Earn-Out Payments In <i>Rock Band</i> Video Game at Issue in Delaware Case

Attorneys for Viacom International Inc. told the Delaware Supreme Court in oral arguments in July that their client did not breach the implied covenant of good faith and fair dealing when it failed to renegotiate an agreement with Electronic Arts Inc. (EA) to distribute the video game Rock Band , thereby reducing the earn-out payments to shareholders of the game's developer, Harmonix Music Systems Inc., which merged with the Viacom entertainment conglomerate in 2006. Viacom's attorneys presented their case to the high court after Harmonix's shareholders appealed a Delaware Court of Chancery decision that dismissed their claims that Viacom purposely sought to reduce Harmonix's earn-out payments.

As the state supreme court mulls the parties' arguments in Winshall v. Viacom, in a separate, but related development in July it affirmed the chancery court's decision to uphold an arbitrator's $298.8 million award to shareholders who claimed they were shortchanged out of the earn-out payments in 2008. Viacom International Inc. v. Winshall, 513. Viacom contended the award should only be $191 million because it should be permitted to write down the cost of unsold games.

In upholding the chancery court's decision, the Delaware Supreme Court decided that BDO USA LLP, which arbitrated the earn-out dispute, was correct when it refused to consider evidence presented by Viacom. “If the subject matter to be arbitrated is the calculation of an earn-out ' all issues as to what financial or other information should be considered in performing the calculation are decided by the arbitrator,” said Justice Carolyn Berger.

Meanwhile, during oral arguments before the en banc state supreme court in Winshall v. Viacom, Viacom's attorney Robert A. Atkins of Paul, Weiss, Rifkind, Wharton & Garrison told the court there was no language in the 2006 merger agreement between Harmonix and Viacom requiring the defendant to maximize the shareholders' earn-out payments.

However, Shawn J. Rabin of Susman Godfrey argued on behalf of Harmonix shareholders that Viacom purposely sought to frustrate his clients' efforts to recoup all of the earn-out payments they were entitled to under the 2006 merger agreement. “Recognizing that our client received a lot of earn-out payments, they did not want our client to receive all of the earn-out payments which they were entitled,” Rabin said. “They did not receive the full benefit of their bargain. I admit they received partial benefit of their bargain, but they are entitled, under contract, to the full benefit of their bargain.”

Walter Winshall, an early investor in Harmonix, was designated as proxy on behalf of the company's shareholders, which filed several complaints against Viacom over the marketing and distribution of Rock Band.

In a 2010 complaint filed in the chancery court, Harmonix alleged that Viacom breached the implied covenant of good faith and fair dealing. According to court documents, under the 2006 merger agreement Viacom promised Harmonix's shareholders an up-front payment of $175 million for their shares, as well as the contingent right to receive uncapped earn-out payments based on Harmonix's financial performance in the two years following the merger.

Harmonix released Rock Band in 2007 and already had an agreement in place with EA to distribute Rock Band through March 2010. However, EA wanted to renegotiate the contract in 2008 in order to increase its rights to the game and its sequels, according to the court documents. Harmonix's shareholders allege that Viacom thwarted their efforts to renegotiate a contract that would have increased their earn-out payments for 2008. The appellant shareholders also allege that under Viacom's direction, Harmonix negotiated a contract that reduced Harmonix's distribution fees in upcoming years after the earn-out period had expired.

Chancery Court Chancellor Leo E. Strine Jr. had dismissed the shareholder lawsuit in a November 2011 decision, ruling that Viacom and Harmonix were not obligated to increase their earn-out payments for 2008 regardless of the opportunities offered to the defendants. Winshall v. Viacom International Inc., 55 A.3d 629 (Del. Ch. 2011).

Rabin told the justices that Strine erred by basing his decision on the language of the March 2007 distribution agreement between Harmonix and EA instead of the September 2006 merger agreement between Harmonix and Viacom. “What the lower court did was it failed to look at the reasonable expectations of the parties at the time of contracting, which was September 2006,” Rabin argued. “Instead, the lower court looked to the reasonable expectations of the party in March 2007, five months later when a document called the 2007 original distribution agreement was signed. It is from this error from looking at the reasonable expectations of the parties five months after the court should have engaged in the inquiry that the motion to dismiss was improperly granted.”

Viacom counsel Atkins countered by telling the supreme court that Strine correctly found that the 2006 merger agreement did not create any expectations that Harmonix would take all steps to maximize the shareholder earn-out. “I think that Chancellor Strine got it exactly right in terms of the temporal analysis,” Rabin said. “He looked at the bargain and the expectations of the parties at the time of the merger agreement and what he found was that there was no bargain and there were no expectations that were denied. There was no bargain in express terms between parties requiring Viacom to maximize the earn-out or increase the earn-out given the opportunity. What is critical here is that these were extremely sophisticated and knowledgable parties about this business.”

Costs

Viacom also filed a cross-appeal with the Delaware supreme court seeking to overturn Strine's December 2012 ruling that the merger agreement did not require Harmonix's shareholders to cover Viacom's defense costs in the lawsuits filed over Rock Band. Under Strine's decision, Viacom is responsible for its own defense costs.

Atkins told the supreme court that Harmonix agreed to indemnify Viacom's defense costs over any third-party lawsuits arising from intellectual property lawsuits filed over the rights to Rock Band. He added that the game was still in development at the time of the merger agreement and the indemnification provisions were necessary to entice the company. Furthermore, Atkins claimed that indemnification provisions appear twice in the agreement. “The agreement, and I think this is critical, provides that where Viacom continues to defend, the stockholder's representative is obligated to pay for the cost,” he said. “It says that explicitly.”

David M. Schiffman of Sidley Austin represented the shareholders on this, arguing that Viacom was not entitled to attorney fees because the indemnification provisions only covered situations in which a court found actual copyright infringement and did not cover mere allegations of infringement. “We did not give a warranty against claims of infringement,” he said. “We gave a warranty against actual infringement.”

Schiffman added that if Harmonix was responsible for Viacom's defense costs in situations where infringement was not proven, it would have been explicitly stated in the merger agreement. “You can design a contract which says that I will indemnify against any claims arising from events before the closing or any claims involving environmental use of the property or any claims about activities before the closing but that's not what this contract said,” Schiffman continued. “This was a contract about the representations that there was no infringement.”

Jeff Mordock is a Reporter for Delaware Business Court Insider, an ALM affiliate of Entertainment Law & Finance.

Attorneys for Viacom International Inc. told the Delaware Supreme Court in oral arguments in July that their client did not breach the implied covenant of good faith and fair dealing when it failed to renegotiate an agreement with Electronic Arts Inc. (EA) to distribute the video game Rock Band , thereby reducing the earn-out payments to shareholders of the game's developer, Harmonix Music Systems Inc., which merged with the Viacom entertainment conglomerate in 2006. Viacom's attorneys presented their case to the high court after Harmonix's shareholders appealed a Delaware Court of Chancery decision that dismissed their claims that Viacom purposely sought to reduce Harmonix's earn-out payments.

As the state supreme court mulls the parties' arguments in Winshall v. Viacom, in a separate, but related development in July it affirmed the chancery court's decision to uphold an arbitrator's $298.8 million award to shareholders who claimed they were shortchanged out of the earn-out payments in 2008. Viacom International Inc. v. Winshall, 513. Viacom contended the award should only be $191 million because it should be permitted to write down the cost of unsold games.

In upholding the chancery court's decision, the Delaware Supreme Court decided that BDO USA LLP, which arbitrated the earn-out dispute, was correct when it refused to consider evidence presented by Viacom. “If the subject matter to be arbitrated is the calculation of an earn-out ' all issues as to what financial or other information should be considered in performing the calculation are decided by the arbitrator,” said Justice Carolyn Berger.

Meanwhile, during oral arguments before the en banc state supreme court in Winshall v. Viacom, Viacom's attorney Robert A. Atkins of Paul, Weiss, Rifkind, Wharton & Garrison told the court there was no language in the 2006 merger agreement between Harmonix and Viacom requiring the defendant to maximize the shareholders' earn-out payments.

However, Shawn J. Rabin of Susman Godfrey argued on behalf of Harmonix shareholders that Viacom purposely sought to frustrate his clients' efforts to recoup all of the earn-out payments they were entitled to under the 2006 merger agreement. “Recognizing that our client received a lot of earn-out payments, they did not want our client to receive all of the earn-out payments which they were entitled,” Rabin said. “They did not receive the full benefit of their bargain. I admit they received partial benefit of their bargain, but they are entitled, under contract, to the full benefit of their bargain.”

Walter Winshall, an early investor in Harmonix, was designated as proxy on behalf of the company's shareholders, which filed several complaints against Viacom over the marketing and distribution of Rock Band.

In a 2010 complaint filed in the chancery court, Harmonix alleged that Viacom breached the implied covenant of good faith and fair dealing. According to court documents, under the 2006 merger agreement Viacom promised Harmonix's shareholders an up-front payment of $175 million for their shares, as well as the contingent right to receive uncapped earn-out payments based on Harmonix's financial performance in the two years following the merger.

Harmonix released Rock Band in 2007 and already had an agreement in place with EA to distribute Rock Band through March 2010. However, EA wanted to renegotiate the contract in 2008 in order to increase its rights to the game and its sequels, according to the court documents. Harmonix's shareholders allege that Viacom thwarted their efforts to renegotiate a contract that would have increased their earn-out payments for 2008. The appellant shareholders also allege that under Viacom's direction, Harmonix negotiated a contract that reduced Harmonix's distribution fees in upcoming years after the earn-out period had expired.

Chancery Court Chancellor Leo E. Strine Jr. had dismissed the shareholder lawsuit in a November 2011 decision, ruling that Viacom and Harmonix were not obligated to increase their earn-out payments for 2008 regardless of the opportunities offered to the defendants. Winshall v. Viacom International Inc., 55 A.3d 629 (Del. Ch. 2011).

Rabin told the justices that Strine erred by basing his decision on the language of the March 2007 distribution agreement between Harmonix and EA instead of the September 2006 merger agreement between Harmonix and Viacom. “What the lower court did was it failed to look at the reasonable expectations of the parties at the time of contracting, which was September 2006,” Rabin argued. “Instead, the lower court looked to the reasonable expectations of the party in March 2007, five months later when a document called the 2007 original distribution agreement was signed. It is from this error from looking at the reasonable expectations of the parties five months after the court should have engaged in the inquiry that the motion to dismiss was improperly granted.”

Viacom counsel Atkins countered by telling the supreme court that Strine correctly found that the 2006 merger agreement did not create any expectations that Harmonix would take all steps to maximize the shareholder earn-out. “I think that Chancellor Strine got it exactly right in terms of the temporal analysis,” Rabin said. “He looked at the bargain and the expectations of the parties at the time of the merger agreement and what he found was that there was no bargain and there were no expectations that were denied. There was no bargain in express terms between parties requiring Viacom to maximize the earn-out or increase the earn-out given the opportunity. What is critical here is that these were extremely sophisticated and knowledgable parties about this business.”

Costs

Viacom also filed a cross-appeal with the Delaware supreme court seeking to overturn Strine's December 2012 ruling that the merger agreement did not require Harmonix's shareholders to cover Viacom's defense costs in the lawsuits filed over Rock Band. Under Strine's decision, Viacom is responsible for its own defense costs.

Atkins told the supreme court that Harmonix agreed to indemnify Viacom's defense costs over any third-party lawsuits arising from intellectual property lawsuits filed over the rights to Rock Band. He added that the game was still in development at the time of the merger agreement and the indemnification provisions were necessary to entice the company. Furthermore, Atkins claimed that indemnification provisions appear twice in the agreement. “The agreement, and I think this is critical, provides that where Viacom continues to defend, the stockholder's representative is obligated to pay for the cost,” he said. “It says that explicitly.”

David M. Schiffman of Sidley Austin represented the shareholders on this, arguing that Viacom was not entitled to attorney fees because the indemnification provisions only covered situations in which a court found actual copyright infringement and did not cover mere allegations of infringement. “We did not give a warranty against claims of infringement,” he said. “We gave a warranty against actual infringement.”

Schiffman added that if Harmonix was responsible for Viacom's defense costs in situations where infringement was not proven, it would have been explicitly stated in the merger agreement. “You can design a contract which says that I will indemnify against any claims arising from events before the closing or any claims involving environmental use of the property or any claims about activities before the closing but that's not what this contract said,” Schiffman continued. “This was a contract about the representations that there was no infringement.”

Jeff Mordock is a Reporter for Delaware Business Court Insider, an ALM affiliate of Entertainment Law & Finance.