Mortal combat

Last fall, lawyers for Sumner Redstone and National Amusements Inc. scrambled to salvage the mogul's holdings in CBS Corp. and Viacom Inc.

Part movie theater chain and part holding company, NAI holds Redstone's stakes in CBS, Viacom and, until recently, Midway Games Inc. As CBS and Viacom shares fell last year, NAI encountered a problem. The sharp declines created issues with debt covenants that imperiled the company.

The solution involved the improbable $100,000 sale of a controlling stake in Midway and title to $70 million in debt, to a little-known Concord, Mass., investor named Mark Thomas. By applying the loss on the sale to taxes, NAI reaped a substantial amount of cash that it could use to address its own balance sheet. Crisis averted.

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Now, months later, another problem is taking shape in the Delaware court where Midway sought bankruptcy protection in February. The sale has become a pivotal issue in early hearings on Midway's ability to draw on cash that Thomas claims as collateral. It promises to be the central dispute in efforts by the "Mortal Kombat" publisher to reorganize its debts. Lawyers for Thomas describe a legitimate sales process that led to a deal and say the price tag and buyer are irrelevant. To save their holdings in CBS and Viacom, unsecured creditors argue, the Redstones and NAI sacrificed Midway.

The creditors' arguments have resonated with Judge Kevin Gross, who called the transaction "a matter of very, very serious concern" during an April bankruptcy hearing, a transcript shows. "This is a game company," Gross said, "but that did not give National Amusement the right to treat a public company as if it were a toy."

NAI and the Redstones were not technically part of the litigation, although they were central to much of the testimony. "Neither Sumner Redstone nor NAI were parties to these proceedings, which involved Midway's motion to use cash collateral," an NAI spokeswoman says. "We strongly disagree with any suggestion that Mr. Redstone or NAI breached any fiduciary duties, and we are confident that any court that heard NAI's or Mr. Redstone's position would find their conduct entirely proper."

Midway has published more than 400 video games over two decades. It also lost lots of money. In 2008, the Chicago company posted a $113 million operating loss against $219 million in revenues. Early last year, Midway sought $30 million in funding from NAI to keep operating. As talks proceeded, Midway discovered, among other things, flaws in its software that projected cash flows: It actually needed $90 million. Midway received the financing in February. Within months, it needed more. In September, NAI provided a factoring agreement.

Given Redstone's stake in Midway and the history between NAI and Midway, the creditors' committee argues that the court should view the $90 million February funding as equity, not debt. The committee says the debtor "went to ask Dad for the money" and charges that neither NAI nor Midway considered whether the company was solvent or could support the new debt.

Sumner Redstone was Midway's controlling shareholder, but not an officer or a director. Until early November, his daughter, Shari Redstone, chaired Midway's board. In video testimony, the senior Redstone said he relied on his daughter's advice about whether to fund Midway.

Shari said she considered Midway fortunate to arrange the financing.

NAI soon had its own problems. In October, the Dedham, Mass., company sold $233 million worth of CBS and Viacom stock to cut its debt and entered talks with creditors. Shari Redstone stepped down from Midway's board on Nov. 7, saying she would focus on her new appointment to a special committee of NAI's board.

Thomas testified he first heard about Midway and its pending sale on Nov. 14, when he got a call from Shearman & Sterling LLP lawyers Creighton Condon and Peter Lyons. Thomas had worked with Lyons when he was chief development officer of auto emissions testing company Envirotest Systems Corp.

He had spent time at ITT Corp. and buyout firm Georgetown Partners LLC.

Thomas conducted due diligence using online information and reports from FMR LLC's Fidelity Investments. He sought a partnership with private equity firm Centerbridge Partners LP. Centerbridge declined, and Thomas offered to buy Midway for $1 million, only to reduce that to $100,000, he says, to reflect risk related to the value of Midway's intellectual property and other concerns. The committee notes that Thomas dropped the price after NAI declined to indemnify him against creditor actions. He also transferred his house to his wife. Thomas insists that was part of an estate management strategy, but creditors suggest it was to shield assets. On Nov. 28, two weeks after Thomas first learned of Midway, the deal closed.

Sumner Redstone denied any kind of cozy relationship with Thomas. In her video deposition, Shari Redstone said she learned of the sale from lawyers "when I had all of my pies in the oven" on the night before Thanksgiving. "I pulled my pies out of the oven. It was not a good night."

Midway itself knew little about Thomas. Internal communications presented in court state that the company could not obtain information from his lawyers, "even to the extent of determining his middle initial."

Linda Dakin-Grimm of Milbank, Tweed, Hadley & McCloy LLP for the creditors' committee said the Shearman lawyers "lined him up to do this transaction by flattering him that he was somehow an expert in mergers and acquisitions and he could do this really quickly and he was all on his own, which frankly means he wasn't going to look into it too deeply and somehow they knew that."

Thomas' lawyers at Kramer Levin Naftalis & Frankel LLP defended the deal. "We have Mr. Redstone and NAI going to their longtime counsel and their longtime counsel suggesting at least one person that they had done business with," Timothy Harkness told the court. "And I think that it's fair to infer from that process that this was not someone just willy-nilly handing out the company."

The change in control triggered put rights held by noteholders, leading to bankruptcy. It is hotly disputed whether it also jeopardized hundreds of millions of dollars in net operating losses that could be applied to future earnings, if Midway ever turns a profit.

The April hearing concerned what is often a mundane bankruptcy matter, a debtor's ability to use cash on its books. The unsecured creditors' committee says Thomas' debts should be recharacterized as equity or subordinated to other debts. They will also pursue damages against the Redstones, Thomas, NAI and members of Midway's board.

"The Redstone entities simply ignored this duty because their backs were to the wall," creditors' committee lawyer Dakin-Grimm said in court. "They made an advised decision to throw Midway to the wolves to save their interest in CBS and Viacom."

Midway wants the parties to mediate their dispute rather than burden the estate with litigation. The judge did not rule on wrongdoing but signaled concerns. "The fact, for example, that acquisition holdings for an investment of $100,000 stands before creditors who invested millions of dollars in Midway is something that the court can't ignore," he said.

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