Viacom’s purchase of video game developer Harmonix Music Systems serves as a testament to the adage “be careful what you wish for.” As shown in Winshall v. Viacom International, Inc. et al. (Del. Ch. Dec. 12, 2012), the Chancery Court strictly interpreted indemnification provisions and concluded that Viacom, the potential indemnitee, was only entitled to the remedies expressly stated in the merger agreement. In Winshall, the court held that:

  • Harmonix’s shareholders (collectively, Sellers) made certain representations relating to video games under development as of the merger closing date and were only liable for breach if such representations were untrue as of such date. Consequently, Viacom was not entitled to indemnification for third party claims related to games that were completed post-merger, since Harmonix did not control the late stage development and publication.
  • Because Viacom failed to show that Sellers had breached a representation, Viacom was not entitled to defense costs.
  • Viacom could not unilaterally extend an escrow period by notifying Sellers of the possibility of a future indemnification claim prior to the expiration of the escrow period.

The Winshall case stems from the 2006 merger of Viacom and Harmonix. From the $175 million cash consideration, $12 million was placed in escrow to pay indemnification claims arising from losses suffered by Viacom as a result of any breach of Sellers’ representations, among other things. In 2008, days before the 18-month escrow period was set to expire, Viacom requested indemnification for legal fees that it incurred in defending against three intellectual property infringement lawsuits related to “Rock Band,” a video game under development by Harmonix at the time of the merger. After the escrow period expired, Viacom sought additional indemnification in connection with a fourth intellectual property infringement lawsuit. Sellers rejected Viacom’s indemnification requests and, after Viacom refused to release funds from escrow, moved for summary judgment. In its opinion, the Chancery Court granted Sellers’ motion on the basis that “Viacom cannot claim indemnification based on representations and warranties that Harmonix made as to the state of its business at the time Viacom bought it, because all of its claims relate to alleged infringements of intellectual property after the deal closed.”

Date Certain Representations

Viacom alleged that Harmonix breached two representations made under the merger agreement. Harmonix represented that:

  • it “ha[d] adequate rights ... as is necessary for the current use” of Harmonix-developed software (Title Representation); and
  • “neither the operation of the Business, nor any activity of the Company, nor any manufacture, use, importation, offer for sale and/or sale of any Current Game” constituted a violation of any third party’s intellectual property rights (IP Representation).

Title Representation

In response to Viacom’s argument that Sellers had breached the Title Representation, the Chancery Court concluded that “it would ... be strange if the Sellers had indemnified Viacom, in 2006, against intellectual property claims arising out of a future version of Rock Band,” since Sellers had no control over the final development and production of the game. The court emphasized that its conclusion was supported by the text of the representation, which (i) referred to “the current use” of Harmonix-developed software and (ii) used the present tense (i.e., “has adequate rights”) to indicate that the representation was made as of the closing date.

The court also noted that Viacom sought indemnification based on third party claims made against the final, published version of Rock Band. Viacom did not allege that Harmonix failed to have the necessary rights required to develop the 2006 prototype of Rock Band. As such, the Chancery Court leaves open the possibility that, if Viacom had instead sought indemnification on the grounds that Harmonix did not have all rights as of the closing date, the court may have ruled against Sellers’ motion for summary judgment because there was a dispute of fact for trial.

IP Representation

The court’s analysis of the IP Representation was bifurcated. First, the court reviewed Viacom’s claims that the Business and activities of Harmonix infringed on third-party intellectual property. In the merger agreement, “Business” was defined as “the business of the company as currently conducted.” Accordingly, the court held that a representation as to the Business was tied to Harmonix’s business as of the 2006 closing date. Likewise, the court dismissed Viacom’s argument that Harmonix’s 2006 activities breached the IP Representation because the infringement lawsuits related to Viacom’s 2007 activities (i.e., publication of the Rock Band game).

Second, the court reviewed Viacom’s claim that the sale of a Current Game infringed on third-party intellectual property. The court found that Viacom’s interpretation of the merger agreement on this issue violated a basic principle of contract interpretation: “where possible, effect is to be given to all terms of the contract.” It reasoned that the defined term “Current Game” and the disclosed list of Current Games would be superfluous if the IP Representation was interpreted to cover Harmonix-published software and future published games, such as Rock Band.

Legal Fees

Viacom represented that it incurred $28 million in defense costs in connection with the intellectual property infringement lawsuits. It argued that Harmonix was responsible for such costs based on the following provisions of the merger agreement: (i) Viacom had the right to conduct the defense of any indemnification claim “at the expense of the applicable indemnifying parties” and (ii) if Viacom chose not to permit Harmonix to assume the defense, Sellers were obligated to pay “the reasonable fees and expenses of counsel retained by [Viacom].”

However, the Chancery Court noted that such arguments were “out of their contractual and logical context” since such contractual rights were dependent on the existence of a breach of representation. Again, the court emphasized that its conclusion was supported by the text of the indemnification provision, which stated that the defense fees would be paid by the “indemnifying parties.” If Viacom failed to show a breach of representation, then Sellers had no duty to indemnify and, therefore, no duty to pay defense costs.

 In addition, the court found Viacom’s argument “odd” because, if the court accepted the argument, it could result in Sellers being responsible for all defense costs related to the subject matter of Sellers’ representations, irrespective of whether Sellers had breached any representation. Moreover, pursuant to Viacom’s analysis, Sellers would be responsible for defense costs, which could not be foreseen as of the closing date, a risk that a sophisticated seller would never accept. Accordingly, the court held that “Viacom’s argument that the Harmonix stockholders have a duty to pay its defense costs even when there has not been a breach of the representations and warranties in the merger agreement is based on a misreading of the agreement.”

Time-Barred

In Viacom’s April 2008 notice of the first three infringement lawsuits, it stated that it “reserve[d] the right to seek indemnification for any other claims by [the plaintiffs in the existing infringement lawsuits] or by other third parties that may result due to [Harmonix’s] breach of its representations and warranties under the [merger agreement].” Almost three months after the indemnification escrow period expired, Viacom relied on this “placeholder” to seek indemnification for defense costs incurred in connection with a fourth intellectual property lawsuit.

The merger agreement required Viacom to notify Sellers “in writing of such claim” within 18 months of the closing date. In its April 2008 notice, Viacom did not notify Sellers of a claim, but rather of a possibility of a claim. Accordingly, the Chancery Court rejected Viacom’s fourth indemnification request because it was “impermissible” under the terms of the merger agreement and time-barred.

Lessons Learned

The Winshall case reminds us of the following lessons in contract drafting and interpretation:

  • Carefully review defined terms and provisions that introduce a timing qualifier to confirm that their use throughout the contract reflects the business deal.
  • Courts strictly interpret contractual provisions. The mutual agreement among parties as expressed within “the four corners” of the document will prevail over one party’s interpretation of the contract absent some ambiguity.
  • To successfully claim a breach of representation, the claimant must show that the representation was breached as of the date made. Thus, with respect to representations regarding assets under development at the time of acquisition, a later claim must prove that the representation was breached as of the closing.
  • A party cannot unilaterally amend contractual terms if such amendment will adversely affect the other party. In the context of indemnification claims, a party cannot simply extend a specified indemnification period by notifying the other party of the possibility of future claims.