Restructuring

Contributed by Cristine Pirro
Today officially marks the start of summer, with the summer solstice bringing more sunlight than any other day of the year.  In honor of the longest day of the year, we review one of the longest opinions we’ve read over the last few months:  Judge Chapman’s 161-page opinion in 4Kids Entertainment, Inc.
4Kids Entertainment, Inc. is a children’s entertainment company that produces children’s television programming for shows such as Pokemon! and Yu-Gi-Oh!.  4Kids also licenses merchandise related to those characters and shows for, among other things, home videos, toys, and trading cards.  Beginning in 2001, 4Kids began to license the Yu-Gi-Oh! children’s series from a consortium of Japanese companies – Nihon Ad Systems, TV Tokyo Corporation, and ASATSU-DK, Inc. – that controls the rights to Yu-Gi-Oh!. The relationship was a relatively successful one for a number of years, generating over $150 million in revenue from 2001 through 2009.  In 2009, however, the relationship began to sour, and the consortium audited 4Kids.  The results of the audit revealed, among other things, an alleged royalty underpayment of $4.8 million by 4Kids.  Over the months that followed, the parties attempted (unsuccessfully) to resolve their issues.  As Judge Chapman put it, “[l]ike characters in the Yu-Gi-Oh! series itself, 4Kids and the Consortium were locked in a high stakes duel over the future of the series in the Western world and, by extension, the survival of 4Kids as a going concern.”
Last year, the consortium sent 4Kids a letter that purported to terminate its license agreement with 4Kids, and two members of the consortium filed a suit in the United States District Court for the Southern District of New York against 4Kids for fraud and breaches of the covenant of good faith and fair dealing. The plaintiffs also sought monetary damages, an accounting, and certain fees and costs relating to the license agreement among the parties.  Approximately two weeks later, 4Kids filed for bankruptcy protection in the United States Bankruptcy Court for the Southern District of New York, and the district court referred the action to the bankruptcy court.
One of the central issues in the adversary proceeding was whether the Japanese company had properly terminated the license agreement.   The Japanese company argued that it had properly terminated the licensing agreements with 4Kids, citing to 4Kids’ alleged breaches; Judge Chapman, in a 161-page opinion, found otherwise.  Judge Chapman reviewed not only the legal requirements behind termination of the agreement, but also the motives behind the Japanese company’s desire to terminate its business with the American company.  Much of her opinion focused on the credibility (or lack thereof) of the consortium’s witnesses and the consortium’s use of an auditor’s findings to rid itself of the contract with 4Kids for the purpose of using its own company as a merchandise licensing agent in the United States.
Background – The Purported Termination
The consortium used the auditor’s findings (namely relating to alleged underpayments by 4Kids pursuant to numerous related license agreements) to conclude that they were not being properly compensated by 4Kids and, therefore, were entitled to terminate the license agreement.  The agreement allowed termination in the event of a breach, provided the non-breaching party furnished written notice of the breach and a chance to cure within 10 business days of actual receipt of the written notice.  Over the course of the several months preceding the consortium’s purported termination of the agreement, the auditor provided its preliminary audit findings to consortium members, and they, in turn, reached out to 4Kids to request information and/or payments.  Throughout their correspondence, none of the letters included words of termination, nor were they sent by mail as required under the agreement.  Although two versions of a December 20, 2010 letter requested payment, one version called for payment six days before the date of the letter, while the other included an inaccurate calendar date for the 10 business day cure period.
In early 2011, certain of the consortium members and 4Kids negotiated the audit claims in an attempt to settle their dispute.  At the beginning of March, some of the consortium members sent a letter to 4Kids demanding 4Kids either sign an agreement giving up significant rights and a majority of their future Yu-Gi-Oh! revenue, or pay $2 – $3 million to settle the audit claims.  Shortly thereafter, those consortium members “inadvertently” copied 4Kids on an internal email stating that if 4Kids failed to commit any money, the consortium would send a termination letter.  4Kids paid $1 million to continue negotiating in good faith, and discussions continued.  By the end of March, the negotiations broke down.  On March 25, 2011, certain members of the consortium emailed a letter to 4Kids purporting to terminate the license agreement, “effective upon receipt.”    Following this letter, the consortium instituted its suit and 4Kids sought bankruptcy protection.
The Court’s Analysis
The court began its analysis with a highly-detailed study of the auditor’s findings.  It found many inconsistencies in the testimony of the consortium’s witnesses concerning the findings and also concluded that the findings did not necessarily signify 4Kids had breached the license agreement.  The court then turned to the purported termination letter sent by the consortium to determine whether it effectuated a valid termination of the agreement.  Although the “termination letter” referenced earlier letters sent by certain members of the consortium, it did not specify which of those constituted an effective termination.  Under New York law, a notice of breach is not effective unless it complies with the contractual requirements for breach.  The consortium required notice in writing by express mail or fax (with a follow-up copy by express mail).  There was no evidence that the letter was sent by either express mail or fax.  The court found that it would have made the termination provision meaningless if termination could have been effected without compliance with this provision; thus, 4Kids never received a proper and effective notice of termination.
The court also found that 4Kids was not allowed a suitable opportunity to cure.  The notice did not provide sufficient information for 4Kids to determine what steps were necessary to cure the alleged breach.  Some of the calculations for payments allegedly owed were inconsistent across letters, and some of the letters failed to provide enough information or supporting documentation for 4Kids to fully evaluate the auditors’ claims.   What’s more, the consortium members refused to unbundle the audit claims, which deprived 4Kids of an effective opportunity to determine the validity of the claims.  The court further noted that even if a proper cure period had been provided, the fact that the parties engaged in extensive negotiations precluded the consortium members from terminating without providing 4Kids a final opportunity to cure.  Under New York law, when two contracting parties attempt to negotiate their disagreements after a cure period has expired, an additional notice and cure period must be given prior to termination.  This additional notice and cure period was not provided even though the parties continued negotiating up until the bankruptcy filing.
Finally, the court stated that even if the formal notice requirements were met and an appropriate cure period had been provided, the termination still would have been ineffective because the audit results were inaccurate, and the true underpayment would have been significantly lower than the purported amount.  Although the consortium members argued that “close enough is good enough;” in other words, if some of the findings are correct, or if the amount asserted is not arbitrary, that is sufficient reason to terminate, the court held to the contrary, finding that because the alleged amount owed was incorrect and inaccurate, it could not form a valid basis for termination.
Throughout the decision over whether the contract was properly terminated, the court reflected multiple times on the good faith of the consortium and the credibility of its witnesses.  The court described the decision to audit 4Kids as uncommon in Japan and questioned the real motive behind the decision to commence the audit.  In the words of the court, the consortium “appears to have misled 4Kids about the purpose of the audit, and apparently has made misrepresentations to the Court on this issue.”  The evidence presented at trial indicated that the consortium was trying to independently conduct operations in the U.S. and was analyzing whether it would be possible to resume daily work without 4Kids.  The consortium’s secret plan to replace 4Kids as its merchandise licensing agent and licensee of the Yu-Gi-Oh! television home and video rights during the audit period led the court to believe the consortium’s end goal was not to resolve the audit dispute, but rather to rid itself of 4Kids.  Having found that the consortium failed to terminate the license agreement, the court held that the agreement remained property of the debtor’s estate.
In the end, the battle for the rights to license the popular series appears to be over (for now).  4Kids remains in possession of its rights under the license agreement.  Whether it chooses to assume the license agreement (and cure any breaches thereunder) or reject it is a battle for another day.