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VOLUME 5 | NUMBER 1 | SPRING 2018

Disney/Fox Merger: Can The Plethora Of Profit Participation Litigation Be Mitigated Through The Threat Of Punitive Damages?

Jordan Matthews


Jordan Matthews-portrait

Jordan Matthews is a corporate lawyer with Weinberg Gonser, LLP. His practice focuses primarily on corporate transactional matters, including entertainment finance and production, sports, venture capital, and corporate finance. He personally represents producers, directors, production companies, athletes, entrepreneurs, C-level executives, and high-net-worth individuals in an array of finance, corporate, and talent-related matters. You can contact him at jordan@weinberg-gonser.com.

I. INTRODUCTION

A cause of action for fraud and the potential for awarding punitive damages is of significant relevance in the area of profit participation litigation in the entertainment industry. Due to “Hollywood accounting,”[1] net profits on successful film and TV projects are virtually non-existent and punitive damages may be one of the few ways to deter the rampant abuse of fraud in the entertainment industry. In the ongoing litigation between Frank Darabont (“Darabont”) and American Movie Classics (“AMC”) over the hit series, The Walking Dead, there is an issue over AMC setting a perpetual imputed licensing fee[2] with an affiliated party.[3] Series co-creator, Robert Kirkman (“Kirkman”), and various other parties also filed suit against AMC over profits concerning The Walking Dead on August 14, 2017.[4] In the allegations asserted by Kirkman et al., the parties claim (among other things), that AMC fraudulently induced breach of various contracts.[5] The plaintiffs demanded punitive damages.[6] In a similar circumstance where the judge also allowed for a finding of punitive damages, Warner Brothers (“WB”) settled a lawsuit with several plaintiffs over the profits from the hit series, Smallville.[7] The plaintiffs alleged that WB Television undersold the series to affiliate entities (first, to WB Network, and subsequently, to The CW), instead of licensing the series to unrelated third-parties for its fair market value.[8] Settlements over profit participation litigation have likely encouraged rightful plaintiffs to pursue their claims.[9]

The ongoing trend of consolidation within the entertainment industry is of particular concern in the context of profit participation litigation and associated damages.[10] Disney’s Bob Iger has based his business model on acquisitions of companies such as Pixar, Marvel Studios, and LucasFilm.[11] Disney is also primed to acquire the majority of 21stCentury Fox’s (“Fox”) assets.[12] AT&T is now set to acquire Time Warner pending a favorable ruling in its litigation with the Department of Justice.[13]

Lionsgate is actively looking for a suitor.[14] CBS and Viacom are considering a merger.[15] The ongoing trend of media consolidation should be concerning for content creators given accounting practices that dramatically undervalue their profits.

II. BACKGROUND

A. Profit Participation Litigation

i. The Walking Dead Litigation (Frank Darabont/CAA)

In the context of Darabont's (and his agency, CAA's) litigation over profits from The Walking Dead, Darabont and AMC initially agreed to terms whereby he would receive up to 12.5% of the profits from production of the series with an unaffiliated company, which AMC would designate.[16] Possibly due to AMC’s favorable opinion of Darabont’s work, it elected to produce the series via an affiliated, rather than unaffiliated party.[17] The parties then finalized an agreement, whereby AMC assured Darabont that transactions with affiliated companies would be on monetary terms comparable to terms that AMC would enter into for a similar transaction with an unrelated third party.[18]

Because AMC produced The Walking Dead through an affiliated party, AMC did not put the series on the market for purposes of establishing a fair market value licensing fee.[19] AMC imputed a license fee for the series, which was designated in accounting statements.[20] The plaintiffs allege that the imputed fee was drastically low, thereby resulting in an accounting deficit and, ultimately, no profit-sharing for the plaintiffs.[21]

AMC set a perpetual imputed licensing fee at 65% of the production cost with a cap of $1,450,000 per episode and with 5% increases in later seasons.[22] This perpetual fee is not a customary industry practice.[23] A license fee is typically re-negotiated at the end of the fourth season through an arm’s length negotiation with an unaffiliated third party.[24] A net loss of $55 million was reported due to AMC’s formula. This increased to $71 million when accounting for interest and various overhead expenditures.[25] Darabont and his financial experts are now attempting to show that the appropriate imputed licensing fee should be $30 million per episode.[26]

ii. The Walking Dead Litigation (Robert Kirkman, et al.)

In the recent litigation initiated by series co-creator, Robert Kirkman, et al., the complaint alleges that “[t]he defendant AMC Entities exploited their vertically integrated corporate structure to combine both the production and exhibition of [The Walking Dead], which allowed AMC to keep the lion’s share of the series’ enormous profits for itself.”[27] Similar to the case asserted by Darabont and CAA, the primary issue involves the imputed perpetual license fee, which is now around $2.4 million.[28] This amount is less than the non-imputed licensing fees for both Mad Men and Better Call Saul, which were produced by Lionsgate and Sony, respectively.[29] The complaint points out that “[t]hose substantial fees for Mad Men and Breaking Bad continued in seasons five and beyond, even though their ratings were a fraction of [The Walking Dead’s].”[30]

iii. Smallville Litigation

In a dispute over profits concerning the long-running series, Smallville,[31] the judge allowed for a finding of punitive damages.[32] Alfred Gough and Miles Millar, along with Tollins/Robbins Productions, asserted damages of around $100 million.[33] The parties contended that WBTV made licensing deals with sister companies WB Network and later, The CW, for less than fair market value.[34] In pertinent part and, in sending the matter to trial, the judge ruled: “[p]laintiffs have demonstrated triable issues regarding these provisions: whether WBTV complied with its arms-length obligation, whether a provision which proposed to add that the agreements be ‘for fair market rates consistent with licenses granted by Warner to non-affiliates’ was included in the Producer’s [Modified Adjusted Gross Definition].”[35] This case settled before trial,[36] so it is unclear how a jury would have decided the issues. The settlement does not take away from the merits of the claim, however, since most civil cases resolve before trial merely because litigation is cost prohibitive.[37]

B. Vertical Integration

Vertical integration occurs when an organization performs many, if not most, functions of a supply chain.[38] In the context of the entertainment industry, not unlike other business, consolidation arises for efficiency purposes and economies of scale.[39] Fox produces and distributes its own content and subsequently licenses the various forms of intellectual property to its affiliated network and basic cable channel outlets (including FX, FXX, and FXM).[40] As there are notable economic benefits for pursuing mergers and acquisitions (“M&A”),[41] the trend in consolidation will continue.

i. Disney's Pending Merger with Fox

In December 2017, Disney proposed a $52.4 billion all-stock deal to acquire Twenty-First Century Fox (“Fox”) and various other assets owned by Rupert Murdoch.[42] Disney is purchasing a significant portion of Fox in order to expand its content production capabilities while simultaneously growing its presence in the direct-to-consumer streaming distribution business.[43]

ii. CBS/Viacom Merger

As of 2018, Shari Redstone, the current controlling shareholder of both Viacom and CBS, announced that the companies are evaluating a merger.[44] From a business perspective, valuations of each respective company have declined due to diminished ratings.[45] Viacom and CBS’ market capitalization is $14 billion and $22.5 billion, respectively.[46]

iii. Lionsgate Acquisition

Lionsgate acquired Starz in 2016[47] and Summit Entertainment in 2012. The Summit acquisition was an all cash and stock deal structured as a leveraged buyout for approximately $412.5 million.[48] Now, Lionsgate is actively looking for suitors.[49] There are even potential discussions regarding the combination of Lionsgate, Viacom, and CBS.[50

III. DISCUSSION

A. Punitive Damages

Punitive damages are not recoverable in an action for breach of contract, no matter how willful, malicious, or fraudulent the breach.[51] Punitive damages may be awarded when a defendant fraudulently induces the plaintiff to enter into a contract.[52] Various factors are relevant in assessing an award for punitive damages including (1) the nature of the defendant’s acts, (2) the number of compensatory damages awarded, and (3) the wealth of a given defendant.[53] Punitive damages are a significant deterrent to fraud in the area of profit participation.

B. Profit Participation & Fraud

One of the primary factors inherent in evaluating punitive damages is the wealth of the defendant.[54] In the case of a breach of contract cause of action, punitive damages only become available when a party fraudulently induces another to enter into an agreement.[55] Rightful claims for fraud and the threat of an award for punitive damages are the only ways to give plaintiffs significant leverage in profit participation litigation, as there is no sign that consolidation in the entertainment industry is slowing down.

There was no claim for fraud in Darabont’s complaint against AMC.[56] AMC’s promise to impute a fair market value licensing fee for the series could be viewed as a fraudulent inducement in light of the circumstances. In the litigation asserted against AMC by Kirkman, et al., the plaintiffs asserted that AMC (1) fraudulently induced the breach of various contracts and (2) knew of and were aware of unfair or fraudulent business practices and therefore violated Business and Professions Code § 17200 et seq.[57] The plaintiffs demanded punitive damages.[58] The judge presiding over the litigation for Smallville also allowed for a finding of punitive damages.[59]

In the Smallville litigation, WB argued it was entitled to summary judgment because the company had sole discretion to set the terms of its licensing agreement. This calls into question whether WB’s bargained for discretion negated its implied obligation to act in good faith.[60] Although this case was settled before trial,[61] this matter begs the question as to whether WB’s representations and warranties misled and fraudulently induced the plaintiffs to enter into the arrangement. Depending on the court’s ruling, this could have substantiated punitive damages, if this case would have gone to trial.

C. Vertical Integration and Fraud Concerns

There are distinct business strategies and market pressures which promote consolidation in the entertainment industry. Companies sometimes seek mergers in order to compete more effectively in a changing industry landscape.[62] After the bankruptcy of Relativity Media,[63] and now, in anticipation of Disney’s acquisition of Fox (one of the six major motion picture studios), Lionsgate is primed to sell, in part, to avoid competing with the major conglomerates.[64]

There is also pressure from Wall Street for media and entertainment companies to integrate in order to increase shareholder value.[65] Although growing shareholder value is one of the primary goals of corporate management,[66] one must also consider the mechanism by which it is created. The increased wealth for shareholders may very well come at a cost to content creators. Both Darabont’s and Kirkman’s lawsuits against AMC, for instance, show plausible ways in which the network orchestrated a scheme to wrongfully keep profits for themselves. Although AMC’s increased profits likely produced greater shareholder wealth, it may have been at the expense of content creators and other related talent. It’s unlikely that media consolidation will deter the trend of manipulative accounting in the entertainment industry.

In a statement related to Disney’s acquisition of Fox, Rupert Murdoch stated: “[w]e are extremely proud… and I firmly believe that this combination with Disney will unlock even more value for shareholders.”[67] Considering the precedent for accounting manipulation in vertically integrated companies, however, this merger should be extensively scrutinized. Disney’s acquisition will only increase the already dynamic and imbalanced trend in vertical integration. Awards for punitive damages in both Darabont’s and Kirkman’s suits against AMC, however, may send a signal to Disney and the rest of the industry that manipulative accounting comes at a potentially hefty price. There are still concerns about the cost and time of litigation, particularly for plaintiffs with little to no leverage.

A content creator typically has an opportunity to realize their contractual right to profits only through lengthy and costly litigation. The threat of litigation is at least plausible for highly regarded talent and their respective agencies, both of which typically have deep pockets. Costly litigation, however, is often not an option for plaintiffs with limited means. Contingency or hybrid fee formulas in cases amounting to fraud in profit participation claims may alter the balance of power. The threat of punitive damages is certainly a hopeful deterrent against conglomerates, which are only increasing in size, power, and wealth.

IV. CONCLUSION

While it is yet to be determined whether the merger between Disney and Fox will occur, questions remain as to whether the ongoing trend in consolidation will create an even greater propensity for accounting manipulation in the entertainment industry. The threat of punitive damages may be the best weapon for rightful plaintiffs.

 


[1] Reed Abelson, The Shell Game of Hollywood ‘Net Profits’; Dreamworks May Be Shaking Up Some Time-Honored Accounting Habits, THE NEW YORK TIMES, (March 4, 1996), https://www.nytimes.com/1996/03/04/business/shell-game-hollywood-net-profits-dreamworks-may-be-shaking-up-some-time-honored.html.

[2] A perpetual imputed licensing fee is essentially a never-ending stand-in number used in accounting statements where no money has actually changed hands and where the figure is not meant to be renegotiated. Hoai-Tran Bui, ‘The Walking Dead’ Hit With Another Lawsuit As Producers Claim AMC Profit Scam, SLASH FILM, (Aug. 15, 2017), http://www.slashfilm.com/new-walking-dead-lawsuit/.

[3] Kim Masters and Mathew Belloni, Fired ‘Walking Dead’ Creator Frank Darabont Sues AMC for Profits, THE HOLLYWOOD REPORTER, (Aug. 14, 2013), https://www.hollywoodreporter.com/thr-esq/fired-walking-dead-creator-frank-666176 (last visited March 5, 2018). “Affiliates are legally independent enterprises, which in relationship to one another are majority-held and majority-holding enterprises (Section 16), controlled or controlling enterprises (Section 17, group companies (Section 18), companies with cross shareholdings (Section 19), or parties to an enterprise agreement (Sections 291 and 292).” N.A. Regulation of Affiliated Parties – Germany, (N.D.), http://group27.narod.ru/ucheba/files/tasis/Documents/English/1/1-3/1-3-2/1-3-2-2.pdf.

[4] Eriq Gardner, ‘Walking Dead’ Producers Claim Massive AMC Profits Scam in New Lawsuit, THE HOLLYWOOD REPORTER, (August 14, 2017), https://www.hollywoodreporter.com/thr-esq/walking-dead-producers-claim-massive-amc-profits-scam-new-lawsuit-1029197.

[5] Gardner, supra note 4.

[6] Gardner, supra note 4.

[7] Eriq Gardner, Warner Bros. Settles Big ‘Smallville’ Vertical Integration Lawsuit (Exclusive), THE HOLLYWOOD REPORTER, (Jan. 3, 2013),  https://www.hollywoodreporter.com/thr-esq/warner-bros-settles-big-smallville-407821.

[8] Gardner, supra note 7.

[9] It seems that the visibility of profit participation litigation may encourage more potential plaintiffs to file claims against studios, as a class of plaintiffs sued Sony Pictures Entertainment in 2013 over their fair share of profits from home video revenue. Paul Tassin, Sony Pictures Entertainment Home Video Revenue Class Action Settlement, TOP CLASS ACTIONS, (Nov. 3, 2017), https://topclassactions.com/lawsuit-settlements/closed-settlements/825109-sony-pictures-entertainment-home-video-revenue-class-action-settlement/.

[10] Mark Sullivan, Why 2017 Will Be A Huge Year For Telecom And Media Mergers, FAST COMPANY, (March 15, 2017), https://www.fastcompany.com/3068696/why-2017-will-be-a-huge-year-for-telecom-and-media-mergers.

[11] Adam Baidawi, Star Wars, Marvel, Pixar: Why Disney bought them all, INTHEBLACK, (April 1, 2016), https://www.intheblack.com/articles/2016/04/01/star-wars-marvel-pixar-why-disney-bought-them-all.

[12] Cynthia Litttleton and Brian Steinberg, Disney to Buy 21st Century Fox Assets for $52.4 Billion in Historic Hollywood Merger, VARIETY, (Dec. 14, 2017), http://variety.com/2017/biz/news/disney-fox-merger-deal-52-4-billion-merger-1202631242/.

[13] Larry Downes, The Government’s Unraveling Antitrust Case Against AT&T-Time Warner, FORBES, (Feb. 1, 2018),  https://www.forbes.com/sites/larrydownes/2018/02/01/the-governments-unraveling-antitrust-case-against-att-time-warner/.

[14] Anita Busch & Dawn C. Chmielewski, Lionsgate Ripe For Takeover As Amazon, Verizon and CBS-Viacom Emerge As Potential Suitors, DEADLINE, http://deadline.com/2018/01/lionsgate-talks-amazon-verizon-cbs-viacom-1202244991/.

[15] Dade Hayes & Dawn C. Chmielewski, In A CBS-Viacom Merger, What Would The Combined Company Look Like?, DEADLINE, http://deadline.com/2018/01/cbs-viacom-merger-combined-company-1202270428/.

[16] Ezra Doner, The Walking Dead: Is AMC’s License Fee “Improper” and “Outrageous”?, LAW OFFICE OF EZRA J. DONER, (March 31, 2015), http://donerlaw.com/the-walking-dead-is-the-license-fee-between-amc-entities-improper-outrageous-and-unconscionably-low/.

[17] Doner, supra note 16.

[18] Complaint, Index No. 654328/2013, Paragraph 6.

[19] See supra note 18.

[20] Supra note 18.

[21] Supra note 18.

[22] Supra note 18.

[23] Supra note 18.

[24] Supra note 18.

[25] Supra note 18.

[26] See Gardner, supra, note 4.

[27] Gardner, supra, note 4.

[28] Gardner, supra, note 4.

[29] Gardner, supra, note 4.

[30] Gardner, supra, note 4.

[31] See Gardner, supra note 7.

[32] Gardner, supra note 7.

[33] Gardner, supra note 7.

[34] Gardner, supra note 7.

[35] Gardner, supra note 7.

[36] Gardner, supra note 7.

[37] Jonathan D. Glater, Study Finds Settling Is Better Than Going to Trial, THE NEW YORK TIMES, (Aug. 7, 2008), https://www.nytimes.com/2008/08/08/business/08law.html.

[38] Michael Sippel, Vertical Integration in the Entertainment Industry and its Impact on Profit Participations, GREEN HASSON & JANKS, (Feb. 23, 2017), https://www.greenhassonjanks.com/blog/media-clips/vertical-integration-entertainment-industry-impact-profit-participations/.

[39] Sippel, supra note 38.

[40] Sippel, supra note 38.

[41] Some benefits of M&A include cost reductions through elimination of redundancies and enhanced revenue through increased market share. Economy Watch, Benefits of Mergers and Acquisitions, ECONOMY WATCH, (July 16, 2010), http://www.economywatch.com/mergers-acquisitions/benefits.html.

[42] See Litttleton and Steinberg, supra note 12.

[43] See Litttleton and Steinberg, supra note 12.

[44] See Hayes & Chmielewski, supra note 15.

[45] Hayes & Chmielewski, supra note 15.

[46] Hayes & Chmielewski, supra note 15.

[47] See Busch & Chmielewski, supra note 14.

[48] Busch & Chmielewski, supra note 14.

[49] Busch & Chmielewski, supra note 14.

[50] Busch & Chmielewski, supra note 14.

[51] Walker v. Signal Companies, Inc., 84 Cal.App.3d 995 (1978).

[52] Walker v. Signal Companies, Inc.supra note 51.

[53] Walker v. Signal Companies, Inc. supra note 51. at 997.

[54] Walker v. Signal Companies, Inc.supra note 51.

[55] Walker v. Signal Companies, Inc.supra note 51.

[56] See supra note 18, Paragraphs 61-79.

[57] Complaint, Case No. BC672124, Paragraphs 177-197.

[58] Supra note 57., at Paragraph 198(c).

[59] See Gardner, supra note 7.

[60] California Civil Jury Instructions (CACI) (2017), JUSTIA, https://www.justia.com/trials-litigation/docs/caci/300/325.html (last visited March 5, 2018).

[61] See Gardner, supra note 7.

[62] See Hayes & Chmielewski, supra note 15.

[63] Anita Busch, Banker Gives Up On Relativity; Investor Officially Pushes For Chapter 7, DEADLINE, (Feb. 8, 2017),  http://deadline.com/2017/02/investment-banker-relativity-investor-chapter-7-1201906082/ (last visited March 5, 2018).

[64] See Busch & Chmielewski, supra note 14.

[65] See Hayes & Chmielewski, supra note 15.

[66] Jia Lynn Yang, Maximizing shareholder value: The goal that changed corporate America, THE WASHINGTON POST,(Aug. 26, 2013), https://www.washingtonpost.com/business/economy/maximizing-shareholder-value-the-goal-that-changed-corporate-america/2013/08/26/26e9ca8e-ed74-11e2-9008-61e94a7ea20d_story.html?utm_term=.33b584cabf10 (last visited March 5, 2018).

[67] See Litttleton and Steinberg, supra note 12.


             
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