Critical Issues in Entertainment M&A Due Diligence
This is the latest in a series of columns by OMelveny & Myers attorneys, focusing on key legal issues specific to a variety of U.S. industries.
For bidders and their counsel contemplating an M&A deal, last years Delaware Supreme Court decision in RAA Management LLC vs. Savage Sport Holdings, Inc. highlights the importance of assessing risk early in the due diligence process. In RAA, the bidder sought to recover its due diligence expenses, claiming that the target company knowingly included false statements in its due diligence disclosures. The court, however, affirmed the dismissal of the bidders complaint, holding that the nonreliance and waiver clause in the parties nondisclosure agreement (NDA) barred the bidder from recovering its expenseseven where the disclosures were allegedly false. In doing so, the court declined to distinguish between disclosures that were inaccurate because of negligence or mistake and those that were inaccurate because of fraud.
Generally, sellers begin the due diligence process with an NDA to protect the confidentiality of information they are disclosing and to limit their liability arising from such disclosure. Bidders must evaluate this information to value the target and assess its potential business and legal risks. As was the case in RAA, NDAs typically include a nonreliance clause in which the bidder acknowledges that the seller makes no representations or warranties with respect to the information it discloses and that any representations or warranties would be made only in the definitive agreements.
RAA confirms the enforceability of nonreliance provisions even in extreme circumstances, crystallizing the importance of a bidders strategic due diligence plan at the outset to expose any discrepancies, misunderstandings, or miscalculations as it refines its evaluation of the target. This planning is particularly crucial in the entertainment, sports, and media (ESM) space, as the bidders in-house counsel must navigate a complex industry in which the key business and legal issues are not always apparent.
When undertaking any due diligence exercise, bidders should seek the assistance of a multi-talented team (potentially including local and international counsel, financial, and tax advisers) with industry-specific expertise. The following guideposts should direct the teams efforts: (1) valuation-related matters; (2) legal considerations (including assessing the scope of risk, identifying liabilities the bidder would directly or indirectly assume, and noting third-party or governmental consents or notices required in light of the transaction structure); and (3) operational issues (i.e., understanding the targets business, identifying key contractual arrangements, and facilitating integration post-closing). Bidders must appreciate the components of each category as early in the negotiation process as possible.
We outline here certain key diligence issues within these guideposts that bidders counsel should consider at the outset of any ESM M&A transaction. The calculus is especially nuanced and complex when deciphering revenue streams and assessing risk in the heterogeneous and industry-specific set of ESM assets, including film and television libraries, book properties, music publishing rights and music catalogs, sports teams, and talent companies.
Rights In/Chain-of-Title: Verifying the Target Company Owns and Controls Value Drivers
To determine what the ESM assets a target actually owns and controls, bidders must be prepared to wade through various intellectual property regimes domestically (at the federal and state levels) and internationally, including copyright, trademark, and right of publicity. Generally, a copyright interest vests in all contributors to a work. For example, a lyric writer, composer, and performing artist each has a copyright interest in a hit single. Bidders will have to review this chain of title (such as inbound acquisition, assignment and licensing agreements, and copyright, trademark, and UCC-1 reports) to confirm that the target acquired sufficient rights from each contributor to exploit those rights and thereby create value. This review should also surface contingent participation or royalty obligations payable to third parties. Bidders frequently direct their attention to the most valuable properties, or to a representative sampling, as a way to efficiently allocate scarce diligence resources.
Along with contractual considerations, any chain of title analysis should account for the nontransferable statutory right of contributors to terminate certain grants of copyright. Generally, for grants prior to 1978, contributors may exercise a termination right commencing 56 years after the work was created. 17 U.S.C. 304. For grants after 1978, contributors may exercise a termination right commencing 35 years after the execution of the grant, i.e., beginning in 2013. 17 U.S.C. 203. Accordingly, bidders should expect to see an increasing number of termination notices in chain of title diligence.
Rights Out: Assessing the Extent and Value of the Library
ESM assets typically generate revenue through the exploitation of a library of rights, through outbound licenses to third-party distributors or licensees for a limited term and in a certain territory. These distributors and licensees, in turn, remit payments to the licensor. By reviewing these rights out agreements, bidders can confirm which assets are encumbered or available (i.e., the avails) and the extent of revenue expected or otherwise achievable. License fees for ESM assets usually consist of an advance paid on execution of the contract, which is then recouped against contingent royalty streams payable to the licensor over the term of rights granted. Accordingly, a bidder may need to adjust the preliminary value ascribed to an asset because the asset may not actually realize revenue for the bidder, if ever, until much later in the exploitation cycle, depending on the amount of the advance and the assets success in the marketplace.
Assignability of Licenses: Confirming Transferability of Key Contracts
The transaction structure may necessitate an assignment of rights or agreements to the bidder. Assignment provisions are particularly important in the ESM context because licensees may not assign certain intellectual property rights (e.g., trademark, rights of publicity, and nonexclusive licenses of copyright) without the licensors express consent. The Ninth Circuit has even held in a widely criticized case that exclusive licenses of copyright that are silent on assignability may not be assigned without consent. Gardner vs. Nike (2002). An unpublished decision from the Northern District of California (SQL Solutions, Inc. vs Oracle Corp. ) also suggests that the transaction structure may unintentionally trigger assignment issues. Citing the general rule in California that an assignment of rights occurs through a change in the legal form of ownership of a business, the SQL court held that a reverse triangular merger results in an assignment of a nonexclusive copyright license by operation of law, thus requiring the licensors consent.
Although a Delaware court, in Meso Scale Diagnostics, LLC vs Roche Diagnostics GMBH (2013), declined to follow the SQL courts lead and reached an opposite conclusion, SQL nonetheless suggests that at least in Californiaand potentially other jurisdictionsbidders must be mindful of the language of the contract itself and the structure of the transaction in their evaluation of the assignability of intellectual property rights.
Existing Litigation and Audit Claims: Assessing Risk
ESM assets, particularly high-grossing ones, are commonly subject to litigation claims. Opportunistic plaintiffs often file these claims, many of which are frivolous, on the eve of release to the public. Accordingly, although an ESM asset may be subject to a high number of claims, the analysis should focus on the underlying merit of these claims. Audit claims, whether actual or potential, may pose greater risks. The exploitation of ESM assets generates revenue in which third-party participants and guild/union residual players (such as SAG-AFTRA, WGA, and DGA) are entitled to share. A licensor typically retains the obligation to make these payments, but licensees (such as motion picture studios), which are entitled to recoup expenses before payment to these players, account and pay on a licensors behalf. Because of the complex accounting practices of many licensees, audits often give rise to claims by these third parties, which may be substantial depending on the success of the asset.
Special Considerations for Sports Transactions
Bidders seeking to acquire a professional sports franchise face other industry-specific considerations affecting the due diligence analysis. In assessing a teams value, a review of its stadium agreement for ownership or lease rights (and the duration of any such lease) and naming rights is critical. Valuation is also heavily driven by the availability of present and future media rights, which often intersect with media rights or revenue sharing granted to the league. Ownership of a team necessarily involves rights and obligations to the league as set forth in the teams franchise agreement. A bidders success in acquiring a team will hinge on understanding this interplay and close coordination with the league.
As RAA makes clear, an M&A bidder will have limited recourse against a target for misrepresentations in the due diligence process when reliance is explicitly contracted out (as it usually is). Accordingly, effective client representation calls for in-house counsels strategic involvement in the diligence process beyond the traditional role of safe-keeper of legal issues affecting the corporation.
In light of the significant costs that any due diligence exercise entails, in-house legal counsel today is thrust into a hybrid rolede facto business adviser tasked with identifying and exploiting industry-specific value drivers and facilitating company goals, while also assessing and managing increasingly intricate legal and business risks. Engaging outside counsel with industry-specific expertise and familiarity with the assets involved is often key to mastering the process and achieving optimal results. In-house counsel should consider obtaining expert guidance early onthe stakes are simply too high not to.
Sean A. Monroe is a partner in O'Melveny & Myers Mergers and Acquisitions Practice. In addition to his broad experience in a range of M&A, private equity, and corporate finance transactions, Monroe handles corporate, securities, and other aspects of entertainment transactions, including motion picture financings, acquisition due diligence and evaluation, and distribution arrangements. Jeannine Tang and Silvia Vannini are associates in the firms Entertainment, Sports and Media Practice. All of the authors reside in OMelvenys Century City office.