Merck’s acquisition” of its rival, Schering-Plough is being structured in an unusual manner. Despite the relative sizes of the two companies (Merck is vastly larger than Schering and has, by far, the higher market capitalization), Schering will function as the “issuing” corporation in the transaction.
Merck will become a wholly-owned subsidiary of Schering and the latter will change its name to Merck. Thus, the transaction can best be described as a “reverse merger,” one in which the smaller company acquires the larger.
This technique is being used primarily for the purpose of insuring that Schering’s joint venture with Johnson & Johnson is not imperiled by the Merck acquisition. Apparently, the joint venture agreement’s termination provision (which is premised on a change in control of either party) will not be triggered by a business combination in which Schering is the surviving corporation.
That will be the case in the Merck/Schering combination even though, for financial accounting purposes, Schering will be regarded as the acquired entity1. As a result, the parties are hoping that the merger structure will foreclose any ability on Johnson & Johnson’s part to abrogate agreements with Schering with respect to important products such as Remicade and Golimumab, both used in the treatment of rheumatoid arthritis as well as other conditions.
Interestingly, the reverse merger is not being used for the usual reason – to “finesse” the continuity of interest (COI) requirement. For a merger, or other acquisitive transaction, to qualify as a tax-free reorganization, it must exhibit, among other things, COI.2 Specifically, the tax code notes that “Requisite to a reorganization…are a continuity of business enterprise…and (except as otherwise provided in Sec. 368(a)(1)(D)) a continuity of interest.”
A merger exhibits COI if, and only if , a substantial part of the value of the proprietary interests in the target corporation are preserved in the potential reorganization.3 A proprietary interest is preserved when it is exchanged for a proprietary interest in the issuing corporation. Conversely, the interest is not preserved when it is acquired by the issuing corporation for consideration other than stock in the issuing company.
However, it is well-settled that the COI test does not apply to the acquired corporation or its shareholders.4 So in cases in which the issuing corporation is not offering sufficient stock to meet the COI test, the path of least resistance is to reverse the “direction” of the merger.5 (For a proprietary interest in the target company to be considered preserved, at least 40 percent of the aggregate consideration must consist of such stock.)6
Essentially, in cases in which not enough stock is offered, COI is satisfied because it only applies to the (technical) acquired corporation and its shareholders. In the Merck/Schering case, the acquiring corporation isthe corporation whose shareholders will be “cashed out” in excessive numbers.Alternatively, the parties may wish, through the “horizontal double dummy” structure, to bring the case under the more permissive provisions of Section 351, which has no COI requirement.7