February 26, 2009

Roche and Genentech’s Tangled Web

– by John Jenkins, Calfee Halter & Griswold

The continuing saga of Swiss pharmaceutical giant Roche’s efforts to acquire the 44% of Genentech that it does not already own added a chapter on Monday, when Genentech’s special committee unanimously voted to recommend against Roche’s most recent $86.50 per share bid. Last month, Roche broke off negotiations with Genentech’s special committee and withdrew its proposal for a negotiated transaction, opting instead to launch a hostile bid after Genentech balked at its $89 per share offer (the company is asking $112 per share).

At first blush, it is tempting to conclude that this whole process is a bit contrived. After all, didn’t Roche’s decision to launch a unilateral tender offer make things easier on everyone under Delaware law? The Unocal Exploration and Siliconix decisions established that a unilateral tender offer followed by short form merger offered controlling shareholders (and subsidiary boards) a path to freeze out minority shareholders without subjecting the transaction to entire fairness review, so why bother with negotiations? Pure Resources made things a little more complicated and Cox Communications suggested that we’d be better off if Delaware just started over, but Delaware law still provides a roadmap for avoiding the entire fairness review that usually applies to parent/subsidiary mergers, doesn’t it?

Delaware may provide a roadmap for many such controlling shareholder-subsidiary mergers, but the contractual relationship between Roche and Genentech makes this situation unusual, and far from simple. The two companies have a wide-ranging business relationship, and there are several agreements in place governing various aspects of their relationship. For purposes of Roche’s bid, the most notable of these agreements is an “Affiliation Agreement” that imposes a number of obligations on Roche in connection with any merger involving Genentech.

According to Roche’s offer to purchase, the Affiliation Agreement requires any merger between Genentech and Roche to either:

– receive the favorable vote of a majority of the shares not beneficially owned by Roche and its affiliates (with no person or group entitled to cast more than 5% of the votes cast at the meeting); or

– provide public shareholders with consideration “equal to or greater than the average of the means of the ranges of fair values for the shares as determined by two investment banks of nationally recognized standing appointed by a committee of [Genentech’s] independent directors.”

The Affiliation Agreement also provides that if Roche owns more than 90% of the outstanding shares for more than two months, it must complete a merger in compliance with either of the requirements described above as soon as reasonably practicable. So if Roche completes its tender offer, it will have to obtain shareholder approval of a long-form merger proposal (which would subject the deal to entire fairness review), or complete a short form merger in which it pays a price determined by Genentech’s chosen investment bankers (which is probably not a pleasant prospect given how far apart the two sides are on valuation). That complicates things considerably.

But the complications do not end there. A purported class action lawsuit filed by a group of institutional investors challenges, among other things, the enforceability of these provisions of the Affiliation Agreement. The plaintiffs allege that agreement’s attempt to limit the percentage of shares that can be voted by any person or group to 5% of the votes cast violate Section 212(a) of the Delaware General Corporation Law (which provides that Unless otherwise provided in the certificate of incorporation, each stockholder is entitled to one vote for each share of stock held by such stockholder) and Genentech’s bylaws. They also challenge the alternative “fair price” procedure as being inconsistent with Roche’s (and the Genentech board’s) fiduciary duties. (See Section III of this complaint).

Roche has kept its cards pretty close to its vest in terms of how it intends to navigate the requirements of the Affiliate Agreement subsequent to the completion of a successful tender offer. Its tender offer materials include a Q&A on how the Affiliate Agreement affects the offer and any subsequent merger. In its response to that question, Roche merely points out that the agreement has no affect on its offer, and notes that compliance with its provisions would be required in connection with any subsequent merger.

Exactly how Roche plans to comply with the agreement is unspecified in the tender offer materials, but it seems like the Affiliation Agreement provides Genentech shareholders who decide to hang on to their shares and wait for a back-end merger with an opportunity to exert significant leverage.

And guess what? It looks like the market knows it.

Most analysts reportedly expect that Roche will up its price in response to the Genentech special committee’s rejection of its current offer. That may prove to be a path to a negotiated deal, and the special committee’s endorsement of a deal will clearly put Roche in a much better position to obtain the shareholder approval that it needs under the Affiliation Agreement. Genentech is probably wagering that this endorsement is something that Roche is willing to up the ante in order to receive. That may turn out to be a pretty good bet.