Pfizer and Warner-Lambert are close to a merger that would create the world's second-largest drug company.

Warner-Lambert has agreed to accept a $85bn takeover offer from Pfizer, reports say.

But completion of the merger hinges on Warner-Lambert being able to pull out of a merger with American Home Products ( AHP).

Warner-Lambert may have to pay a $1.8bn penalty clause if it pulls out of its $59bn merger with AHP.

AHP is demanding at least an extra $200m in compensation, a demand that Pfizer is reluctant to accept.

On Thursday, an AHP official said that it still hopes that Warner-Lambert will honour the deal.

The two companies are still in talks. It is unclear if AHP will up its bid for Warner-Lambert.

Drug warfare

The companies are nearing the end of a three-month fight for Warner-Lambert.

What sparked the takeover battle was control of a drug: Lipitor, Warner-Lambert's prized cholestorol drug.

Together, Pfizer and Warner-Lambert have successfully marketed the drug since 1997.

Pfizer's fear that it might lose the right to market the drug prompted it to enter takeover talks for Warner-Lambert.

The takeover battle began in early November when Pfizer made its unsolicited bid for Warner-Lambert just hours after Warner-Lambert and AHP agreed to their merger.

Warner-Lambert initially saw Proctor & Gamble as a white knight to counter the Pfizer bid.

Formidable mix

Pfizer's best known drug is Viagra and the combined company would boast a product range that includes blood pressure control drug Norvasc, antidepressant Zoloft, as well as consumer products like Bubblicious Gum and Listerine.

"This will be a formidable global company that investors will be very happy with," Tony Butler, a Lehman Brothers analyst said.

The merger would follow last month's merger between Glaxo Wellcome and SmithKline Beecham to create the world's biggest drug company.

It comes at a time of consolidation in the pharmaceutical industry as drug giants seek to cut their research costs by pooling resources.