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Herman Law LLC » Drafting Tips from Recent Chancery Court Decision in Viacom “RockBand” Debacle
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Drafting Tips from Recent Chancery Court Decision in Viacom “RockBand” Debacle

Posted on Jan 27th, 2013

Drafting Tips from Recent Delaware Chancery Court Decision in Viacom “RockBand” Debacle

The most recent decision in the saga between Viacom and Harmonix – the maker of “RockBand” – awards $12 million to the seller stockholders of Harmonix for amounts held in escrow to back up their indemnity to Viacom. Even though four separate claims for infringement of intellectual property were brought against Harmonix after the closing, and the Harmonix executives admitted that they were aware of the other patents that led to the claims, the Court found that the seller did not breach its representations and warranties in the merger agreement and that Viacom did not have a right to an indemnity against the escrow. As one can imagine, this case brings up some interesting drafting issues worth considering before your next M&A deal.

In September 2006 Viacom bought Harmonix for a cash payment of $175 million plus an earn-out based on Harmonix’s earnings for 2007 and 2008. The deal included a $12 million 18-month escrow to indemnify Viacom for losses from breaches by Harmonix of its representations and warranties. At the time of the deal, GuitarHero had already been released, but other products such as RockBand were still in the works. Since intellectual property was likely a key asset in the transaction, there were a number of representations by Harmonix relating to its intellectual property. As discussed below, those reps were qualified in various ways, and those qualifications made the difference in this decision.

After the closing, four different sets of patent, trademark and copyright infringement claims were brought against the acquired business. While some of those claims had been raised prior to the closing and disclosed to Viacom, others were not. Viacom took on the claims, spending almost $30 million in legal fees, and then sought to set off its losses against the escrow, claiming a right under the indemnification provisions in the merger agreement. The Delaware Chancery Court disagreed.

Viacom argued that the seller stockholders had a duty to defend pending the determination of whether there was a duty to indemnify. Distinguishing a number of earlier decisions, the Court strictly construed the indemnification clause in the merger agreement to read that there was no separate no duty to defend unless there was an underlying duty to indemnify. The duty to defend arises from specific contract language and guarantees coverage independent of the outcome of the legal conflict it covers; the duty covers the cost of defending the claim regardless of the claim’s merit. However, indemnification involves the guarantee by the party to cover any judgment against the other party. Viacom wanted its legal fees independent of the outcome of the legal conflicts, but it was only indemnified against judgments in those cases (if at all). So, from a buyer’s perspective, one drafting consideration would be to clearly separate a duty to defend as one of the remedies in the agreement, potentially limiting that obligation to specific claims or litigations that may have been known or foreseen at the time of the closing.

Here, a right to indemnity arose only from breaches of representations and warranties of the merger agreement. It is important to note that had there been a separate indemnification obligation for third party claims arising from any intellectual property of Harmonix, or relating to business conduct prior to the closing, the outcome of this case may have been very different.

To determine whether there was a breach, the Court focused on two types of reps relating to the intellectual property. The first represented that the Company had sufficient rights to all intellectual property as necessary for the “current use” of its products. Because the claims for which Viacom sought indemnity related to the commercial version of RockBand, which was only in prototype stage at the time of the deal, the Court found that there was no breach.

It is worth noting that there could have been a claim here if the language specifically included the underlying intellectual property in the prototypes or other works in process, as integrated into the final work product. Also, while there was a broader representation regarding rights in “Company Developed Software”, that particular term also did not expressly include RockBand.

The other representations at issue related to potential infringement and were qualified by knowledge.While the Court agreed that management did have knowledge of the other parties’ patents, the crucial distinction here is that Viacom could not show that management had knowledge that they Harmonix’ products were infringing on those patents. That said, it is a bit surprising that there was no special indemnity for claims arising from that known third party intellectual property.

While it is easy to critique with 20/20 hindsight, the scenario represented in this decision is not uncommon and presents a good case study. Hundreds of startups each year are acquired for their talent and nascent technology, and buyers often take over product direction after the closing. Particularly with the explosion in patent troll litigation, often brought after the announcement of an acquisition (or investment) to target the buyer’s deeper pockets, the risk of infringement litigation that relates back to the pre-closing period is significant. In that situation, as here, sellers should look to limit their liability to current technology and known infringement, shifting the freedom to operate and infringement risks on the buyer. On the other hand, buyers would be well-advised to look for broader indemnification obligations with longer survival periods (and lots of exceptions and exclusions for key material reps), with an express duty to defend, for any third party infringement claims relating to the sellers’ products that existed at the time of the transaction, whether in a final production or prototype stage.

If you have any questions about this topic, please feel free to email us.