Critical Issues in Entertainment M&A Due Diligence

This is the latest in a series of columns by O’Melveny & 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 year’s 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 bidder’s complaint, holding that the nonreliance and waiver clause in the parties’ nondisclosure agreement (NDA) barred the bidder from recovering its expenses—even 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 bidder’s 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 bidder’s 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 team’s 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 target’s 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