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Why Google’s Deal with YouTube Presented an Acceptable Level of “Legal Risk”

October 17th, 2006 by David Kronemyer · No Comments

Any business transaction involves both “business risk” and “legal risk.” The former is that the economics of the deal don’t work. Either the company, or its management, doesn’t perform as anticipated; the price was too high; or, the market for the company’s product is different, than was expected. The latter involves the prospect of claims, either against one’s transacting counterpart; or, brought by third parties. For example, representations and warranties in an asset purchase agreement may turn out to be false. Or, the other party to the contract simply may repudiate it – which occurs more often than you might think! Then, there always is the prospect of claims by third parties, potentially assertible against the acquiring company, on various grounds.

Provision can be made in an asset purchase agreement (or any other contract, for that matter) for indemnification against such claims. Indemnification provisions, however, only are as strong as the ability of the indemnifying party to perform. For this reason, any indemnification provision should be collateralized by, say, some kind of reserve, or retention against the purchase price, or even a standby letter of credit. This type of security, though, may be difficult to negotiate.

For these reasons, it is important for the acquiring company to get some kind of grasp on the legal risk any acquisition transaction presents. This particularly is true with intellectual property rights, which can be fraught with potential claims. For example, it might be alleged that royalties were not paid; that assets were improperly or inefficiently exploited; or, that there have been acts of infringement. The monetary value of these types of claims frequently is difficult to quantify. The mere fact there is “some” degree of risk shouldn’t be sufficient, in and of itself, to disqualify a potential transaction. Obviously this is a slippery slope, so, the question often becomes, what degree of risk is “acceptable,” in light of all other current factors. An acceptable degree of risk under one set of circumstances, may be unacceptable in others.

For example, one of the reasons why Tom Freston allegedly was ousted as CEO of Viacom was because he hadn’t been aggressive enough in pursuing new media acquisitions, such as MySpace, Fabrikant, G., “Viacom C.E.O. Ousted as Stock Price Falls,” New York Times (Sep’t 5, 2006); Goldsmith, J., “Sumner speaking out,” Variety (Oct. 5, 2006). In fact, Sumner Redstone, Viacom’s Chairman, has been quoted as saying that he was “humiliated” by the loss, Sorkin, A. & Edmonston, P., “Google Is Said to Set Sights on YouTube,” New York Times (Oct. 7, 2006). Frankly, I doubt this is true. Freston probably was doing his best, but had concluded (almost surely in collaboration with Redstone) that the transaction either presented too much business, or legal, risk.

Even Rupert Murdoch, News Corp.’s CEO, initially had doubts whether a new-media acquisition such as MySpace made sense, Siklos, R., “News Corporation Buys An Internet Company,” New York Times (Jul. 19, 2005). Now, however, Murdoch is being heralded as a genius because he purchased MySpace for $580 million, and shortly thereafter negotiated a three-year advertising deal with Google that should pay $900 million, meaning he’s $320 million ahead of the game, Hansell, S., “Google Deal Will Give News Corp. Huge Payoff,” New York Times (Aug. 8, 2006).

Google recently acquired YouTube for $1.65 billion, Sorkin, A. & Leeds, J., “Dot-Com Boom Echoed in Deal To Buy YouTube,” New York Times (Oct. 10, 2006). Some of the reports of that acquisition speculated that MySpace now is worth several times what Mur doch paid for it, e.g., Sorkin, A. & Edmonston, P., “Google Is Said to Set Sights on YouTube,” op. cit. In fact, MySpace’s founder, Brad Greenspan, alleged in a lawsuit that the company now was worth an astonishing $20 billion, “MySpace Purchase Ruled Lawful, News Corp. Says,” Los Angeles Times (Oct. 10, 2006).

I’m confident Viacom was given the opportunity to submit a competing offer to buy YouTube, but either it was flat-footed, or its offer didn’t cut the mustard. Perhaps at some point in the future, Mr. Redstone will use this as an excuse to can Mr. Freston’s replacements? And, of course, there are many who say that, at $1.65 billion, Google radically over-paid, see, e.g., Hurley, C. & Che, S., “Valuing Google Is a Shot in the Dark,” Wall St. Journal (Oct. 14, 2006); and Siklos, R., “A Loopy Deal That Actually Makes Sense,” New York Times (Oct. 15, 2006). All we need to do is to sit back and wait for the coverage that makes Google’s acquisition of YouTube seem every bit as prescient as News Corp.’s acquisition of MySpace.

In any event, I was reminded of the dynamic of “too much legal risk” as I read several articles suggesting that Google’s acquisition of YouTube in fact presented an unacceptable degree of legal risk. The naysayers include: Goldstein, P., “The People’s Republic of YouTube,” Los Angeles Times (Oct. 17, 2006); Karnitschnig, M. & Delaney, K., “Media Titans Pressure YouTube Over Copyrights,” Wall St. Journal (Oct. 14, 2006); “Does YouTube Make Google a Big Target For Copyright Suits?,” Wall St. Journal (Oct. 11, 2006); and Kirsner, S., “Et tu, YouTube,” Daily Variety (Oct. 10, 2006). The legal issue is a matter of copyright law: whether YouTube could be liable because its users post video clips of footage that others (primarily, television broadcasters, movie studios, and record companies) own.

There sure has been a lot of saber-rattling. For example, Doug Morris, CEO of the Universal Music Group, stated that YouTube owes his company “millions of dollars” on account of alleged infringement, Duhigg, C., “Music Chief Rails at Websites,” Los Angeles Times (Sep’t 14, 2006). And, “Mark Cuban, a dot-com billionaire who has invested heavily in tech-related entertainment companies, recently said YouTube would be ‘sued into oblivion’ as soon as it was owned by a company with deep pockets, and that anyone who bought the company was ‘a moron,’” Gaither, C. & Chmielewski, D., “Google May Be Vying for Site,” Los Angeles Times (Oct. 7, 2006).

As if to validate this concern, right before the acquisition, YouTube was busy entering into agreements with key licensors such as the Warner Music Group, Leeds, J., “Warner Music Makes Licensing Deal With YouTube,” New York Times (Sep’t 19, 2006); Marlowe, C., “New spin to YouTube, WMG deal,” Hollywood Reporter (Sep’t 19, 2006). Then, it entered into (presumably, similar) deals with CBS Corp., Sony-BMG Music Entertainment, as well as Universal Music Group, Delaney, K., “Google Nears Deal With YouTube,” Wall St. Journal (Oct. 9, 2006), “YouTube cuts deals with CBS, major music labels,” Hollywood Reporter (Oct. 10, 1006). “The deals clear the way for music videos, television news, sports clips and entertainment programs to be distributed free on YouTube in exchange for a share of whatever advertising revenue may follow,” Gaither, C. & Chmielewski, D., “Google Bets Big on Videos,” Los Angeles Times (Oct. 10, 2006). Throughout this time, YouTube has been super-vigilant to respond to cease-and-desist letters, by taking down offending videos, Delaney, K. & Smith, E., “YouTube Model Is Compromise Over Copyrights,” Wall St. Journal (Sep’t 19, 2006).

There are good arguments on both sides of the rights question, which I won’t parse out, here (it’s too boring!). What I would like to suggest is that Google’s management was fully justified in proceeding with the acquisition of YouTube, because the propensity of lawyers always is to overstate the risk of litigation. To paraphrase Paul Simon, there must be 50 ways to say no to a deal, and this is one of the most oft deployed. But, the fact of the matter is, while some people might sue, all of those suits are manageable. Furthermore, it is in the best interests of potential content licensors to enter into agreements with YouTube, as it quickly has turned into an ideal outlet through which to advertise, market and promote their products.

I had personal experience with this when EMI acquired Roulette Records from the legendary Morris Levy. I was on point in the transaction, from EMI’s side. EMI senior management was terrified of the deal, because Morris had an endearing habit of not paying royalties to his artists. “There will be millions of dollars worth of claims,” it was said, “all we are doing is acquiring a bunch of liabilities.” So, EMI made the decision only to acquire international rights, and actually lent money to Rhino Records, which it then distributed, to acquire all of the domestic (U.S.) rights. The burghers of EMI were well content with this arrangement, when the transaction closed. “We sure dodged the bullet on that one, didn’t we, old mate?”

Needless to say, every last claim was resolved within the space of a few months. Few (if any) lawsuits were filed. The “problem,” such as it was, disappeared in a puff of smoke. There came a time when Rhino shifted its U.S. distribution to the Warner Music Group, which bought half the company, then later bought the rest. And, Rhino has gone on to sell millions of dollars worth of Roulette records.

There are a couple of morals that can be derived from this story. One is that it is hard to over-value intellectual property rights, as they will tend to appreciate over time, particularly with the advent of new media. Second, there only are so many “catalogs” of intellectual property rights available at any time for purchase, particularly those with items potentially demanded by consumers. And, third, you never ever should let lawyers make the business decision whether to proceed; because, inevitably, they will default to an “asset protection” mode, rather than being proactive. I’m not saying they shouldn’t do that, because that’s their training, background and experience; but, it is antithetical to properly evaluating business, as against legal, risk.

UPDATE: On October 18, 2006, an irascible Doug Morris made good his earlier vow by suing Grouper.com and Bolt.com, two video-sharing web-sites, for copyright infringement, Smith, E. & Delaney, K., “Vivendi’s Universal Sues Two Web Sites Over Video Sharing,” Wall St. Journal (Oct. 18, 2006); Fritz, B. & Gallo, P., “Biz’s share scares,” Daily Variety (Oct. 18, 2006); DiOrio, C., “UMG files suit against pair of P2P sites,” Hollywood Reporter (Oct. 18, 2006). Interestingly, Grouper.com seems to be owned by Sony Pictures, a competitor of UMG’s sister company, Universal Films. Grouper Chief Executive Josh Felser was quoted as saying the lawsuit is “without merit,” adding: “Our Web site is protected by federal law, and we’re vigilant about taking down copyrighted content when we’re properly notified.”

Ironically, the WSJ ran a companion article on the incredible marketing opportunities presented by new-media sites such as MySpace and YouTube, Angwin, J., McBride, S. & Smith, E., “Record Labels Turn Piracy Into a Marketing Opportunity,” Wall St. Journal (Oct. 18, 2006). The New York Times also is doing its best to point out the seemingly obvious, Sorkin, A. & Leeds, J., “Music Companies Grab a Share of the YouTube Sale,” New York Times (Oct. 19, 2006). Yet, sesquipedalian antipodes like Mr. Morris seem to be ignoring new reality. “You’re either part of the solution,” as Eldridge Cleaver put it in 1968, “or part of the problem.”