As Wall Street analysts and investors debate the proposed advantages of the $41.1 billion merger, one of the great unknowns is how Johnson & Johnson will react. That's because Schering-Plough has a commercial agreement with J&J to market Remicade (infliximab), a tumor necrosis factor inhibitor used to treat rheumatoid arthritis, and a Phase III follow-up known as golimumab, outside the U.S.

At issue is the interpretation of a change-of-control clause in the original 1998 deal between the two companies. If J&J decides that Schering has changed hands, the consumer health giant may decide it once again has the rights to market Remicade and golimumab in ex-U.S markets. Should that happen, Merck stands to lose one of Schering's most valuable cash cows.

Merck execs seemed prepared for the problem. On a conference call yesterday, they went out of their way to highlight what would appear to be a tortured aspect to the deal: a reverse merger in which Schering, renamed Merck, will continue as the surviving public corporation.

"We believe the transaction is structured so that Schering's rights are not affected by the merger and we will retain distribution rights to the products," Merck's CEO Richard Clark proclaimed.

But analysts aren't so sure. During a question-and-answer session, securities analysts peppered Clark and his team with questions related about the effects of the change of control provision.

"We do expect JNJ to drag Merck/Schering into arbitration over the change of control provisions related to Remicade/golimumab that may be triggered by this deal," wrote UBS analyst Roopesh Patel in a same day investor note. "While uncertainty may persist for months, we believe Merck has a shot at prevailing," Patel added.

The ultimate ownership of those international rights is not a trivial issue. With sales exceeding $2 billion in 2008, Remicade is Schering's biggest standalone product, and since the drug won't lose patent protection until 2014, a good deal of money has yet to flow into the register (¹ Also see "Market Snapshot: Anti-TNFs Grow Despite Tough Market" - Pink Sheet, 8 December, 2008., p.18).

Moreover, golimumab, which was filed with US and EU regulators in 2008, extends the duration of Schering's agreement an additional 15 years beyond the its launch, which is expected this year or next.

So it was understandable that analysts were curious about the earnings per share guidance for the newly merged entity. Would it be significantly affected if Merck lost rights to the anti-TNF drugs? Merck's CFO Peter Kellogg provided an unequivocal answer: "Regardless of the assumptions you make for the Remicade business, this high single digit, non GAAP EPS CAGR guidance holds," he said.

Clark, moreover, made clear Merck is intent on acquiring Schering regardless of potential arbitration concerning Remicade and golimumab. "This is a strategic bid for the future and it's not based on one or two products," he said in response to analysts' questions.

How not to trigger a change-of-control clause

Remicade's value helps explain why Merck and Schering have jumped through several hoops - or are attempting to - in order to try and prevent J&J from regaining full ownership to the drug under change of control provisions.

According to the 1998 contract, a change of control constitutes "any merger, reorganization, consolidation, or combination in which a party to this agreement [in this case Schering] is not the surviving corporation." (Our italics.) In an effort to wiggle past the first part of the contractual definition, the two companies have structured the deal as a reverse merger in which Schering, whose shareholders will own a minority 32 percent of shares in the combined group, is the surviving entity.

Never mind that this is Merck buying Schering, or that the new company will be called Merck, run by Merck's CEO Richard Clark out of Whitehouse Station, N.J.

"The surviving parent company is the existing [Schering] corporate entity," insisted Bruce Kuhlik, Merck's general counsel. "Under the expressed terms of the distribution agreement, this change of control provision focuses on whether there has been a change in the surviving public company. It doesn't refer to a stock ownership or anything of the sort … We're confident in our belief that this will not trigger a loss of rights."

Except that the J&J/Schering contract isn't quite so simple. It has other definitions of what might trigger a change of control, including a clause related to alterations in the board of directors. Effectively, if representation in the "incumbent board" - Schering in this instance - no longer constitutes a majority that might be grounds for J&J to challenge ownership rights to Remicade and golimumab.

And this may indeed be the case. The board of the newly merged entity will include the existing Merck board and three representatives from the Schering board, according to Peter Kim, EVP and President of Merck Research Labs.

Just as Merck and Schering hope to wriggle around the ownership clause by way of a reverse merger, they also anticipate using another loophole: having the existing Schering board appoint the new members. "There is a reference in the agreement to the board participation and membership. But it doesn't apply where the existing board appoints new members and that's what's happening here," said Kim.

Still, the fact that the drugmakers provided guidance for the new company both with and without the two TNF inhibitors suggests that they're not absolutely sure that these tactics will work.

The next move belongs to J&J

"Case law would suggest that this would not hold water," said one lawyer familiar with change of control clauses. But the whole dance, he surmised, "may just be a negotiating tool" in order to bring J&J to the negotiating table.

Analysts at Bernstein Research appear to agree, suggesting that some form of "horse trading"' may occur such that Merck ends up with the products.

Alternatively, J&J may decide to issue its own counter-bid, given the potential synergies between the two companies. "The fit between the two companies is as good as - if not better - than the fit between Schering and Merck," wrote Bernstein's Tim Anderson in a same day research note. Indeed, with its 50 percent ownership stake in the TNF inhibitors, J&J's position is analogous to Merck, which aims to consolidate costs associated with the Zetia (ezetimibe) and Vytorin (simvastatin/ezetimibe) joint venture through the proposed reverse merger (² Also see "Merck/Schering: The Next Wave Of Consolidation" - Pink Sheet, 9 March, 2009.).

"I think all options are on the table. JNJ can pick up Remicade and the follow-up perhaps inexpensively - at a discount - because Merck and Schering really want this deal done, said David Moskowitz of Caris & Co.

Either way, J&J is unlikely to stay quiet for long, whether it's to extract whatever value it can in exchange for rights to the rheumatoid arthritis drugs or - as Anderson and Moskowitz suggest - play black knight to Merck's white one.

With a thriving consumer health business plus one of the most diversified portfolios in the business, J&J's need for Schering may be less acute, but it might be tempted given the relatively cheap price Merck is offering for the company to try and broker a deal.

J&J has refused to comment publicly on the possibility, but Schering's Fred Hassan is sanguine on the ultimate outcome. "I had a cordial conversation with [J&J's CEO] Bill Weldon this morning," he said, without alluding to the actual substance of their chat.

- Melanie Senior and Ellen Foster Licking (m.senior@elsevier.com; e.licking@elsevier.com)

Will Johnson &amp; Johnson Undercut Merck’s Bid to Buy Schering-Plough?

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