down, Biogen sent off a July 28 letter to Elan alleging that the Elan-J&J partnership would materially breach the collaboration agreement. Specifically, Biogen claims that Johnson & Johnson’s option to finance a change of control purchase by Elan violates the collaboration agreement’s prohibition that neither party may assign or delegate any of its rights or obligations under the agreement without the written consent of the other party. Under the agreement, a material breach would initiate a 60-day cure period, at the end of which Biogen could terminate the collaboration agreement and take over Elan’s rights to Tsyabri. 

On August 6, Elan responded by filing a complaint in a Manhattan federal court seeking a preliminary injunction staying the 60-day period and a ruling that Elan’s and Johnson & Johnson’s arrangement does not breach the Tsyabri collaboration agreement. A federal judge in Manhattan has set a hearing for August 31.   

Without being able to review the Elan-Johnson & Johnson agreements, it’s difficult to assess whether or not their terms violate the Tsyabri collaboration agreement. From Elan’s own description of the agreements, however, we can presume with reasonable confidence that the issue will boil down to whether Johnson & Johnson’s option to finance an Elan change of control purchase of Biogen’s Tsyabri stake is equivalent to an assignment or delegation of Elan’s rights under the collaboration agreement. After reviewing the Tsyabri collaboration agreement, it doesn’t seem that the Elan-J&J deal violates the no assignment provision. 

Of course, we’ll be able to hear the opinion of a federal judge on the matter shortly.      

Update: Elan Loses to Biogen in Court for Assigning Tysabri Obligations to Johnson & Johnson

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

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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!

           Pharma Contractual Dispute: Biogen and Elan to See Each Other in Court

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All companies look to forge strong relationships with their distributors. These affiliations are particularly important in industries where distributors add value through education, showrooms, installation or other service elements.

The first question in any distributor affiliation is how much control the supplier should exercise over the relationship. This question often turns on whether the manufacturer produces a commodity product or a proprietary one and the relative size of the parties. Distributors usually will not accept efforts to control the distribution of a product that can be obtained from a number of sources. However, a manufacturer that produces a proprietary product that is in demand has the ability, if it wishes, to exercise important controls over its distribution network.

Some manufacturers build a distribution control system into their marketing plan by setting up franchise systems or exclusive distributorships from the start. Whatever the name, these systems share a common goal from the point of view of the manufacturer: to shape the way its products are distributed in the marketplace.

The past 20 years have seen a marked increase in the control exercised by manufacturers over their products. Antitrust law and policy have adopted the view that consumers benefit when a manufacturer exercises control over its network of distributors in certain ways. Of course, it remains illegal to control pricing policies. That said, there are a wide variety of measures that manufacturers can adopt to shape the way their products get to market.

Perhaps the simplest measure is to grant a customer the exclusive right to sell products in a territory. This is often necessary to entice a well-capitalized distributor to take on a new product line. Other permitted controls include customer restrictions, advertising and trademark policies, stocking requirements for inventory or samples, and full line or exclusive requirements.

Distribution Agreements

Distribution agreements are a popular way to cement the relationship between a manufacturer and its distributors. Contracts are often drafted by the manufacturer and presented to the distributor as a finished deal. However, it is generally possible to negotiate these agreements, especially where the manufacturer is launching a new product or is trying to capture a new market.

Checklist of Material Terms in Distribution Agreements

The following is a checklist of the material items that should be addressed in a distribution agreement:

• What trademarks or trade names may the products be sold under? May the distributor use the trademark as part of its business name? What sort of approvals must be obtained in connection with the use of the trademark?

• Territory: exclusive, a designated primary area of responsibility or wide open? What happens if sales are made outside the prescribed territory? 

• May the manufacturer make direct sales in the territory?

• Are any accounts reserved to the manufacturer, such as national accounts?

• Must the business be conducted from a specific location? Can new locations be added in the future?

• What happens if other distributors sell within the protected territory?

• Can the distributor handle the products of competitors?

• Is the distributor required to carry the full line of products?

• What is the term of the agreement? How is the term renewed?

• Are there minimum purchase requirements?

• Must the distributor maintain a minimum quantity of inventory?

• May the distributor sell to other distributors or only to end-users?

• How are prices determined?

• What protections, if any, are there for price increases?

• Is the distributor required to participate in promotional allowances or other rebate programs instituted by the manufacturer?

• Must the distributor disclose its financial information to the manufacturer? Are there any minimum financial criteria to maintain the distribution?

• Under what circumstances may the distributor be terminated? May either party terminate the agreement without cause? What happens to unsold inventory following termination?

• What training or ongoing technical support is the manufacturer required to provide?

• Is the distributor authorized or required to provide warranty service? What parts will be stocked? How is payment for warranty service to be structured?

• Under what circumstances can the distributor return merchandise to the manufacturer?

• What are the terms of delivery? What are the distributor’s rights to inspect and test?

• Does the manufacturer promise continuous availability of products, spare parts and/or service?

• Will the manufacturer hold the distributor harmless from and actions for patent, trademark or copyright infringement?

• What insurance are the parties required to maintain?

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