Caveat Emptor a Astros

added 12/1/2013 by Patrick Hajovsky

caveat emptor - Phrase. Used as a warning to anyone buying something that there might be unforeseen problems or faults with what is bought.

Houston Astros - Baseball team. Used as a warning to anyone who might be thinking of becoming a baseball fan.

On November 21, Jim Crane's Houston Baseball Partners, LLC, sued Drayton McLane, his business McLane Champions LLC (don't you just love that name?), Comcast and NBC Universal. Our typically incurious local media featured this story in the back of the Sports section on Friday, November 22, and then with a more detailed description on the front of the Sports section on Saturday, November 23. This lawsuit is going to go down as one of the most significant events in Houston sports history, rivaling the downfall of Judge Roy Hofheinz and the Astros bankruptcy of the 1970s.

First, let's dispatch with what this lawsuit is not about. It's not about the team purchase itself. It's not about the move to the AL. It's related to those things, but only in the sense that a wet tongue is related to a frozen pole. I'll let you figure out which is which here.

Second, I am, by training and practice, a lawyer. I've worked on many business deals in my career, but I'm not at all a "deal lawyer". These matters were handled by insanely competent attorneys and I have no reason to doubt that the lawsuits will be handled by attorneys of the same caliber. My comments here are based on reflections from reading the actual lawsuit (which you can read for yourself here) and the public comments made over the last several years up to now. I highly recommend reading the lawsuit. It's fascinating stuff, but I'm a nerd about these things.

So, having said that, I'll now go into my perceived expert role and say what this lawsuit is about. This is all about the access fee charged for distributors to carry Astros games. That is the core of the suit. Crane says Drayton McLane (and Rockets owner Leslie Alexander) negligently set the access fee ridiculously high when Comcast Sports Network became an operating entity. Then, Crane alleges the Astros (and Alexander) concealed from him the nature of that huge hole in the viability of the network.

How big of a hole was this? Think the middle of the Milky Way, and then triple it, and then let it swallow up the galaxy. Crane argues that the fee was/is not only too high, it's ridiculously, ludicrously, knee-cappingly high, to the point that it would never have been feasible.

So your next question should be, "So what? Didn't you know this when you bought the team?" That's clearly McLane's response, given his public comments about the lawsuit. So let's look at this events in chronological order.

2003: Astros and Rockets form Houston Regional Sports Network, LLC, and immediately license their broadcast rights to it.

2010: Yes, it took seven years to get to the next step. That's important, as you may remember the long term frustration in getting this network off the ground, with McLane and the Rockets constantly going back and forth. That is potentially critical for what happens here, which we'll call "Setting the Hook". In this act, Comcast enters the picture to provide support and services to the network, in exchange for naming rates and an ownership interest.

At this point, McLane and Alexander, claims the suit, had a number in mind for the access fees cable and satellite carriers would pay to broadcast their little darling of a network. The difference between that number and an actually feasible number is roughly the difference between the competent implementation of Obamacare and the reality.

But, hey, aggression in business is not a totally bad thing, right? Water will find its level, and business realities will make this even out, correct? Not so fast, because this is where it gets really interesting. Comcast, unlike McLane and Alexander, have a little something called "market knowledge." Comcast knows the access fee is too high and advises McLane and Alexander against using the excessive number. They refuse. The lawsuit doesn't explicitly say why they refused, but one can infer that the network will not be viable without the excessive number.

Furthermore, and here the lawsuit actually does infer this, the sale of the Astros would be markedly, demonstrably less appealing to buyers unless the original financial projections (which cannot exist without the high access fees) are put in place. In other words, the fix was in for a potential buyer at this point, and the only buyer on the horizon in late 2010? James Robert Crane.

But it gets worse. As the lawsuit points out, Comcast knew the access fees were way too high and unmarketable. So what do they do? Comcast insists that their purchase deal to run the network and the access fees they would pay must include a "Most Favored Nation" (MFN) clause. This means that if the network ever uses a lower access fee with any other distributor, say Dish or U-Verse, then the fee Comcast pays the network drops down to match it. In essence, Comcast agrees to pay the ridiculous fee, but when it proves unviable, Comcast will get to pay the inevitably lower fee everyone else will pay. They bought in to get the naming rights and negotiated a sweetheart deal in the process.

The problem for Crane? The network is only viable financially if the higher fee is charged. There's no room here. Apparently, per Crane, the network can't exist without this high fee (Editor's note: For a counterpoint to this claim, read this column by Patrick Creighton after you are done here). And the network is the single largest source of projected revenue for the Astros. Without the network, which can't exist financially without the exorbitant fee, the Astros' financial prospects dim considerably.

All of this was concealed from Crane during the purchase. Or so he says. To bring a claim of fraud, the Defendants have to hide this information from Crane during the due diligence phase of the purchase process which, basically, lasts until the last second before signing.

2011: Crane's exclusive negotiating rights period begins in late 2010, and the deal is signed in May, 2011. A closing date is dependent on MLB's approval, which took awhile for various and sundry reasons. The deal closes on November 22, 2011.

Understand, in deals of this nature, what buyers and sellers think are critical documents to close the deal is inherently in conflict. A seller simply cannot disclose some information as it is confidential to how a business operates. In that context, Crane now complains about restricted access to documents. Further, his group was given but one conversation with someone "in the know" on the cable rights transactions. He is Jon Litner, Group President of NBC Sports Group.

Crane claims that Litner knowingly withheld information about this key defect, giving assurances that Comcast is a seasoned operator and wouldn't get involved unless the deal would make money. Crane then alleges Pam Gardner and Jackie Traywick (respectively, President of Business Operations and Chief Financial Officer of the Astros) not only gave the same assurances, they said Comcast was the one who initially proposed the base rates.

Comcast was uniquely situated to understand the importance of the access fee rates. As stated in the Original Petition, Comcast is a major television content distributor in the Houston market. They negotiated the MFN status because they knew the rates were too high and so gave themselves nothing to lose. Compare this to Crane's position. He claims his group didn't know the rates were unreasonably high, that the information was concealed from him and thus he didn't get a chance to do anything similar, such as walk away or negotiate something else.

This is where Crane's argument breaks down substantially in my view. Crane says McLane, Comcast and NBC knew of this startling defect in the business plan and didn't tell him. Yet Crane admits they had the agreement Comcast signed. Why would Comcast need an MFN provision? Wouldn't that give one pause if one is doing due diligence?

If you're a fiduciary and you don't know something, you are required by law to seek out an expert. With what cable industry experts did Crane consult? Anyone? What did Crane think was going to happen here? This is, again since it bears repeating, the single largest source of revenue for the Astros, in a singularly unique business structure for Houston. Other than, arguably, Home Sports Entertainment (HSE) back in the 1980s, nothing like this has ever been done in Houston. As a buyer, do you just expect folks to outline all of the potential defects of a complex transaction? Expect this issue to be hammered home by the Defendants.

Let's go back to the timeline. Crane says he first found out about this concealment in December 2012. Huh? The Rockets season began in late October 2012, and the risk of not broadcasting Rockets games on TV due to the rights fee issue had to have been known well in advance of that. In fact, it was well publicized prior to the season beginning. Wouldn't one be curious of this issue at that time, and not two months later?

Crane had owned the team a year by this point. Did they not find out about the inflated issue before this? Or, did they in fact agree with the premise that everything would work out okay because they assumed Comcast knows what they were doing? Sounds like a big gamble with "the single largest source of revenue" for the Astros, as Crane claims in the Original Petition.

Over and over again, throughout 2012 and 2013, the Astros and the Rockets have assailed the public that the problem is not the rights fee but that other carriers weren't giving the unique nature of the network its due. They vilified these distributors time and again as keeping the teams from their fans. Crane personally took to the airwaves many times making this point. I'm certain Crane would say, not without justification, that he was merely doing his best to make this deal work, all the while knowing that other carriers wouldn't touch the sort of fees he demanded.

But remember the bar which Crane has to overcome. He knew or should have known of the defect. If I give you documents and fully disclose them to you, it's up to you to read them and discover what they mean, not me. To what did he have access during the sale? I'm guessing a heck of a lot. The fact there was a poison pill in the Comcast deal, did the documents to which they had access open that up? Should it have? Did he consult anyone other than the folks who desperately wanted to make this work and who may not have had his interests first in their minds? I'd hope so, but this will be a core issue going forward.

Finally, this lawsuit is strange not for what's alleged (fraud), but for what's not being alleged. Crane not only sued McLane's company, he's suing McLane personally. However, Crane hasn't sued the Rockets, or Alexander. Why? The Original Petition makes it crystal clear they are a key part of the deal, and as integral to the "fraud" as McLane, Comcast and NBC.

That brings up some questions. Does Crane not want to sue a fellow owner? Does he still need the Rockets to put together a similar network in the future? What conversations has he had with Alexander about this lawsuit? Does Alexander also want to sue McLane for pushing this unsustainable rights fee arrangement, and costing Alexander millions? I don't know the answer to any of those questions, but if I were an enterprising young reporter with a natural curiosity (i.e., this means I don't work for the Houston Chronicle), I'd camp out on Alexander's doorstep and find out.

So what happens next? All of the defendants will now file general answers to the lawsuit, and those will be filed in the next couple of weeks. In most lawsuits, a general denial can be issued, which will not get into any specifics. But in some suits, the defendants are so hacked off they will get specific with some facts. Drayton McLane is not a pushover, so I expect specifics.

What I don't see happening anytime soon is a settlement, although I do think a settlement without a trial will eventually happen. Most business cases end in a financial settlement. The process of a lawsuit is brutal and expensive. After the initial claim and response period, you enter the "discovery" phase, where the parties must produce documents related to the suit and where depositions can be taken. Crane will have to sit for a deposition, where I can see the following taking place:

Defendant's Lawyer: Were you given a copy of the Comcast agreement?

Crane: Yes.

Lawyer: Did you read it?

Crane: Well, my people did.

Lawyer: Any cable industry experts among your people?

No matter what Crane answers at that point, it's bad. If he says yes, then his "people" were incompetent. If he says no, then he's incompetent. Jim Crane is a lot of things but incompetent is not one of them. Either way, that little exchange will strike at the heart of the burden of proof for fraud. I'd expect Crane will have a better answer than I'm imagining, or he'll avoid that scenario at all costs.

Another thing that I see happening is that Comcast Sports Network is going out of business, and soon. Crane has already said publicly that the network is in need of a major cash infusion from the partners, and the network is in bankruptcy already. Given the amount of money the network owes the Astros, liquidation is the only option, assuming the rights fee issue is as central to the business model as this lawsuit claims. I don't see how a business can emerge from bankruptcy as a viable entity without a central revenue source. That means either the Astros go into 2014 with no local TV, or they get Fox Sports Southwest to pick up the games again. I'm guessing the latter.

One final observation. In all of your endeavors, I would hope that you're told to always leave things better than when you first entered. From the stripping of the Major League club of top stars to reduce payroll for a potential sale to the now worthless television network, do you think Drayton McLane left the Astros better than when he entered, the same, or worse? Before you answer, consider the fact that Jeff Bagwell and Craig Biggio played for the team their whole career. Consider the pennant runs of 2004 and 2005. Then consider how one should run a business that is, in part, a public trust.

It's not an easy answer. I could have named this column "Beware McLanes Bearing Gifts", but it's hardly a gift when you spend $615 million and end up with squat. It darn sure would make me want to sue somebody.