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No Revisionist History: Supreme Court of Delaware Narrowly Interprets Post-Closing Obligations Under Representations and Warranties, Earn-out and Indemnification Provisions

Corporate Law and Directors & Officers Alert | October 18, 2013
By: Lori S. Smith, Maurice Pesso and Ariel Fliman

On October 8, 2013, the Supreme Court of Delaware issued an opinion upholding a Court of Chancery decision which narrowly interprets earn-out and indemnification obligations under a merger agreement.  The Court’s decision in Winshall v. Viacom International Inc. et al., which showcases the Court’s strict adherence to the agreement’s express terms, highlights the implications of clearly defining the parties’ respective post-transaction responsibilities and obligations.

Background

Winshall arises from the 2006 merger of Viacom International Inc. and Harmonix Music Systems, Inc., a developer of video games such as “Rock Band” and “Guitar Hero.”  The companies’ merger agreement (the “Merger Agreement”) provided that Viacom would acquire Harmonix for $175 million in total consideration, of which $12 million would be held in escrow for 18 months.  Harmonix shareholders also received a right to uncapped earn-out payments based on Harmonix’s financial performance for two years after the merger.  The Merger Agreement did not include any express provision which required that the post-merger business be conducted so as to ensure or maximize the earn-out payments.  The Merger Agreement also provided that Harmonix’s selling shareholders had an obligation to indemnify Viacom, the surviving corporation in the merger, and their respective affiliates “against and hold them harmless from and against any and all Losses” based upon, arising out of, or by reason of any breach of the sellers’ representations and warranties.  The escrow funds would be available to  indemnify Viacom for losses attributable to breaches of those representations and warranties, such as third-party claims for intellectual property infringement.  However, the selling shareholders were obligated to cover any indemnifiable losses above the escrow amount from the monies otherwise payable under the earn-out.  Viacom was required to give notice of any claim in respect of a third party as to which it may request indemnification.  Further, Viacom had the right to direct the defense or settlement of any such claim at the expense of the applicable indemnifying parties. 

At the time of the merger, Harmonix was developing the “Rock Band” video game, a product that would achieve enormous success when it was released to the public.  Shortly after the merger, Harmonix entered into an agreement with Electronic Arts (EA) to distribute “Rock Band” in exchange for the payment to EA of distribution fees.  These distribution fees became an important component of the earn-out amount due to the selling shareholders because it was one of the largest single-post merger expenses that Harmonix incurred.  The huge success of “Rock Band” would result in a significant increase in the earn-out payment that otherwise would have been due to the selling shareholders.  However, the distribution fees payable to EA had an offsetting effect of reducing the amount of such earn-out payments attributable to “Rock Band.”  As a result of the success of “Rock Band,” Viacom had an opportunity to renegotiate its agreement with EA.  In 2008, EA and Harmonix entered into an amended licensing agreement that extended the term of the original agreement and expanded EA’s right to distribute additional games.  During the negotiations, EA offered to reduce the 2008 distribution fees in exchange for receiving other benefits, but Viacom and Harmonix did not accept that proposal.  Instead, the amended agreement left the 2008 distribution fees unchanged and reduced the distribution fees for years beginning in 2009.  The amended agreement also accelerated into 2008 certain payments due to Harmonix from EA that would otherwise have been paid in early 2009.  

During 2007 and 2008, four claims for violation of intellectual property rights were asserted by third parties against Harmonix arising out of “Rock Band.”  Before the escrow period ended, Viacom sought indemnity from the escrow funds for its defense costs in connection with three of these claims, which alleged that “Rock Band” infringed on various intellectual property rights.  In addition, Viacom sought indemnity for another infringement action initiated after the escrow period ended.  In September 2008, four months after the contractual escrow period ended, Walter Winshall, on behalf of the selling shareholders, demanded the release of the escrowed funds.  Viacom declined to release the escrow funds to the selling shareholders, citing certain alleged breaches of representations and warranties regarding Harmonix’s knowledge of actual or potential infringement claims.

In December 2010, Winshall filed a complaint against Viacom and Harmonix in the Delaware Court of Chancery: (1) alleging Viacom and Harmonix breached their implied obligation of good faith and fair dealing by not taking advantage of the opportunity to negotiate lower distribution fees with EA during the earn-out period and thereby maximize the selling shareholders’ earn-out payments; (2) seeking declaratory relief that Viacom was not entitled to indemnification; and (3) demanding the release of the escrow funds.  The Court of Chancery concluded that there was no valid claim for breach of the implied covenant of good faith and fair dealing but ruled in favor of Winshall on the indemnification matters.  Winshall appealed as to the ruling on the implied covenant of good faith and fair dealing.  In addition, Viacom cross-appealed on the indemnification matters, claiming among other things that even if there was no breach of representations and warranties which triggered their obligation to indemnify, the selling shareholders were independently obligated to cover Viacom’s costs of defending the third-party claims.   

The Court’s Decision

In its decision, the Supreme Court of Delaware affirmed the Court of Chancery’s holding that: (1) Winshall failed to state a cognizable claim against Harmonix and Viacom for breach of the implied covenant of good faith and fair dealing based on their failure to maximize the shareholders’ earn-out income; (2) Viacom was not entitled to indemnification for either underlying breaches of representations and warranties or its costs of defense from third-party claims as to which it had not proven an underlying right to indemnification; and (3) the selling shareholders were entitled to payments from the $12 million held in escrow.

With respect to the implied covenant cause of action, Winshall argued that Viacom and Harmonix breached their obligation of good faith and fair dealing by negotiating a distribution agreement in 2008 that resulted in reduced earn-out payments for the selling shareholders.  The essence of Winshall’s argument was that the companies had an implied duty to use their significant market power to negotiate a more favorable distribution arrangement that would result in greater earn-out payments and that they should have accepted EA’s offer to lower the 2008 distribution fees in exchange for other benefits.  The Court held that the implied covenant could not impose such an obligation given that the clear terms of the merger agreement did not create any obligation to maximize earn-out income.  Because neither Viacom nor Harmonix made any decision intended to sabotage or intentionally undermine the selling shareholders’ earn-out rights, there was no breach of the implied duty.  In the Court’s view, Winshall’s implied covenant claim could succeed only if it was “clear from the Merger Agreement that Viacom and Harmonix would have agreed to take whatever steps were available and required to maximize the amount of the earn-out.  The parties to the Merger Agreement could have created such an obligation in their contract, but they did not.”

In its cross-appeal, Viacom argued that the Court of Chancery erred in holding that Viacom was not entitled to indemnification, as the selling shareholders were obligated to provide indemnity based on their breaches of representations and warranties.  The Court rejected Viacom’s argument because the third-party intellectual property claims alleged infringement only after the merger had closed, and the Merger Agreement’s representations and warranties operated only as of the time that Viacom closed its acquisition of Harmonix.  Because the Merger Agreement’s indemnity provisions were expressly conditioned on the existence of such breaches, the selling shareholders had no contractual obligation to provide indemnity.

The Court also rejected Viacom’s argument that even if no breach had occurred, the shareholders still had an “independent duty to pay defense costs” under the Merger Agreement that is distinct from and “broader than the duty to indemnify.”  In the Court’s view, agreements intended to create separate duties to indemnify and to defend do exist, but such intention is expressed by “employ[ing] an ‘indemnify and defend against claims’ clause or similar language to that effect.”  In contrast, the Viacom-Harmonix Merger Agreement expressly provided only a duty to “indemnify,” without any specific obligation to “defend.”  Viacom and Harmonix argued that a procedural indemnification clause providing that they “may request indemnification” in connection with a third-party infringement claim obligated the selling shareholders to pay defense costs upon receiving such a request, whether a breach of a representation or warranty existed or not.  However, the Court rejected the notion that any indemnity obligations existed unless a breached representation or warranty entitled Viacom to such indemnification.  In particular, the indemnity provision of the Merger Agreement stated that “the defense or settlement of any such claim [is] at the expense of the applicable indemnifying parties,” and the selling shareholders were not “indemnifying parties” until a contractual obligation to indemnify was triggered.  The Court held that any interpretation of the Merger Agreement to the contrary “contradicts its plain text and evident logic.”

Given that the selling shareholders did not breach any representations or warranties, and that they did not have any independent indemnity duties to Viacom, the Court held that Viacom was not entitled to retain the $12 million held in escrow.

Implications

The Court’s holding in this case underscores the implications of being precise when defining the scope of either party’s obligations.  Courts tasked with interpreting the intent of parties to an agreement will closely scrutinize the terminology used, and also consider why certain customary language may have been omitted or modified.  Courts will not allow parties to use an implied covenant of good faith and fair dealing to re-write a contract in order to secure rights that they did not expressly provide for in negotiations.  If a seller wants to require that a buyer act in a manner that not only avoids intentional manipulation of an earn-out to the detriment of the seller, but also imposes an affirmative duty to maximize the earn-out, then this should be expressly stated in the agreement.  Further, using the phrase “indemnify and defend” rather than “indemnify” or expressly providing for advancement of expenses during the defense of a claim, arguably would have created a significantly expanded set of obligations for the selling shareholders in Winshall

We note that in this transaction, the Purchaser had the right to control and direct the defense of third-party claims.  Therefore, Viacom was looking for reimbursement of costs that it had incurred directly to fund the defense of alleged breaches of representations and warranties even though it had been unsuccessful on the merits of its claims for indemnification for the underlying breach.  It is customary in many merger agreements to allow the indemnifying parties to, in the first instance, have the right to control the defense of such claims at their own expense. Alternatively, such agreements generally provide that if the indemnifying party fails to assume the defense of such actions on a timely basis or elects not to assume such defense, then the indemnified party has the right to assume the defense at the cost of the indemnifying party.  In such a situation, drafters of agreements should be clear about the parties’ intent as to who will bear such expenses advanced to fund the defense of a claim if it is ultimately determined that there has been no breach.  Further, if the parties intend that there be an obligation to advance expenses to fund such litigation during its pendency, then the drafters should expressly include such a clause, which has become customary in other contexts such as investment banking and director indemnification agreements.

For more information regarding this News Alert, please contact Lori S. Smith (212.714.3075; smithl@whiteandwilliams.com), Maurice Pesso (212.631.4405; pessom@whiteandwilliams.com) or Ariel Fliman (212.868.4837; flimana@whiteandwilliams.com)

This correspondence should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation and legal questions.
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