Viacom in legal battle over Rock Band payments

Viacom Inc. and the former owners of the studio that makes its Rock Band video games are enmeshed in a legal battle, wrangling over hundreds of millions of dollars at the same time that sales of the games are plummeting.

Former shareholders in Harmonix Music Systems have filed a lawsuit that has triggered a high-stakes arbitration proceeding with Viacom just as the media giant is attempting to sell the video game maker after years of losses. The legal and financial morass is likely to complicate that effort.

The two sides have gone to an independent arbitrator over the issue of additional payments based on sales of Rock Band that the Harmonix shareholders believe are owed to them under the terms of the 2006 acquisition of the studio by Viacom. The amount in dispute totals hundreds of millions of dollars, according to people familiar with the situation.

At the same time, a proxy for the original Harmonix owners bought out by Viacom is suing the New York-based owner of MTV Networks and Paramount Pictures in Delaware Chancery Court for more than $13 million, alleging unfair business practices.

The legal conflicts come amid a rapid downturn in sales for music video games in the last two years, which led Viacom to decide to exit the business.

MTV acquired Harmonix, which created the hit Guitar Hero games for Activision, for $175 million plus potential future payments based on performance.

Initially estimating that the 2007 performance payments would be $208.7 million, according to a filing with the Securities and Exchange Commission, Viacom ended up paying only $150 million after the media company concluded that Harmonix’s performance was not as strong as it had originally projected. Two months later, according to a November 2008 SEC filing, Viacom said it expected the 2008 performance payment to be more than the $150 million it paid the previous year.

That estimate also proved overly optimistic.

Despite more than $1 billion in retail sales to date, Viacom has been unable to make a profit on Rock Band games. The company has said that is partly because of the costs of producing and shipping the guitar- and drum-shaped controllers. The trend worsened in 2009 as sales of music video games began falling.

By early 2010, Viacom had radically changed its view on what it owed Harmonix’s shareholders. In an SEC filing, it claimed that it was owed a “refund of a substantial portion of amounts previously paid.”

Viacom’s legal action to extract repayment is unusual, according to one expert.

“Earn-outs are quite typical when buying a private company, but it’s very difficult to get money back in that context,” said Ehud Kamar, a professor at the USC School of Law.

People close to the matter said the “substantial portion” in Viacom’s claims represents nearly all of the $150 million it paid to the former Harmonix shareholders. They added that Viacom believes it does not owe any performance payment for 2008.

Walter Winshall, an investor in Harmonix who was designated proxy for the shareholders in the purchase agreement, disputed Viacom’s calculation, according to the lawsuit.

Although the suit does not specify how much Winshall believes shareholders are owed, people close to the matter said he has claimed it is hundreds of millions of dollars more than the $150 million that Viacom has already paid out.

In his lawsuit, Winshall alleges that Viacom breached a covenant of good faith and fair dealing by failing to renegotiate an agreement with Electronic Arts Inc., which distributed and marketed Rock Band, on more favorable terms after the game’s launch. The media company allowed the deal to run its course through 2009, the suit states, because an earlier renegotiation would have increased the performance payment due to Harmonix shareholders.

A Viacom spokesman said in a statement, “We have been more than fair with Mr. Winshall, who is trying to rewrite the terms of our contract. We intend to defend this vigorously.”

The lawsuit comes at a time when retaining Harmonix employees, including Chief Executive Alex Rigopulos and Chief Technical Officer Eran Ergozy, will be important to Viacom to successfully sell the studio. One person close to Viacom said that the dispute was primarily with outside investors and that the company believed it had retained good relationships with Harmonix staff.

ben.fritz@latimes.com