Justia.com Opinion Summary: This case involved a dispute over earn-out payments related to a merger between Viacom and Harmonix where plaintiff was one of the selling stockholders of Harmonix. Plaintiff sued on behalf of the selling stockholders, alleging that Viacom and Harmonix purposefully renegotiated the distribution contract with EA so as to reduce the earn-out payments payable to the Harmonix stockholders, and thus breached the covenant of good faith and fair dealing implied in the Merger Agreement. The court dismissed plaintiff's claim and held that it would be inequitable for the court to imply a duty on Viacom and Harmonix's part to share with the selling stockholders the benefits of a renegotiated contract addressing EA's right to distribute Harmonix products after the expiration of the earn-out period.
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IN THE COURT OF CHANCERY OF THE STATE OF DELAWARE
WALTER A. WINSHALL, in his capacity as
the Stockholders’ Representative,
Plaintiff,
v.
VIACOM INTERNATIONAL, INC., a
Delaware Corporation, and HARMONIX
MUSIC SYSTEMS, INC., a Delaware
Corporation,
Defendants.
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Civil Action No. 6074-CS
OPINION
Date Submitted: August 18, 2011
Date Decided: November 10, 2011
Gregory V. Varallo, Esquire, Scott W. Perkins, Esquire, RICHARDS, LAYTON &
FINGER, P.A., Wilmington, Delaware; David M. Schiffman, Esquire, Linton J. Childs,
Esquire, Jennifer Peltz, Esquire, SIDLEY AUSTIN LLP, Chicago, Illinois, Attorneys for
Plaintiff.
Stephen P. Lamb, Esquire, Joseph L. Christensen, Esquire, PAUL, WEISS, RIFKIND,
WHARTON & GARRISON LLP, Wilmington, Delaware; Leslie G. Fagen, Esquire,
Daniel J. Leffell, Esquire, PAUL, WEISS, RIFKIND, WHARTON & GARRISON LLP,
New York, New York, Attorneys for Defendants.
STRINE, Chancellor.
I. Introduction
This is a dispute over earn-out payments. In 2006, defendant Viacom
International, Inc., a media conglomerate whose portfolio includes such brands as MTV
and Nickelodeon, acquired defendant Harmonix Music Systems, Inc., a company best
known for creating the music-oriented video games Rock Band and Guitar Hero (the
“Merger”). Under a merger agreement entered into by Viacom, Harmonix and the selling
stockholders of Harmonix (the “Selling Stockholders”), including the plaintiff, Walter A.
Winshall, as the representative of the Selling Stockholders (the “Merger Agreement”),
Viacom promised the Selling Stockholders 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, 2007 and 2008.
About one year after the Merger closed, Harmonix released a new video game,
Rock Band, which was an immediate success. Harmonix had already entered into an
agreement with Electronic Arts, Inc. (“EA”) for the distribution of Rock Band through
March 2010, but the game’s popularity caused EA to want to renegotiate the contract in
order to gain a broader scope of rights to Rock Band and its sequels. Because of EA’s
interest in amending the distribution agreement, Harmonix and Viacom allegedly had an
opportunity to negotiate for an immediate reduction in distribution fees that would have
potentially increased the Selling Stockholders’ earn-out payments for 2008. But, at the
direction of Viacom, Harmonix did not amend its contract with EA so as to immediately
reduce its distribution fees. Rather, Harmonix and EA’s amended agreement involved a
reduction in distribution fees in upcoming years, after the expiration of the earn-out
1
period. The revised contract granted EA a number of important new rights having
nothing to do with EA’s already firm right to distribute Rock Band during 2008. These
new rights included a clarification of EA’s distribution rights to Rock Band sequels, an
expansion of EA’s distribution rights to cover Rock Band products made for handheld
gaming devices, and an obligation on the part of Harmonix to release The Beatles: Rock
Band or a comparable product during the term of the distribution agreement with EA.
Winshall sued Viacom and Harmonix on behalf of the Selling Stockholders,
alleging that Viacom and Harmonix purposefully renegotiated the distribution contract
with EA so as to reduce the earn-out payments payable to the Harmonix stockholders,
and thus breached the covenant of good faith and fair dealing implied in the Merger
Agreement. I dismiss Winshall’s claim.
Winshall would have me imply a duty on the part of Viacom and Harmonix to
take any opportunity during the earn-out period to increase the earn-out payment for
2008, regardless of whether that opportunity was offered to Viacom and Harmonix in
exchange for granting the counterparty rights to future assets in which the recipients of
the earn-outs had no reasonable expectancy interest. Even assuming that Viacom and
Harmonix intentionally forewent a possible opportunity to increase Harmonix’s profits
during the earn-out period, and structured the amended contract with EA so that Viacom
and Harmonix could enjoy all of the benefits for themselves, Viacom and Harmonix took
no steps to reduce any reasonable contractual expectation of the Selling Stockholders. It
would be inequitable for this court to imply a duty on Viacom and Harmonix’s part to
share with the Selling Stockholders the benefits of a renegotiated contract addressing
2
EA’s right to distribute Harmonix products after the expiration of the earn-out period.
The implied covenant of good faith and fair dealing is not a license for a court to make
stuff up, which is what Winshall seeks to have me do.
II. Factual Background
The following facts are drawn exclusively from Winshall’s amended complaint
(the “Amended Complaint”), the exhibits attached thereto, and the documents that it
incorporates. 1
A. Viacom Acquires Harmonix
On September 20, 2006, after the release and success of Harmonix’s video game
Guitar Hero, Viacom, Harmonix, the Selling Stockholders, and Winshall entered into the
Merger Agreement. 2 As a result of the Merger, which closed on October 27, 2006,
Harmonix became a wholly-owned subsidiary of Viacom. The Selling Stockholders
relinquished their shares in exchange for two forms of consideration. First, they were
paid $175 million in cash, due at closing. Second, they received the contingent right to
1
In certain circumstances, this court may consider the plain terms of documents incorporated in
the complaint without converting a motion to dismiss into one for summary judgment. See, e.g.,
Vanderbilt Income & Growth Assocs., L.L.C. v. Arvida/JMB Managers, Inc., 691 A.2d 609, 613
(Del. 1996) (explaining that there is an exception to the general Rule 12(b)(6) prohibition against
considering documents outside of the pleadings when the documents are “integral” to a
plaintiff’s claim and incorporated into the complaint); Hillman v. Hillman, 910 A.2d 262, 269
(Del. Ch. 2006) (considering the plain terms of written agreements that were integral to the
complaint in determining a motion to dismiss, among other things, a claim for breach of
contract).
2
The Merger Agreement designates Winshall as the “Stockholders’ Representative.” Am.
Compl. Ex. A (Agreement and Plan of Merger (September 20, 2006)) § 10.8(d). In that capacity,
he is the attorney-in-fact for the Selling Stockholders, and has the authority to enforce their rights
under the Merger Agreement.
3
be paid cash earn-outs for the years 2007 and 2008 based on the extent to which
Harmonix’s “Gross Profit” exceeded certain targets. 3
Under the Merger Agreement, Gross Profit is defined as the sum of “Product
Gross Profit” for all of Harmonix’s products, Product Gross Profit being the difference
between (i) the “Net Revenue” attributable to the product and (ii) the sum of all “Direct
Variable Costs” attributable to the product. 4 Direct Variable Costs consist of, among
other things, “distribution fees” and “royalties payable to third parties.” 5 As a result of
the Merger, the Selling Stockholders became entitled to receive cash payments equal to
three and a half times the excess, if any, over Gross Profit thresholds of $32 million in
2007 and $45 million in 2008. The amount of the earn-out payments was not subject to a
cap or ceiling.
In other words, the Selling Stockholders were entitled under the Merger
Agreement to potentially unlimited cash payments based on the cumulative financial
performance of all Harmonix products in the two years following the company’s
acquisition by Viacom. Notably, the Merger Agreement does not contain any provision
governing the operation of Harmonix during the earn-out period, nor does it contain any
efforts clause related to the earn-out payments. The Merger Agreement further provides
that both Winshall (as the Selling Stockholders’ representative) and Viacom are entitled
3
Id. § 2.1(c)(ii)(A)-(B).
Id. §§ 2.1(c)(ii)(I), 2.1(c)(ii)(N).
5
Id. § 2.1(c)(ii)(E).
4
4
to submit any disputes relating to the amounts of the 2007 and 2008 earn-out payments to
a “Resolution Accountant,” whose determination will be binding on the parties. 6
B. Harmonix Enters Into A Distribution Agreement With EA
On March 6, 2007, Harmonix entered into an agreement with EA for the
distribution of a new project, the video game Rock Band (the “Original EA Agreement”).
Under the Original EA Agreement, which had a term of three years and was set to expire
on March 6, 2010,7 Harmonix agreed to pay sales and other fees to EA for the
distribution of Rock Band. Winshall alleges that these fees were “one of the largest
single expenses incurred by Harmonix.” 8 The Original EA Agreement provided that, if
EA met a specified “sequel threshold” by earning a certain amount of revenues by the
six-month anniversary of Rock Band’s launch, it would receive the right to distribute
sequels to Rock Band. 9 If EA did not meet the sequel threshold requirement by the time
Harmonix began work on a sequel, it would receive a right of “first negotiation” to such
sequel. 10 The Original EA Agreement defines a “Sequel” as a game that has “content and
branding such that the ordinary user would regard it as a sequel version” of Rock Band. 11
It is clear on the face of the Original EA Agreement that Rock Band 2 would be a Sequel,
but not entirely clear that a derivative game involving a specific band, such as The
6
Id. § 2.4(c).
EA and Harmonix further agreed that the Original EA Agreement would “automatically renew
for additional one-year periods” unless either party gave the other advance notice of termination.
Christensen Aff. Ex. 1 (Licensing Agreement (March 6, 2007)) § 37(a).
8
Am. Compl. ¶ 34.
9
Christensen Aff. Ex. 1 (Licensing Agreement (March 6, 2007)) §§ 15(d), 15(e)(i).
10
Id. § 15(e)(ii).
11
Id. § 15(c).
7
5
Beatles: Rock Band, would be. 12 Furthermore, a Rock Band game made for a platform
not contemplated by the Original EA Agreement would not be a Sequel to which EA had
distribution rights. 13 Importantly, Harmonix was not obligated under the Original EA
Agreement to “propose or create a Sequel.” 14
When the Original EA Agreement was negotiated, Rock Band was still in
development, and Winshall alleges that the Original EA Agreement reflected the
uncertainty of Rock Band’s market potential “by setting a relatively high distribution fee
but giving Harmonix the right to renegotiate.” 15 But, the Amended Complaint does not
allege that the Original EA Agreement contained a renegotiation provision, and there is in
fact no provision in the Original EA Agreement that gives Harmonix the right to
renegotiate with EA based on Rock Band’s performance in the market. The “right to
renegotiate” referred to by Winshall is thus simply a right any party has to ask a
counterparty to consider amending a deal.
C. The Success Of Rock Band Gives Harmonix Leverage Over EA
When Rock Band was launched on November 20, 2007, it was a huge hit.
According to Winshall, “[a]fter only 15 months on the market, Rock Band surpassed $1
billion in retail game sales in North America.” 16 Rock Band’s immediate success
12
The Original EA Agreement specifies that “a video game with substantially the same title as
[Rock Band] with an added ‘II’ or ‘2’ and with similar game play for one or more of the
Authorized Platforms would be a Sequel.” Id.
13
Id. (“For clarity, only a video game for an Authorized Platform (i.e., Sony PlayStation 3,
Microsoft Xbox 360 or Nintendo Wii) may be a Sequel under this Agreement.”).
14
Id.
15
Pl. Br. at 3.
16
Am. Compl. ¶ 17.
6
following its launch made it possible for Viacom and Harmonix to renegotiate the terms
of the Original EA Agreement in 2008. Winshall alleges that “EA offered Harmonix a
reduction in 2008 distribution fees in order to retain the worldwide distribution rights to
Rock Band and its sequels.” 17 The Amended Complaint does not allege exactly when
renegotiations began or when EA offered this reduction in fees, but the Original EA
Agreement was not amended until October 2008, a mere two months before the end of
the final earn-out year. Instead of taking EA up on its offer of a 2008 fee reduction,
Viacom and Harmonix agreed to amend the Original EA Agreement so as to allow EA to
continue distributing Rock Band in 2008 for the same fees, while procuring reduced fees
in the future as well as certain other benefits that had no effect on the Selling
Stockholders’ potential earn-out payment for 2008.
D. What Did Viacom, Harmonix And EA Gain From Renegotiation?
It is worth pausing over the important differences between the Original EA
Agreement and the agreement as amended (the “Amended EA Agreement”), because
they are material to an analysis of Winshall’s claim. 18
The Amended EA Agreement broadened and clarified the scope of Rock Band
products to which EA had distribution rights. EA shored up its rights to Rock Band 2
(which was released in 2008) and a “Project 9” (which was under development by
17
Am. Compl. ¶ 37.
The amendments made to the Original EA Agreement are evidenced in a term sheet, dated
October 10, 2008, that was submitted by Viacom and Harmonix.
18
7
Harmonix at the time). 19 Project 9 was The Beatles: Rock Band. Under the Amended
EA Agreement, unlike under the Original EA Agreement, Harmonix was obligated to
develop The Beatles: Rock Band or a comparable product before the distribution
agreement expired. The Amended EA Agreement provided that, if The Beatles: Rock
Band was not released during the term of the agreement (which was extended to March
31, 2010), the term would extend to the last day of the quarter during which the game
was released, with a drop dead date of December 31, 2010. EA and Harmonix also
agreed that EA would have distribution rights to versions of Rock Band made for
handheld gaming devices (specifically, Sony PSP and Nintendo DS versions), which was
another right for which the Original EA Agreement had not specifically provided.
In exchange for this expansion of its distribution rights, EA agreed that
distribution fees would stay the same for Rock Band and Rock Band 2, but would be
reduced for The Beatles: Rock Band or any substitute project in the event that Harmonix
could not get the necessary rights from The Beatles. EA also made a firm commitment to
purchase millions of dollars of advertising from certain Viacom media outlets, and agreed
to pay “[r]oyalties for forecasted shipments in November and December 2008 . . . as an
advance no later than December 30, 2008.” 20 These payments were not otherwise due
until later periods. The benefits conferred on Harmonix and Viacom by the Amended EA
Agreement had no effect, positive or negative, on the amount of the 2008 earn-out
payment over what was expected under the Original EA Agreement. In other words,
19
Christensen Aff. Ex. 1 (Term Sheet: Amendment to the Licensing Agreement by and between
Harmonix and EA (October 10, 2008)) at 1.
20
Id. at 4.
8
these new benefits did not affect the inputs to the earn-out payment calculus set forth in
the Merger Agreement.
E. Winshall Sues Viacom And Harmonix
On March 28, 2011, Winshall filed the Amended Complaint in this court on behalf
of the Selling Stockholders. The Amended Complaint contains three counts, but I need
only address Count I for purposes of this opinion. In Count I, Winshall asserts that
Viacom and Harmonix breached their implied covenant of good faith and fair dealing
under the Merger Agreement by renegotiating the Original EA Agreement with the intent
to defer, until after the earn-out period, a reduction in fees that was justified by the high
volume of Rock Band sales in late 2007 and early 2008, thereby “manipulating and
reducing” the amount of the 2008 earn-out payment due to the Selling Stockholders. 21 In
other words, Winshall contends that, given the opportunity to renegotiate the EA
Agreement, Viacom and Harmonix were obligated to use that opportunity to lower the
distribution fees paid to EA in 2008 and, thus, increase the 2008 earn-out payment to the
Selling Stockholders.
III. Procedural Framework
Viacom and Harmonix have moved to dismiss Count I of Winshall’s complaint for
failure to state a claim upon which relief can be granted. 22
21
Am. Compl. ¶ 48.
In the alternative to their motion to dismiss, Viacom and Harmonix have moved under Court
of Chancery Rule 26(c) to stay this action pending the determination of certain disputes over the
amounts of the earn-out payments for 2007 and 2008 by the Resolution Accountant in
accordance with the terms of the Merger Agreement. Because I resolve the motion to dismiss in
Viacom and Harmonix’s favor, there is no need to address their motion to stay.
22
9
As recently reaffirmed by the Delaware Supreme Court, the pleading standards
governing a motion to dismiss under Court of Chancery Rule 12(b)(6) are minimal. 23
23
Cent. Mortg. Co. v. Morgan Stanley Mortg. Capital Holdings LLC, 27 A.3d 531, 536 (Del.
2011). In Central Mortgage, the Supreme Court seems to have had been persuaded by an
advocate that the Court of Chancery had altered Delaware’s approach to the Rule 12(b)(6)
pleading standard to conform to recent federal case law, notably Ashcroft v. Iqbal, 556 U.S. 662
(2009), and Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007). See Cent. Mortg. Co., 27 A.3d
at 537 (perceiving that the Court of Chancery had moved to adopt recent federal decisional law
such as Twombly and Iqbal). This appears to have in part inspired the Supreme Court to
articulate an approach to dismissal motions that builds on the most liberal federal approach. See
id. That very relaxed standard is the one articulated under Conley v. Gibson, stating that “a
complaint should not be dismissed for failure to state a claim unless it appears beyond doubt that
the plaintiff can prove no set of facts in support of his claim which would entitle him to relief.”
355 U.S. 41, 45-46 (1957). In fact, our Supreme Court has now suggested that “vague
allegations” that could “conceivably” conjure up a state of affairs that, while not supported by
pled facts, might support a cause of action, are sufficient to state a claim upon which relief may
be granted. Cent. Mortg. Co., 27 A.3d at 536-37. By this means, Central Mortgage seems to
have been intended to keep Delaware true to itself and immune from federal influence. See id. at
537 (“[W]e emphasize that, until this Court decides otherwise or a change is duly effected
through the Civil Rules process, the governing pleading standard in Delaware to survive a
motion to dismiss is reasonable ‘conceivability.’”).
What is to me regrettable if this is the case is that to the extent Twombly and other federal
cases were originally cited by this court, it was to emphasize that our Supreme Court – i.e., the
Delaware Supreme Court – had long put more rigor in Rule 12(b)(6) than its federal counterpart,
the United States Supreme Court. For years, this court had understood our Supreme Court to
require a plaintiff to plead non-conclusory facts that supported a cause of action. See, e.g., Price
v. E.I. DuPont de Nemours & Co., 26 A.3d 162, 166 (Del. 2011) (“We decline . . . to accept
conclusory allegations unsupported by specific facts . . . .”); Nemec v. Shrader, 991 A.2d 1120,
1125 (Del. 2010) (“We do not . . . blindly accept conclusory allegations unsupported by specific
facts . . . .”); Gantler v. Stephens, 965 A.2d 695, 704 (Del. 2009) (same); Feldman v. Cutaia, 951
A.2d 727, 731 (Del. 2008) (stating that “conclusory allegations need not be treated as true”); In
re Gen. Motors (Hughes) S’holder Litig., 897 A.2d 162, 168 (Del. 2006) (“A trial court is not . . .
required to accept as true conclusory allegations without specific supporting factual
allegations.”) (internal citation omitted); Solomon v. Pathe Commc’ns Corp., 672 A.2d 35, 38
(Del. 1996) (“[C]onclusions . . . will not be accepted as true without specific allegations of fact
to support them.”) (citing In re Tri-Star Pictures, Inc., Litig., 634 A.2d 319, 326 (Del. 1993)).
That, of course, did not mean that a plaintiff had to meet a particularized pleading standard when
pleading a cause of action under Rule 12(b)(6). See Malpiede v. Townson, 780 A.2d 1075, 108283 (Del. 2001) (contrasting the particularized pleading standard under Court of Chancery Rule
23.1 with the more lenient standard under Rule 12(b)(6)); Solomon, 672 A.2d at 39 (Del. 1996)
(same). But it did mean that conclusory allegations were insufficient and that the pleading of
factual allegations making out a cause of action was required. Hence, when this court cited to
Twombly in the case of Desimone v. Barrows, it was only to note that the federal courts seemed
10
When considering Winshall’s motion to dismiss, I must accept all well-pleaded factual
allegations in the Amended Complaint as true, accept even vague allegations in the
Amended Complaint as “well-pleaded” if they give the defendants notice of the claim,
draw all reasonable inferences in favor of the plaintiff, and deny the motion unless the
plaintiff could not recover under any “reasonably conceivable” set of circumstances
susceptible of proof. 24 I find that Winshall fails to meet even this minimal pleading
burden.
to be moving to a pleading standard more consistent with Delaware’s approach. See Desimone v.
Barrows, 924 A.2d 908, 928 (Del. Ch. 2007). That, critically, was the causal direction, not the
reverse one that seems to have been suggested by a party in Central Mortgage. Furthermore, by
using the phrase “plausible,” this court had no intention to engage in the fine linguistic slicing
games enjoyed by its federal counterparts. To this mind, if something is conceivable, it is
plausible. If something is implausible, it is inconceivable. See WEBSTER’S THIRD NEW
INTERNATIONAL DICTIONARY OF THE ENGLISH LANGUAGE 469, 1736 (G. & C. Merriam Company
1976) (defining “conceivable” to mean “capable of being conceived, imagined, or understood,”
or “logically possible,” and defining “plausible” to mean “superficially worth of belief:
credible”); see also ROGET’S DESK THESAURUS 405 (Random House, Inc. 1995) (identifying
“conceivable” as a synonym of “plausible”). In the hands of Marc Vetri, Daniel Boulud or
Mario Batali, thin slicing of this kind results in delightful salumi or charcuterie. For the purposes
of helping to formulate a workable pleading standard, I confess to finding such minute cutting to
have more false precision than utility.
Given the substantial costs of discovery, the burdens to the judicial system, and the drag
on economic efficiency that come with excessive litigation, there was substantial benefit to
Delaware’s long-standing approach to Rule 12(b)(6), which provided a fair and efficient
approach to determining which complaints passed go. One of the strengths of our common law
case-by-case approach is that individual cases that seem to be a departure can, with the context
provided by later cases, be seen to have had a more case-specific meaning and less systemic
effect. I am chary, therefore, about reading Central Mortgage as a marked departure from
Delaware’s longstanding tradition of requiring that a plaintiff plead sufficient non-conclusory
facts to support a pleading stage inference that a cause of action exists.
24
Cent. Mortg., 27 A.3d at 536.
11
IV. Legal Analysis
Under Delaware law, an implied covenant of good faith and fair dealing inheres in
every contract. 25 The implied covenant “requires a party in a contractual relationship to
refrain from arbitrary or unreasonable conduct which has the effect of preventing the
other party to the contract from receiving the fruits of the bargain.” 26 A party is liable for
breaching the covenant when its conduct “frustrates the overarching purpose of the
contract by taking advantage of [its] position to control implementation of the
agreement’s terms.” 27
The court must be mindful that the implied covenant of good faith and fair dealing
should not be applied to give plaintiffs contractual protections that “they failed to secure
for themselves at the bargaining table.” 28 In other words, the implied covenant is not a
license to rewrite contractual language just because the plaintiff failed to negotiate for
protections that, in hindsight, would have made the contract a better deal. 29 Rather, a
25
Dunlap v. State Farm Fire & Cas. Co., 878 A.2d 434, 442 (Del. 2005) (internal citation
omitted); see also Katz v. Oak Indus., 508 A.2d 873, 880 (Del. Ch. 1986) (“Modern contract law
has generally recognized an implied covenant to the effect that each party to a contract will act in
good faith towards the other with respect to the subject matter of the contract.”); Fitzgerald v.
Cantor, 1998 WL 842316, at *1 (Del. Ch. Nov. 10, 1998) (“All contracts are subject to an
implied covenant of good faith and fair dealing.”); 23 WILLISTON ON CONTRACTS § 63:22 (4th
ed. 2000) (“Every contract imposes an obligation of good faith and fair dealing between the
parties in its performance and its enforcement, and if the promise of the defendant is not
expressed by its terms in the contract, it will be implied.”).
26
Dunlap, 878 A.2d at 442 (internal citation omitted).
27
Id.
28
Aspen Advisors LLC v. United Artists Theatre Co., 861 A.2d 1251, 1260 (Del. 2004).
29
See Allied Capital Corp. v. GC-Sun Holdings, L.P., 910 A.2d 1020, 1032-33 (Del. Ch. 2006)
(“[I]mplied covenant analysis will only be applied when the contract is truly silent with respect
to the matter at hand, and only when the court finds that the expectations of the parties were so
fundamental that it is clear that they did not feel a need to negotiate about them.”); see also
Nemec v. Shrader, 991 A.2d 1120, 1126 (Del. 2010) (holding that, when conducting an analysis
12
party may only invoke the protections of the covenant when it is clear from the
underlying contract that “the contracting parties would have agreed to proscribe the act
later complained of . . . had they thought to negotiate with respect to that matter.” 30
Winshall argues that, because Viacom and Harmonix had the market power to
renegotiate the Original EA Agreement, and because an opportunity presented itself
whereby the amount of the 2008 earn-out payment could be increased, Viacom and
Harmonix had an implied obligation under the Merger Agreement to take that
opportunity. I find that Winshall has failed to allege facts that support a reasonable
inference that the Selling Stockholders did not get the benefit of their bargain under the
Merger Agreement. On these facts, even viewed in the light most favorable to Winshall,
the Selling Stockholders could not conceivably have had a reasonable expectation that
Viacom and Harmonix had a duty to renegotiate the Original EA Agreement to increase
the amount of earn-out payments the Selling Stockholders would receive.
A. Winshall Has Not Alleged Facts To Support A Claim For Breach Of The Implied
Covenant Of Good Faith And Fair Dealing
Keeping in mind the standard of review that I must apply at the motion to dismiss
stage, I assume for purposes of this decision that, when faced with a chance to renegotiate
the EA Agreement so as to either maximize the earn-out payments owed to the Selling
Stockholders or so as to confer a benefit on themselves, Viacom and Harmonix chose the
of whether a party breached the implied covenant of good faith and fair dealing, the court “must
assess the parties’ reasonable expectations at the time of contracting and not rewrite the contract
to appease a party who later wishes to rewrite a contract he now believes to have been a bad
deal.”).
30
Dunlap, 878 A.2d at 442 (citing Katz, 508 A.2d at 880).
13
latter course. I also assume that, although the Original EA Agreement was not amended
until October 2008, EA offered either a reduction in distribution fees for the remainder of
2008, or a retroactive reduction in distribution fees that would have covered all or part of
2008. Winshall does not plead that the fee reduction offered by EA would have had any
effect on the 2007 earn-out payment. Essentially, there was a contractual surplus
available to be had because of the opportunity presented by EA’s desire to enter into a
broader, more thorough agreement with Harmonix. The dispute here boils down to
whether Viacom and Harmonix’s decision to take this surplus for themselves rather than
use some of it to increase the potential payments to be made to the Selling Stockholders
constituted a breach of the implied duty of good faith and fair dealing under the Merger
Agreement.
I find that Winshall’s already tenuous argument buckles in light of two factors: (i)
although Viacom and Harmonix did not accept a reduction in 2008 distribution fees,
neither did they take action to increase the 2008 fees beyond what was expected under
the Original EA Agreement; and (ii) it is not conceivable that the benefits conferred on
Viacom and Harmonix by the renegotiation were offered in exchange for product sales in
which the Selling Stockholders had a valid expectancy interest – i.e., sales during 2008.
1. Viacom And Harmonix Did Not Impair The Selling Stockholders’
Rights Under The Merger Agreement
It is undisputed that, under the Merger Agreement, Viacom was obligated to pay
earn-out payments to the Selling Stockholders if Harmonix’s financial performance
exceeded certain targets. The distribution fees payable to EA under the Original EA
14
Agreement factored into the earn-out payment calculus because they made up part of the
“Direct Variable Costs” as defined in the Merger Agreement. But, Winshall does not
allege that Viacom or Harmonix took any actions to undermine Harmonix’s capacity to
generate profit below the level reasonably expected by the parties at the time that they
entered into the Merger Agreement. Rather, he argues that Viacom and Harmonix
breached the implied covenant of good faith and fair dealing by failing to take an
opportunity that would have increased the 2008 earn-out payment.
To my mind, there is a critical difference between Viacom and Harmonix’s actions
here and the actions of an acquiror who promises earn-out payments to the sellers of the
target business and then purposefully pushes revenues out of the earn-out period. It is
true that when a contract confers discretion on one party, the implied covenant of good
faith and fair dealing requires that the discretion – such as Viacom’s discretion in
controlling Harmonix after the Merger and during the earn-out period – be used
reasonably and in good faith. 31 Thus, for example, if Viacom and Harmonix had agreed
to pay double EA’s ask in distribution fees in 2008 in return for paying no distribution
fees in 2009, such an agreement would arguably be a breach of the implied covenant. In
that case, Viacom and Harmonix would be depriving the Selling Stockholders of their
reasonable expectations under the Merger Agreement by actively shifting costs into the
earn-out period that had no place there. But, “[a] party does not act in bad faith by
relying on contract provisions for which that party bargained where doing so simply
31
See Airborne Health, Inc. v. Squid Soap, LP, 984 A.2d 126, 146-47 (Del. Ch. 2009).
15
limits advantages to another party.” 32 Winshall would have me hold that the discretion
over the Harmonix business afforded to Viacom when it acquired Harmonix from the
Selling Stockholders was subject to an implied covenant of good faith that encompassed
not only a duty not to harm the Harmonix business so as to reduce Gross Profit for
purposes of calculating the earn-outs, but also to do everything it could to increase the
earn-out payments. As Viacom and Harmonix point out, “on [Winshall’s] logic,
Defendants would have been obligated to negotiate the distribution fees down to zero for
2008 to maximize the impact on the [earn out payment for 2008] and make up the
shortfall with higher payments thereafter – a commercially absurd outcome.” 33 This is
not a tenable application of the limited implied covenant of good faith and fair dealing.
Winshall’s argument is rendered even more inconceivable in light of the fact that
the Merger Agreement provided for unlimited earn-out payments to the Selling
Stockholders to the extent that Harmonix’s financial performance exceeded certain
thresholds. Using the implied covenant of good faith and fair dealing to imply an
obligation to maximize those already uncapped payments is simply not in line with the
reasonable expectations of the parties. To my mind, no reasonable commercial actor in
Viacom’s position at the time of the acquisition would agree not only to pay earn-outs
subject to no cap or ceiling, but also to be duty-bound to accept any opportunities that
would have the effect of increasing those earn-out payments during the relevant period.
Certainly, the Merger Agreement sets forth no such duty. Winshall’s claim here is an
32
33
Nemec, 991 A.2d at 1128.
Def. Reply. Br. at 10.
16
attempt to rewrite the terms of the Merger by having me imply such a duty into the
interstices of the 79-page, single-spaced Merger Agreement. This is exactly the kind of
rank contractual revisionism that courts must avoid when addressing implied covenant
claims. 34
Because the facts do not support an inference that Viacom and Harmonix acted to
deprive the Selling Stockholders of their reasonably expected benefits under the Merger
Agreement, this case is readily distinguishable from Keating v. Applus+ Technologies,
Inc., 35 a case that Winshall describes as “closely analogous” to the present one. 36 In
Keating, the stockholders of Keating Technologies sold their company to Applus. Under
the stock purchase agreement entered into by the parties, these selling stockholders were
entitled to earn-out payments based on revenues earned by Keating Technologies under
any new contracts signed during the six years after the sale. 37 Shortly after the earn-out
period expired, the company entered into a major contract. 38 The selling stockholders
sued, alleging that Applus “deliberately delayed” entering into the contract so that it
could avoid its earn-out obligations under the stock purchase agreement. 39 The court
held that the complaint stated a claim for breach of the implied covenant of good faith
and fair dealing, stating that “Applus cannot avoid its contractual obligations by creating,
34
See Cincinnati SMSA Ltd. P’ship v. Cincinnati Bell Cellular Sys. Co., 708 A.2d 989, 992 (Del.
1998) (“In cases where obligations can be understood from the text of a written agreement but
have nevertheless been omitted in the literal sense, a court’s inquiry should focus on what the
parties likely would have done if they had considered the issue involved.”) (internal citation
omitted).
35
2009 WL 261091 (E.D. Pa. Feb. 4, 2009) (applying Delaware law).
36
Pl. Br. at 17.
37
Keating, 2009 WL 261091, at *1.
38
Id.
39
Id.
17
in bad faith, an outcome that technically satisfies the express terms of the [stock purchase
agreement], but deprives plaintiffs of their legitimate expectations.” 40
Here, by contrast, the Selling Stockholders had no legitimate expectation that, if
Harmonix was offered a chance to renegotiate the amount of distribution fees payable
under a distribution agreement that was entered into after the Merger, the terms of which
are not challenged as unfair, it would choose a structure that benefited the Selling
Stockholders and increased the amount of already unlimited earn-out payments that it
was obligated to make under the Merger Agreement. Keating would be analogous to the
present case if Viacom and Harmonix had, for example, deliberately delayed the release
of Rock Band or Rock Band 2 until after the earn-out period expired. But, it is not alleged
that Viacom and Harmonix intentionally pushed revenue out of the earn-out period, or
that they purposely shifted costs into the earn-out period in exchange for reduced costs in
some future period.
2. The Amended EA Agreement Conferred Broader Rights In The Future
Winshall’s claim is not only inconceivable, its acceptance would be unfair. Why?
Because under the facts pled in the complaint and the documents that it incorporates, it is
clear that Winshall seeks to have the Selling Stockholders receive increased earn-out
payments based on assets – products to be sold after 2008 that EA wished to distribute –
in which the Selling Stockholders had no contractual expectancy. Winshall claims that
“the huge and immediate success of Rock Band . . . gave [Viacom and Harmonix] an
opportunity to negotiate for a reduction of the distribution fees in 2008 if EA wanted to
40
Id. at *4.
18
retain the distribution rights to Rock Band and its sequels.” 41 But, under the plain terms
of the Original EA Agreement , EA had distribution rights to Rock Band products until
March 2010. It is undisputed that EA had rights to the Rock Band products that entered
the market during the earn-out period – Rock Band and its sequel Rock Band 2. As
Viacom and Harmonix acknowledged at oral argument, these were the games in which
the Selling Stockholders clearly had an expectancy interest. 42 But that interest only
extended to the sales of these games in 2007 and 2008, not to sales made in later periods.
The question then becomes, why did EA want to renegotiate its agreement with
Harmonix in 2008, when it already had the distribution rights to Rock Band and Rock
Band 2 until 2010? Given the absence of a renegotiation provision in the Original EA
Agreement based on Rock Band’s performance, Winshall’s allegation makes sense only if
I assume that EA was offering a reduction in 2008 distribution fees in return for new
benefits. Even Winshall does not suggest, and it would be unreasonable to assume, that
EA wanted to renegotiate because it charitably decided that it was too much in the plush
with the distribution fees payable by Harmonix under the Original EA Agreement. It was
just embarrassed to be doing so well! Not “reasonably conceivable” to me. 43
Rather, as a reasonable commercial actor, EA must have wanted some extension
of its distribution rights to Rock Band products. Nothing in the Amended Complaint
41
Am. Compl. ¶ 34.
At oral argument, counsel for Viacom and Harmonix stated that he thought “anything that was
on the market in 2008 is part of the earn-out period.” Winshall v. Viacom Int’l, Inc., C.A. No.
6074, at 80 (Del. Ch. Aug. 18, 2011) (TRANSCRIPT).
43
Cent. Mortg. Co. v. Morgan Stanley Mortg. Capital Holdings LLC, 27 A.3d 531, 536 (Del.
2011). In fact, I do not find it “rationally” conceivable, if a more liberal point of view is
required. Cf. Cerberus Int’l, Ltd. v. Apollo Mgmt., L.P., 794 A.2d 1141, 1150-51 (Del. 2002).
42
19
rationally supports an inference that Harmonix could have pulled the plug on the Original
EA Agreement in 2008, before the end of the earn-out period. EA would not offer
concessions in return for any 2008 Rock Band products, because it already had the
contractual rights to Rock Band and Rock Band 2, which were the Rock Band games
released during that year. I can only infer that EA was trying to button up its rights to
future products in future periods – products that were released after the expiration of the
earn-out period and in which the Selling Stockholders had no reasonable expectancy
interest.
This is the only inference rationally supported by the Amended Complaint and the
relevant contracts that it incorporates. These documents make clear that the key
concession that EA got in return for amending the Original EA Agreement was a
guaranteed right to The Beatles: Rock Band, a game that was still in development during
the earn-out period. Before entering into the Amended EA Agreement, Harmonix was
not required to produce any sequels to Rock Band. After the amendment, Harmonix had
an obligation to develop and launch The Beatles: Rock Band – or a comparable product –
during the term of its distribution agreement with EA. Given the enduring and justifiable
popularity of John, Paul, George, and Ringo,44 and the gangbuster performance of the
original Rock Band pled in the Amended Complaint, the only fair inference to draw here
is that the distribution rights to The Beatles: Rock Band were a coveted ticket.
It also bears noting that the Amended EA Agreement provided that EA would
have the right to distribute versions of Rock Band made for handheld gaming devices.
44
I mean, really, what group is better? Sorry Stones fans, but the Liverpool lads rule.
20
Again, this demonstrates an expansion of the scope of EA’s rights under the Original EA
Agreement. EA was bargaining with Viacom and Harmonix for broader opportunities in
the future, not for the rights that it already had. Thus, Winshall’s argument fails in that
the Selling Stockholders had no expectancy interest in the products covered by the new
agreement.
In fact, what Winshall proposes is that Viacom had a duty to apply consideration
that EA was offering for products that would be on the market after 2008 and in which
the Selling Stockholders therefore had no expectancy and bestow it on the Selling
Stockholders. Thus, the implied covenant of good faith and fair dealing, in Winshall’s
view, requires that a party to an agreement not simply refrain from upsetting the
fundamental expectations of the other party, as implied by the explicit terms of the deal,
but actually improve that deal by expanding its contractual counterparty’s expectancy as
a matter of judicially compelled charity, not toward a 501(c)(3), but toward another
sophisticated commercial actor. Delaware law does not imply such an extraordinary
duty, which would be a fundamentally unfair judicial rewriting of a contract.
A. Winshall Does Not Survive The Motion To Dismiss
Because Of The Missing Schedule L
Winshall does not allege in his Amended Complaint that Harmonix had any
contractual right to terminate the Original EA Agreement before it expired in March
2010, and thereby deprive EA of distribution rights to Rock Band and Rock Band 2
during the earn-out period. But, at oral argument, Winshall’s counsel raised for the first
time the issue of a side agreement to the Original EA Agreement, as provided for in
21
Exhibit L to the Original EA Agreement, never having been completed. He orally
speculated that the absence of the agreement contemplated by Exhibit L was evidence of
why EA came forward to offer inducements to renegotiate the Original EA Agreement,
including a reduction in 2008 distribution fees.
The Original EA Agreement provides, in relevant part:
EA’s rights and obligations to distribute [Rock Band products] . . .
are conditioned upon the agreement by Harmonix and EA upon a
Minimum Royalty Base and Minimum Sales Deduction therefor,
whether in Schedule L, or by separate written agreement of the
parties. To the extent that these amounts are not set forth on
Schedule L, then the Parties will use their best efforts to agree on
such amounts in writing in signed amendment to this Agreement on
or before May 31, 2007.45
Schedule L, which is attached to the Original EA Agreement, does not set forth all of
these amounts. Winshall’s counsel claimed at oral argument that they were never agreed
upon, that no “signed amendment” was executed on or before May 31, 2007, and that
Harmonix therefore had the right to terminate the Original EA Agreement at a time when,
due to the success of Rock Band, it had enormous leverage over EA. I reject this
argument.
First, this argument was never fairly made in the Amended Complaint or in
Winshall’s brief in opposition to Viacom and Harmonix’s motion to dismiss. There is no
allegation of any insecurity on the part of EA about an undefined Minimum Royalty Base
and Minimum Sales Deduction. This argument was therefore not fairly or timely
45
Christensen Aff. Ex. 1 (Licensing Agreement (March 6, 2007)) § 27(c).
22
presented and was waived. 46 Second, Winshall’s attempt to portray Schedule L as the
lynchpin to the entire Original EA Agreement strains credulity and my concept of
conceivability. It is undisputed that EA began and continued to distribute Rock Band
(which was launched well after May 31, 2007) under the Original EA Agreement without
interruption and with great success for Viacom and Harmonix. I cannot plausibly infer,
given what Winshall has himself pled about the success of Rock Band, that the failure to
have a locked-in Exhibit L to the Original EA Agreement gave Viacom a clear right to
terminate the contract without having any obligation to negotiate the amounts of the
Minimum Royalty Base and Minimum Sales Deduction in good faith, when the Original
EA Agreement plainly states that the parties will use their “best efforts” to negotiate such
amounts. 47 Furthermore, the facts alleged in the Amended Complaint themselves suggest
that EA initiated negotiating in 2008, that it entered a revised agreement with Harmonix
securing important rights beyond 2008, and therefore that EA was offering a concession
for future rights in periods after the earn-out expired (i.e., to The Beatles: Rock Band),
not to secure what it already had a firm right to in 2008 – the right to distribute Rock
Band and Rock Band 2 in that year.
V. Conclusion
For the foregoing reasons, Viacom and Harmonix’s motion to dismiss is
GRANTED. IT IS SO ORDERED.
46
See, e.g., Thor Merritt Square, LLC v. Bayview Malls LLC, 2010 WL 972776, at *5 (Del. Ch.
Mar. 5, 2010); Franklin Balance Sheet Inv. Fund v. Crowley, 2006 WL 3095952, at *4 (Del. Ch.
Oct. 19, 2006); Criden v. Steinberg, 2000 WL 354390, at *4 (Del. Ch. Mar. 23, 2000).
47
Christensen Aff. Ex. 1 (Licensing Agreement (March 6, 2007)) § 27(c).
23
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