Due Diligence Considerations in M&A Deals in Entertainment, Sports and Media Industries

Any due diligence exercise should be assisted by a multi-perspective team that potentially includes local and international counsel and financial and tax advisers with industry-specific expertise. The following guideposts should direct the team's efforts: 1) valuation-related matters; 2) legal considerations (including assessing the scope of risk, identifying liabilities the bidder would directly or indirectly assume, and noting third-party or governmental consents or notices required in light of the transaction structure); and 3) operational issues (i.e., understanding the target's business, identifying key contractual arrangements and facilitating integration post-closing). Bidders must appreciate the components of each category as early in the negotiation process as possible.

This article outlines certain key diligence issues within these guideposts that bidders' counsel should consider at the outset of any ESM M&A transaction. The calculus is especially nuanced and complex when deciphering revenue streams and assessing risk in the heterogeneous and industry-specific set of ESM assets, including film and television libraries, book properties, music publishing rights and music catalogs, sports teams and talent companies.

To determine the ESM assets a target actually owns and controls, bidders must be prepared to wade through various intellectual property regimes domestically (at the federal and state levels) and internationally, including copyright, trademark and right of publicity. Bidders will have to review asset 'chain of title' (such as inbound acquisition, assignment and licensing agreements, and copyright, trademark and UCC-1 reports) to confirm that the target acquired sufficient rights from each contributor to exploit those rights and thereby create value. This review should also surface contingent participation or royalty obligations payable to third parties. Bidders frequently direct their attention to the most valuable properties, or to a representative sampling, as a way to efficiently allocate scarce diligence resources.

Along with contractual considerations, any 'chain of title' analysis should account for the nontransferable statutory right of contributors to terminate certain grants of copyright. Generally, for grants prior to 1978, contributors may exercise a termination right commencing 56 years after the copyright was secured. See, 17 U.S.C. 304. For grants after 1978, contributors may exercise a termination right commencing 35 years after the execution of the grant, i.e., beginning in 2013. See, 17 U.S.C. 203.

Outbound Licenses

ESM assets typically generate revenue through the exploitation of a 'library' of rights, through outbound licenses to third-party distributors or licensees for a limited term and in a certain territory. These distributors and licensees, in turn, remit payments to the licensor. By reviewing these 'rights out' agreements, bidders can confirm which assets are encumbered or available (i.e., the 'avails') and the extent of revenue expected or otherwise achievable. License fees for ESM assets usually consist of an advance paid on execution of the contract, which is then recouped against contingent royalty streams payable to the licensor over the term of rights granted. Accordingly, a bidder may need to adjust the preliminary value ascribed to an asset because the asset may not actually realize revenue for the bidder, if ever, until much later in the exploitation cycle, depending on the amount of the advance and the asset's success in the marketplace.

Assignment Provisions

The transaction structure may necessitate an assignment of rights or agreements to the bidder. Assignment provisions are particularly important in the ESM context because licensees may not assign certain intellectual property rights (e.g., trademark, rights of publicity and nonexclusive licenses of copyright) without the licensors' express consent. The U.S. Court of Appeals for the Ninth Circuit even held in a widely criticized case that exclusive licenses of copyright that are silent on assignability may not be assigned without consent. Gardner v. Nike Inc., 279 F.3d 774 (9th Cir. 2002). A decision from the U.S. District Court for the Northern District of California, SQL Solutions Inc. v. Oracle Corp., C-91-1079 (N.D.Calif. 1991), also suggested that the transaction structure may unintentionally trigger assignment issues. Citing the general rule in California that an assignment of rights occurs through a change in the legal form of ownership of a business, the SQL court held that a reverse triangular merger (e.g., when a bidder forms a subsidiary to acquire the target company) results in an assignment of a nonexclusive copyright license by operation of law, thus requiring the licensor's consent. (In 2013, a Delaware Chancery Court, in Meso Scale Diagnostics LLC v. Roche Diagnostics GMBH, 62 A.3d 62 (Del. Ch. 2013), declined to follow the SQL court's lead and reached an opposite conclusion, but at least in California ' and potentially other jurisdictions ' bidders must be careful of the assignability issue.)

ESM assets, particularly high-grossing ones, are commonly subject to litigation claims. Opportunistic plaintiffs often file these claims, many of which are frivolous, on the eve of release to the public. Accordingly, although an ESM asset may be subject to a high number of claims, the analysis should focus on the underlying merit of these claims. Audit claims, whether actual or potential, may pose greater risks. The exploitation of ESM assets generates revenue in which third-party 'participants' and guild/union residual players (such as SAG-AFTRA, the Writers Guild of America and the Directors Guild of America) are entitled to share. A licensor typically retains the obligation to make these payments, but licensees (such as motion picture studios), which are entitled to recoup expenses before payment to these players, account and pay on a licensor's behalf. Because of the complex accounting practices of many licensees, audits often give rise to claims by these third parties, which may be substantial depending on the success of the asset.

Bidders seeking to acquire a professional sports franchise face other industry-specific considerations affecting the due diligence analysis. In assessing a team's value, a review of its stadium agreement for ownership or lease rights (and the duration of any such lease) and naming rights is critical. Valuation is also heavily driven by the availability of present and future media rights, which often intersect with media rights or revenue sharing granted to the league. Ownership of a team necessarily involves rights and obligations to the league as set forth in the team's franchise agreement. A bidder's success in acquiring a team will hinge on understanding this interplay and close coordination with the league.

As RAA made clear, an M&A bidder will have limited recourse against a target for misrepresentations in the due diligence process when reliance is explicitly contracted out (as it usually is). Accordingly, effective client representation calls for in-house counsel's strategic involvement in the diligence process beyond the traditional role of safe-keeper of legal issues affecting the corporation.

Conclusion

In light of the significant costs that any due diligence exercise entails, in-house legal counsel today is thrust into a hybrid role ' de facto business adviser tasked with identifying and exploiting industry-specific value drivers and facilitating company goals, while also assessing and managing increasingly intricate legal and business risks. Engaging outside counsel with industry-specific expertise and familiarity with the assets involved is often key to mastering the process and achieving optimal results.

Sean A. Monroe is a partner in O'Melveny & Myers Mergers and Acquisitions Practice. In addition to his broad experience in a range of M&A, private equity and corporate finance transactions, he handles corporate, securities and other aspects of entertainment transactions, including motion-picture financings, acquisition due diligence and evaluation, and distribution arrangements. Jeannine Tang and Silvia Vannini are associates in O'Melveny & Myers' Entertainment, Sports and Media Practice. All of the authors are based in the firm's Century City, CA, office.

For entertainment, sports and media (ESM) industries bidders ' and their counsel ' contemplating a merger-and-acquisition deal, last year's Delaware Supreme Court decision in RAA Management LLC v. Savage Sport Holdings Inc. , 45 A.3d 107 (Del. 2012), highlighted the importance of assessing risk early in the due diligence process. In RAA, the bidder sought to recover its due diligence expenses, claiming that the target company knowingly included false statements in its due diligence disclosures. The state supreme court, however, affirmed the dismissal of the bidder's complaint, holding that the non-reliance and waiver clause in the parties' nondisclosure agreement (NDA) barred the bidder from recovering its expenses ' even where the disclosures were allegedly false. In doing so, the court declined to distinguish between disclosures that were inaccurate because of negligence or mistake and those that were inaccurate because of fraud.

Generally, sellers begin the due diligence process with an NDA to protect the confidentiality of information they are disclosing and to limit their liability arising from such disclosure. Bidders must evaluate this information to value the target and assess its potential business and legal risks. As was the case in RAA, NDAs typically include a non-reliance clause in which the bidder acknowledges that the seller makes no representations or warranties with respect to the information it discloses and that any representations or warranties would be made only in the definitive agreements.

RAA confirmed the enforceability of non-reliance provisions even in extreme circumstances, crystallizing the importance of a bidder's strategic due diligence plan at the outset to expose any discrepancies, misunderstandings or miscalculations as it refines its evaluation of the target. This planning is particularly crucial in entertainment, sports and media, as the bidder's in-house counsel must navigate complex industries in which the key business and legal issues are not always apparent.

Any due diligence exercise should be assisted by a multi-perspective team that potentially includes local and international counsel and financial and tax advisers with industry-specific expertise. The following guideposts should direct the team's efforts: 1) valuation-related matters; 2) legal considerations (including assessing the scope of risk, identifying liabilities the bidder would directly or indirectly assume, and noting third-party or governmental consents or notices required in light of the transaction structure); and 3) operational issues (i.e., understanding the target's business, identifying key contractual arrangements and facilitating integration post-closing). Bidders must appreciate the components of each category as early in the negotiation process as possible.

This article outlines certain key diligence issues within these guideposts that bidders' counsel should consider at the outset of any ESM M&A transaction. The calculus is especially nuanced and complex when deciphering revenue streams and assessing risk in the heterogeneous and industry-specific set of ESM assets, including film and television libraries, book properties, music publishing rights and music catalogs, sports teams and talent companies.

To determine the ESM assets a target actually owns and controls, bidders must be prepared to wade through various intellectual property regimes domestically (at the federal and state levels) and internationally, including copyright, trademark and right of publicity. Bidders will have to review asset 'chain of title' (such as inbound acquisition, assignment and licensing agreements, and copyright, trademark and UCC-1 reports) to confirm that the target acquired sufficient rights from each contributor to exploit those rights and thereby create value. This review should also surface contingent participation or royalty obligations payable to third parties. Bidders frequently direct their attention to the most valuable properties, or to a representative sampling, as a way to efficiently allocate scarce diligence resources.

Along with contractual considerations, any 'chain of title' analysis should account for the nontransferable statutory right of contributors to terminate certain grants of copyright. Generally, for grants prior to 1978, contributors may exercise a termination right commencing 56 years after the copyright was secured. See, 17 U.S.C. 304. For grants after 1978, contributors may exercise a termination right commencing 35 years after the execution of the grant, i.e., beginning in 2013. See, 17 U.S.C. 203.

Outbound Licenses

ESM assets typically generate revenue through the exploitation of a 'library' of rights, through outbound licenses to third-party distributors or licensees for a limited term and in a certain territory. These distributors and licensees, in turn, remit payments to the licensor. By reviewing these 'rights out' agreements, bidders can confirm which assets are encumbered or available (i.e., the 'avails') and the extent of revenue expected or otherwise achievable. License fees for ESM assets usually consist of an advance paid on execution of the contract, which is then recouped against contingent royalty streams payable to the licensor over the term of rights granted. Accordingly, a bidder may need to adjust the preliminary value ascribed to an asset because the asset may not actually realize revenue for the bidder, if ever, until much later in the exploitation cycle, depending on the amount of the advance and the asset's success in the marketplace.

Assignment Provisions

The transaction structure may necessitate an assignment of rights or agreements to the bidder. Assignment provisions are particularly important in the ESM context because licensees may not assign certain intellectual property rights (e.g., trademark, rights of publicity and nonexclusive licenses of copyright) without the licensors' express consent. The U.S. Court of Appeals for the Ninth Circuit even held in a widely criticized case that exclusive licenses of copyright that are silent on assignability may not be assigned without consent. Gardner v. Nike Inc. , 279 F.3d 774 (9th Cir. 2002). A decision from the U.S. District Court for the Northern District of California, SQL Solutions Inc. v. Oracle Corp., C-91-1079 (N.D.Calif. 1991), also suggested that the transaction structure may unintentionally trigger assignment issues. Citing the general rule in California that an assignment of rights occurs through a change in the legal form of ownership of a business, the SQL court held that a reverse triangular merger ( e.g. , when a bidder forms a subsidiary to acquire the target company) results in an assignment of a nonexclusive copyright license by operation of law, thus requiring the licensor's consent. (In 2013, a Delaware Chancery Court, in Meso Scale Diagnostics LLC v. Roche Diagnostics GMBH , 62 A.3d 62 (Del. Ch. 2013), declined to follow the SQL court's lead and reached an opposite conclusion, but at least in California ' and potentially other jurisdictions ' bidders must be careful of the assignability issue.)

ESM assets, particularly high-grossing ones, are commonly subject to litigation claims. Opportunistic plaintiffs often file these claims, many of which are frivolous, on the eve of release to the public. Accordingly, although an ESM asset may be subject to a high number of claims, the analysis should focus on the underlying merit of these claims. Audit claims, whether actual or potential, may pose greater risks. The exploitation of ESM assets generates revenue in which third-party 'participants' and guild/union residual players (such as SAG-AFTRA, the Writers Guild of America and the Directors Guild of America) are entitled to share. A licensor typically retains the obligation to make these payments, but licensees (such as motion picture studios), which are entitled to recoup expenses before payment to these players, account and pay on a licensor's behalf. Because of the complex accounting practices of many licensees, audits often give rise to claims by these third parties, which may be substantial depending on the success of the asset.

Bidders seeking to acquire a professional sports franchise face other industry-specific considerations affecting the due diligence analysis. In assessing a team's value, a review of its stadium agreement for ownership or lease rights (and the duration of any such lease) and naming rights is critical. Valuation is also heavily driven by the availability of present and future media rights, which often intersect with media rights or revenue sharing granted to the league. Ownership of a team necessarily involves rights and obligations to the league as set forth in the team's franchise agreement. A bidder's success in acquiring a team will hinge on understanding this interplay and close coordination with the league.

As RAA made clear, an M&A bidder will have limited recourse against a target for misrepresentations in the due diligence process when reliance is explicitly contracted out (as it usually is). Accordingly, effective client representation calls for in-house counsel's strategic involvement in the diligence process beyond the traditional role of safe-keeper of legal issues affecting the corporation.

Conclusion

In light of the significant costs that any due diligence exercise entails, in-house legal counsel today is thrust into a hybrid role ' de facto business adviser tasked with identifying and exploiting industry-specific value drivers and facilitating company goals, while also assessing and managing increasingly intricate legal and business risks. Engaging outside counsel with industry-specific expertise and familiarity with the assets involved is often key to mastering the process and achieving optimal results.

Sean A. Monroe is a partner in O'Melveny & Myers Mergers and Acquisitions Practice. In addition to his broad experience in a range of M&A, private equity and corporate finance transactions, he handles corporate, securities and other aspects of entertainment transactions, including motion-picture financings, acquisition due diligence and evaluation, and distribution arrangements. Jeannine Tang and Silvia Vannini are associates in O'Melveny & Myers' Entertainment, Sports and Media Practice. All of the authors are based in the firm's Century City, CA, office.