OTHER INCOME (EXPENSE), NET

6 Months Ended

Jun. 30, 2011

OTHER INCOME (EXPENSE), NET

OTHER INCOME (EXPENSE), NET

5.   OTHER INCOME (EXPENSE), NET

Other income (expense), net consisted of the following:

	Three months ended						Six months ended
	June 30,						June 30,
	2011			2010			2011			2010
Loss on letter agreement derivative instrument	$	(22,078	)	$	—		$	(22,078	)	$	—
Gains (losses) on foreign exchange derivative instruments	5,595			(2,900		)	5,089			(9,069		)
Foreign exchange gains (losses)	(9,877		)	(6,432		)	(12,399		)	(7,534		)
Other income (expense), net	$	(26,360	)	$	(9,332	)	$	(29,388	)	$	(16,603	)

In 2011, in connection with the retention of Deutsche Bank as a financial advisor to Cephalon, we entered into a letter agreement with members of Deutsche Bank AG and its affiliates (the “DB Group”) that established a methodology designed so that payments under the letter agreement would have the effect of fixing the DB Group’s contractual benefits with respect to the hedging transactions described below, such that DB Group would be indifferent under the hedge transactions to the price paid for Cephalon common stock in a cash acquisition of Cephalon, such as the merger.  The methodology takes into account certain variables including volatility of our stock, interest rates (based on LIBOR) and estimated merger closing dates.

A member of Deutsche Bank AG and its affiliates (“the DB Group”) and Cephalon are parties to (a) certain convertible note hedge transactions issued by the DB Group and purchased by Cephalon as hedges to the conversion features of the convertible senior subordinated notes issued by Cephalon in 2005 and 2009 and (b) certain warrants issued by Cephalon and purchased by the DB Group. We refer to the convertible note hedge transactions as the hedge transactions, and to the convertible senior subordinated notes as the convertible notes. The hedge transactions and the warrants are call options on Cephalon common stock. The warrants have higher strike prices than the effective strike prices of the hedge transactions. Cephalon expects that the hedge transactions will be exercised, and the warrants will be settled in connection with the merger, in each case in accordance with their terms. Exercise of the hedge transactions will involve payments by the DB Group to Cephalon and settlement of the warrants will involve payments by Cephalon to the DB Group in amounts that are currently undetermined. See Note 12 for further detail on the convertible notes.

The DB Group has advised Cephalon that, since the entry into the hedge transactions and the warrants, the DB Group has hedged, and will continue to hedge until their exercise or settlement, respectively, certain risks and exposures (including, among others, equity price risk) under the hedge transactions and the warrants through market transactions (including by purchasing or selling the convertible notes or Cephalon common stock, or entering into or unwinding derivative transactions) and that certain of such hedging activity is designed to make the DB Group indifferent to the exercise value of the warrants and its payment obligations under the hedge transactions.

The terms of the hedge transactions contain contractual limitations on payments related to the time value of the hedge transactions to Cephalon in the case of conversions of the convertible notes prior to their maturity in connection with certain merger events, such as the merger. Because of these contractual limitations, which were designed so Cephalon could achieve certain tax and commercial objectives, the possibility existed that the DB Group could recognize a significant contractual benefit under the terms of the hedge transactions in the event of early conversions of convertible notes and corresponding exercises of the hedge transactions, such as in connection with the merger. The contractual benefit to the DB Group would be the time value of the hedge transactions not fully paid to Cephalon as a result of the contractual limitations described above. Assuming market conditions, including stock prices prevailing during the period of Deutsche Bank’s engagement as financial advisor, prior to the execution of the April 15, 2011 letter agreement among Cephalon, Deutsche Bank AG and Deutsche Bank described below, the value of the contractual benefit to the DB Group generally would have decreased as the cash acquisition price for the shares of Cephalon common stock increased (and vice versa). Other market conditions, such as interest rates and volatilities, as well as the time remaining to expiration of the hedge transactions, will also affect the value of the contractual benefit to the DB Group.

To address the matters described in the prior paragraph and in connection with the retention of Deutsche Bank as a financial advisor to Cephalon, Deutsche Bank and Cephalon entered into a mutually acceptable agreement designed to alighn the DB Group’s contractual benefit with respect to the exercise of the hedge transactions, such that the DB Group would be indifferent under the hedge transactions to the price paid for the Cephalon common stock in a cash acquisition of Cephalon, such as the merger. In connection with the merger, Deutsche Bank, Deutsche Bank AG and Cephalon entered into a letter agreement dated April 15, 2011 that provided that, in connection with the exercise of the hedge transactions, the DB Group would fix the value of the contractual benefit at $151,800,000. The aligning methodology does not mean that the DB Group will receive $151,800,000 in cash upon exercise of the hedge transactions. Rather, the $151,800,000 value of the contractual benefit will be settled through a cash payment of an amount equal to the difference between $151,800,000 and the actual contractual benefit calculated by the DB Group in connection with the exercise of the hedge transactions in accordance with their terms. Such amount will be payable at the time of exercise of the hedge transactions by Cephalon to the DB Group if the actual contractual benefit calculated by the DB Group is less than $151,800,000 or by the DB Group to Cephalon if the actual contractual benefit calculated by the DB Group exceeds $151,800,000.

The April 15, 2011 agreement does not amend or otherwise modify the documents governing the existing hedging transactions, and the rights of the parties to the agreement are independent of the rights of the parties to the documents governing the hedging transactions.  The agreement is a free-standing derivative instrument measured at fair value,  For the three and six months ended June 30, 2011, we recognized a loss of $22.1 million from the decrease in fair value of this derivative instrument.

In 2011, we entered into a series of foreign exchange forward contracts and foreign exchange option contracts related to our ChemGenex transaction.  Together, these contracts protect against fluctuations between the Australian dollar and the U.S Dollar and changes in the value of these contracts are recognized within net income.  These forward exchange contracts settled in June 2011.  For the three and six months ended June 30, 2011, we recognized a gain of $5.6 million from the increase in fair value of these foreign exchange contracts.

In 2010, we entered into a foreign exchange forward contract related to our Mesoblast transaction.  This contract protects against fluctuations between the Australian Dollar and the U.S. Dollar and changes in the value of this contract are recognized within net income.  This contract settled in February 2011.  For the six months ended June 30, 2011, we recognized a loss of $0.5 million from the decrease in fair value of this foreign exchange contract.

In 2010, we entered into foreign exchange forward contracts related to our Mepha GmbH transaction.  These contracts protected against fluctuations between the Swiss Franc and the U.S. Dollar.  Changes in the value of these contracts were recognized within net income. For the three and six ended June 30, 2010, we recognized losses of $2.9 million and $9.1 million, respectively, from the decrease in fair value of these foreign exchange contracts.