In Winshall v. Viacom Int’l., C. A. No. 6074-CS (Del. Ch., Nov. 10, 2011), read opinion here, the Delaware Court of Chancery granted a motion to dismiss a claim for breach of the implied covenant of good faith and fair dealing in a dispute over post-merger earn-out payments. What is also of note for practitioners is that the Chancellor provided some very interesting commentary about the pleading standard for Rule 12(b)(6) motions and the Delaware Supreme Court’s recent decision in Cent. Mortg. Co. v. Morgan Stanley Mortg. Capital Holdings LLC, 27 A. 3d 531, 536 (Del. 2011), a decision that was highlighted on these pages (along with several links to related commentary on this pleading issue), here. See footnote 23 starting on page 10 of the opinion (linked above). Stay tuned for more commentary on this pleading issue in future posts on this blog.

Kevin F. Brady of Connolly Bove Lodge & Hutz LLP provided this summary.

In 2006, Viacom International, Inc., acquired Harmonix Music Systems, Inc., a company best known for creating the music-oriented video games Rock Band and Guitar Hero, through an agreement between Viacom, Harmonix and the selling stockholders of Harmonix (the “Selling Stockholders”), which included the plaintiff, Walter A. Winshall. 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 2007 and 2008. The merger agreement did not contain any provision governing the operation of Harmonix during the earn-out period, nor did it contain any efforts clause related to the earn-out payments.

In March, 2007, Harmonix entered into a three-year agreement with Electronic Arts, Inc. for the distribution Rock Band wherein Harmonix agreed to pay sales and other fees to EA for the distribution of Rock Band and if EA met a specified “sequel threshold” by earning a certain amount of revenues, it would receive the right to distribute sequels to Rock Band. Rock Band had a very successful launch in November, 2007, so that made it possible for Viacom and Harmonix to renegotiate the terms of the original EA agreement in 2008. The amended EA Agreement broadened and clarified the scope of Rock Band products to which EA had distribution rights — Rock Band 2 (which was released in 2008) and The Beatles: Rock Band (which was under development by Harmonix at the time).

Winshall filed suit alleging, among other things, that Viacom and Harmonix breached their implied covenant of good faith and fair dealing under the Merger Agreement because when they were 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.

Under Delaware law, the implied covenant of good faith and fair dealing:

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. Rather, a 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.

Winshall argued that, because Viacom and Harmonix had the opportunity to increase the amount of the 2008 earn-out payment, Viacom and Harmonix had an implied obligation under the merger agreement to take that opportunity. The Court disagreed finding that Winshall failed to allege facts that supported a reasonable inference that the Selling Stockholders did not get the benefit of their bargain under the merger agreement. The Court also found that Viacom and Harmonix did not impair the Selling Stockholders rights under the merger agreement. 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. Moreover, the Court found that “it was 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.”

Finally, the Court noted 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… and a party does not act in bad faith by relying on contract provisions for which that party bargained where doing so simply limits advantages to another party.”

BONUS SUPPLEMENT: Professor Stephen Bainbridge provides scholarly insights on this case here.