Analysis: Billions at stake in Merck/J&J Remicade dispute

NEW YORK Wed Sep 29, 2010 8:20pm BST

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NEW YORK (Reuters) - With billions of dollars at stake, Merck & Co must convince arbitrators that it deserves to retain overseas sales of the blockbuster arthritis treatment Remicade and potentially more lucrative follow-up drug Simponi to avoid taking a serious hit to its earnings and share price.

The drugmaker will find out in about a month if its reverse merger strategy worked, when an arbitration panel of three former federal judges decides if Schering-Plough's 2009 merger with Merck constituted a change of control at Schering-Plough that would terminate its Remicade/Simponi distribution deal with Johnson & Johnson.

A loss by Merck would likely result in "a mid-single-digit percentage drop in the stock" and a hit to earnings per share "in the neighborhood of 5 percent," said Damien Conover, an analyst for Morningstar.

Underscoring the stakes for Merck, the drugmaker has hired high-powered attorney David Boies to argue its case.

The companies went to great lengths to structure last year's $41 billion deal as a reverse merger under which the smaller Schering-Plough technically acquired Merck.

By all outward appearances, however, it was a traditional acquisition by the larger company. The combined entity retained the Merck name and stock symbol, and is run out of Merck's corporate headquarters by Merck Chief Executive Dick Clark. Schering- Plough's CEO, Fred Hassan, left soon after the deal was completed and is now chairman of Bausch & Lomb.

"The reverse merger is a little bit difficult to swallow," said Les Funtleyder, an analyst with Miller Tabak & Co., who follows both Merck and Johnson & Johnson.

"I think investors are generally thinking that J&J will come out better than they went in and Merck will come out worse than they went in," said Funtleyder, noting that J&J shareholders were more focused on the massive recalls of Tylenol, Motrin and other J&J consumer healthcare products.

Despite appearances, and the likelihood that J&J will argue that reality should take priority over the technical nuances of the Merck-Schering deal, the law may be on Merck's side.

"This is literally one of the things that keep M&A lawyers up at night," said Eric Talley, professor of law and co-director of the Berkeley Center for Law, Business and the Economy at University of California, Berkeley.

"People have tried that kind of an argument in a lot of judicial venues to say, 'Judge, I want you to ignore the formal structure of this merger and pierce into its economic realities and call it what it is.' Courts have been very unfriendly to that approach," Talley said.

While there is at least one notable exception in a case involving Oracle Corp. that J&J will likely cite, Talley said, "the doctrine has continued to persist in corporate law that the way you structure a deal really matters."

SETTLEMENT STILL A POSSIBILITY

Conover is anticipating a settlement, "even though we're reaching the last hours here."

"If that's the outcome, I don't think it's going to be too materially negative or positive for either company. It removes a risk overhang for Merck and increases a little bit of economics for J&J," he said.

Without such an agreement, a decision by the arbitration panel would be final and binding with three basic potential outcomes: A ruling returning the rights to J&J that may also include damages to be paid by Merck; a finding that the merger did not constitute a change of control, which would keep the current Remicade/Simponi distribution deal in place; or some form of compromise that would allow Merck to continue selling the drugs overseas under altered terms.

"In this case it's going to be very, very hard to split the baby because either the license reverts back or it doesn't revert back," Talley said. But he noted that "in arbitration, the rules are definitely a little bit less cut and dry."

"I would think it's probably a longshot that they would be willing to structure some Solomonic middle ground, but unlike an ordinary court they would at least be able to do it."

Even though the case has reached binding arbitration, Deutsche Bank's longtime pharmaceutical analyst, Barbara Ryan, sees the likelihood of a settlement as high.

"Our expectation has always been, and still is, that the two companies will probably negotiate a settlement of this dispute that is mutually beneficial," Ryan said.

"We would guess that it could result in a higher royalty being paid to J&J and/or some consumer assets trading from Merck to J&J to resolve the matter," she added.

"I think they'd rather choose their own fate than have a panel of judges choose it," Ryan said.

But J&J has said it is seeking a ruling that Merck's acquisition of Schering-Plough was a change of control that triggered J&J's right to terminate the deal.

"The termination of the agreements would return full rights to Johnson & Johnson for the distribution of these products in markets outside the United States where Schering-Plough currently has the rights to distribute these products," J&J said in a statement.

J&J has little to lose from its challenge outside of legal expenses, but the stakes are extremely high for Merck. The company reported $669 million in second-quarter sales from Remicade, making it one of Merck's biggest products. And Simponi, with many years' more patent life than its older cousin, may prove to be the more important bargaining chip.

"I think this is more of a Simponi story than Remicade. It's a drug that has a bright future," said Funtleyder, who sees it becoming a multibillion-dollar medicine.

Merck said in a regulatory filing that it expects a ruling within 20 days of the conclusion of the arbitration hearing.

"An unfavorable outcome in the arbitration would have a material adverse effect on the company's financial position, liquidity and results of operations," Merck said.

But Ryan believes Merck has laid the legal groundwork to prevail, should the sides fail to reach a settlement.

"I think that Merck dotted its Is and crossed its Ts in developing this merger agreement, and I would not expect that Merck would lose in the arbitration," Ryan said.

"I tend to think they either think they have a very strong case or a reasonable idea of what it will take to make J&J happy in resolving this," Ryan added.

Still, to make its case Merck reached out to Boies, the lawyer who represented Al Gore in litigation over the disputed 2000 U.S. presidential election, and more recently American Express in its antitrust case against Visa and Mastercard.

Asked if selecting such a high-profile attorney sends a message, Ryan quipped, "I guess it's that they don't intend to lose." (Reporting by Bill Berkrot, editing by Matthew Lewis)

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