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How Merck Bet $2.6B on a Technicality

Up to $2.6 billion of Merck (MRK)'s revenue hangs on a technicality in a legal document, and it could all be washed away by the end of September, Merck disclosed today. The technicality revolves around Merck's deal with Johnson & Johnson (JNJ) which allows Merck to sell Remicade, an injectable drug that treats inflammatory disorders. You can tell Merck's shareholders are anxious about the Remicade deal because Merck's SEC filing says it was made "in response to questions from investors."

Originally, J&J and Schering-Plough made a deal which gave Schering rights to sell Remicade. That deal stated that if Schering ever experienced a "change of control" then it could be cancelled and all rights to Remicade would revert back to J&J. Merck acquired Schering in November 2009, in part to get its hands on Remicade, which earned $1.3 billion in revenues in the first six months of this year. Remicade is now Merck's second-biggest drug, after the asthma treatment Singulair.

Normally, when one company buys another, the company being bought undergoes a "change of control." In the Merck-Schering acquisition, however, both companies' lawyers performed a set of legal tricks to make it look like Schering was actually buying Merck and then renaming itself "Merck." The company even reissued new Merck stock in place of old Merck stock -- even though the two stocks are identical instruments from a financial point of view, and even have the same stock symbol, MRK. The maneuvering was clearly a figleaf, as Schering CEO Fred Hassan cashed out a staggering $50 million severance payment based in large part on a change-of-control provision that triggered such payments.

Now an arbitrator will decide whether Merck must give up Remicade to J&J. If Merck has gotten this wrong all hell will break loose. Merck will have to give back to J&J a year's worth of Remicade revenues and all future Remicade revenues. Then it will have to fire all the staff it employed to sell and distribute the drug (or at least transfer them to J&J). And then Merck will likely be sued by its own shareholders, who will be angry that Merck's management deluded themselves into thinking that buying Schering was not a change of control for CEO Richard Clark but was one for Hassan.

Previously, analysts have suggested that Merck and J&J will settle rather than wait for the arbitrator to rule. With arbitration just days away, that settlement is conspicuous by its absence. The worst-case scenario for J&J is that things stay as they are -- the deal J&J struck in the first place. That will only happen if the arbitrator applies an overly technical interpretation of the agreement between the two companies, which apparently doesn't specifically say that a reverse-merger counts as a change of control. Why would J&J settle when it can't possibly lose?

In the meantime, Merck must hope that the arbitrator -- who has much more leeway than a judge and can rule based on technicalities or merits -- will abandon common sense and decide that even though the Remicade deal waddles and quacks like a duck, it is not a duck per se.

That's an extraordinary thing upon which to bet $2.6 billion.


Image by Flickr user Joel Telling, CC.
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