Viacom Int'l, Inc. v. Winshall

VIACOM INTERNATIONAL, INC., Plaintiff and Counter-Defendant,

v.WALTER A. WINSHALL, in his capacity as the Stockholders' Representative, Defendant and Counter-Plaintiff.

Civil Action No. 7149-CS

COURT OF CHANCERY OF THE STATE OF DELAWARE

Date Submitted: June 20, 2012

Date Decided: August 9, 2012

MEMORANDUM OPINION

Stephen P. Lamb, Esquire, PAUL, WEISS, RIFKIND, WHARTON & GARRISON LLP,

Wilmington, Delaware; Leslie Gordon Fagen, Esquire, Daniel J. Leffell, Esquire, Robert A.

Atkins, Esquire, PAUL, WEISS, RIFKIND, WHARTON & GARRISON LLP, New York,

New York, Attorneys for Plaintiff and Counter-Defendant.

Gregory V. Varallo, Esquire, Scott W. Perkins, Esquire, RICHARDS, LAYTON &

FINGER, P.A., Wilmington, Delaware; David M. Schiffman, Esquire, Linton J. Childs,

Esquire, Leah K. Holt, Esquire, SIDLEY AUSTIN LLP, Chicago, Illinois, Attorneys for

Defendant and Counter-Plaintiff.

STRINE, Chancellor.

I. Introduction

As is often the case when sophisticated parties use the technique of an earn-out procedure to paper over a value gap, the technique has resulted in litigation. As is often the case, that is so even though the parties agreed in a merger agreement that the amount of the earn-out would be determined in alternative dispute resolution by "Resolution Accountants," rather than in litigation. Here, an acquirer who has been ordered by the Resolution Accountants to pay an earn-out to the target company's selling stockholders has filed suit seeking to vacate the order of the Resolution Accountants setting the amount of the earn-out that must be paid. The acquirer has advanced a number of differing linguistic formulations for its protestation that the Resolution Accountants' decision should be vacated, but all of its formulations come down to the notion that the Resolution Accountants erred by refusing to consider an alternative approach to determining the earn-out that the acquirer originally raised in a preliminary calculation of the earn-out, but ultimately did not include in its contractually-mandated calculation of the earn-out (the "Earn-Out Statement") or the "work papers and supporting documentation" required to accompany that Earn-Out Statement.¹ Although the acquirer successfully urged the Resolution Accountants to refuse to consider any arguments that the selling stockholders' representative did not include in the "Summary of Issues" he was required to submit within 20 days of receiving the Earn-Out Statement on the grounds that the stockholders' representative was required to timely make all his arguments in that Summary of Issues, the acquirer says that the Resolution Accountantswere out of bounds in refusing to consider an argument and facts that the acquirer could have, but chose not to, include in its Earn-Out Statement and the information backing up that Earn-Out Statement.

In this decision, I dismiss the acquirer's challenge to the Resolution Accountants' order and grant the selling stockholders' cross-motion to enforce the order under the Federal Arbitration Act ("FAA"), which applies to this dispute. By the clear terms of the merger agreement entered into by the parties (the "Merger Agreement"), the Resolution Accountants were charged with determining the earn-out. Thus, there is no question of "substantive arbitrability," as the core issue determined by the Resolution Accountants - the amount of the earn-out - was clearly a matter for them to decide. Being empowered to decide that core question, the Resolution Accountants were also empowered to make the usual discretionary decisions that any adjudicator must make, including whether the acquirer was entitled to present arguments not included in its Earn-Out Statement. This is precisely the kind of procedural question that the adjudicator makes in the first instance, and that is not subject to challenge in the limited context of review under the FAA. Here, the Resolution Accountants interpreted the Merger Agreement as limiting both the acquirer and the selling stockholders to the arguments raised in their Earn-Out Statement and Summary of Issues: key, contractually-mandated documents that then shaped the parties' agreement on pre-hearing discovery. That interpretation was a matter for the Resolution Accountants in the first instance, as the acquirer itself acknowledged in asking the Resolution Accountants to exclude arguments that the selling stockholders' representative did not put in the Summary of Issues. Under the FAA, that interpretationcannot be set aside as "misconduct" or "exceed[ing] [the arbitrators'] powers."² Moreover, even if the acquirer were entitled to a judicial determination of the question, which it is not, it would still not have a basis to vacate the ruling, because the Resolution Accountants' determination that the acquirer was bound by its Earn-Out Statement and the documentation it offered in support of that Statement was a correct reading of the Merger Agreement.

II. Background

A. The Parties Enter Into The Merger Agreement And The Selling Stockholders ArePromised The Possibility Of Earn-Outs

The acquirer in this case is plaintiff Viacom International, Inc., a well-known media conglomerate. The target was Harmonix Music Systems, Inc., a developer of music-oriented video games. On September 20, 2006, when Harmonix was enjoying the success of its popular video game Guitar Hero and was developing a new game, Rock Band, Viacom and Harmonix entered into the Merger Agreement, in which Viacom agreed to cash out Harmonix's stockholders. The parties appointed defendant Walter A. Winshall as the "Stockholders' Representative," with the authority to enforce the selling stockholders' rights to receive any payment under the Merger Agreement and to represent the selling stockholders in any post-merger disputes.³

Viacom agreed in the Merger Agreement to pay Harmonix's stockholders $175 million in cash at closing and also promised the selling stockholders the contingent right to receive earn-out payments based on Harmonix's financial performance in 2007 and2008 (the "Earn-Outs"). The 2008 Earn-Out, which is the only Earn-Out currently in dispute, was defined as "the positive amount, if any, ... equal to the product of (x) [Harmonix's] Gross Profit for Fiscal Year 2008 minus $45,000,000 and (y) 3.5."⁴ In other words, if Harmonix's "Gross Profit" in 2008 was $145 million, Viacom would owe Harmonix's former stockholders $350 million, on this basis: ($145 million - $45 million) * 3.5 = $350 million. The Merger Agreement defined "Gross Profit" as the sum of "Product Gross Profit" for all of Harmonix's products, meaning "the positive or negative difference, between (i) Net Revenue attributable to such product and (ii) the sum of all Direct Variable Costs attributable to such product."⁵ The "Direct Variable Costs" were in turn defined as "all costs and expenses attributable to, related to or associated with the business and products of [Harmonix], which vary based on the number of units manufactured or sold."⁶ Examples of Direct Variable Costs given by the Merger Agreement include manufacturing costs, distribution fees, marketing costs, and royalties payable to third parties.⁷

B. The Process For Settling Earn-Out Disputes

The Merger Agreement set forth a process for determining the amount of the 2008 Earn-Out, as well as a resolution process in case the parties could not agree on the amount to be paid.⁸ As a first step, Viacom had to prepare the Earn-Out Statement,deliver it to Winshall, and provide Winshall with "reasonable access to all work papers and supporting documentation relating to the [] Earn-Out Statement."⁹ If Winshall then "disagrees with [Viacom's] calculation of the ... [Earn-Out], [he] must deliver to [Viacom] ... a written description of each such disagreement," i.e., the Summary of Issues, within 20 days.¹⁰ The Merger Agreement specifies that "in connection with any dispute resolution regarding the [Earn-Out], the Stockholders' Representative will not dispute any additional issues or amounts other than the [ones described in the Summary of Issues]."¹¹ In the event that Viacom and Winshall cannot resolve the identified disagreements in the Summary of Issues (the "Earn-Out Disagreements"), then either party may submit these unresolved Earn-Out Disagreements to the Resolution Accountants.¹² The Merger Agreement provides that "[t]he scope of the Resolution Accountants['] engagement (which shall not be an audit) shall be limited to the resolution of the Earn-Out Disagreements, and the recalculation of the [Earn-Out] ... in light of such resolution, and [the Resolution Accountants] shall be deemed to be acting as experts and not as arbitrators."¹³

Having said that the Resolution Accountants are "experts and not [] arbitrators," the Merger Agreement goes on to say that "[t]he resolution of the dispute by the Resolution Accountants will be a final, binding and conclusive resolution of the parties'dispute, shall be non-appealable, and shall not be subject to further review."¹⁴ If one just read this sentence, one would perhaps view the parties as having waived any judicial review altogether. But not content with having deemed the Resolution Accountants as experts and not arbitrators and thus caused one eyebrow-knitting moment, the drafters forged on to state in a later subsection that "[t]he determination of the [2008 Earn-Out] ... shall be final and binding on all parties, and no such party shall have the right to bring any claim disputing such final determination, in the absence of fraud or manifest error."¹⁵ This formulation matches to some extent the grounds for review under §§ 10 and 11 of the FAA, in that § 10(a)(1) of the FAA allows a court to vacate an arbitration award that "was procured by [] fraud"¹⁶ and in that "manifest error" can be read as covering the same ground as § 11(a) of the FAA, which allows modification "[w]here there was an evident material miscalculation of figures or an evident material mistake in the...