12:16pm PT by Eriq Gardner
Former Rhythm & Hues Owners Sued for Having "Pillaged" Oscar-Winning VFX House (Exclusive)
When Rhythm & Hues declared bankruptcy in February 2013, laying off hundreds of employees and taking $17 million in loans just so it could complete VFX work for Universal and Fox, the court filings led to weeks of discussion about how a company that had worked on such films as The Hunger Games and The Lord of the Rings and won an Oscar for Life of Pi had gotten into such dire straits. Low margins, the use of digital moviemaking and cheap labor in foreign countries were all factored in to the downfall of Rhythm & Hues, which sold itself for $17.8 million at auction as creditors continued to circle the bankrupt estate.
On Friday, two years after Rhythm & Hues filed for Chapter 11 bankruptcy, the Trustee in the case brought a new complaint against the company's former officers and directors, including John Patrick Hughes, Pauline Ts’o and Keith Goldfarb. The suit presents a different take on what led R&H to go bust.
"While claiming to promote a caring and artistic corporate culture that enhanced R&H’s value, Hughes, Ts’o and Goldfarb breached their duties of loyalty, due care, and good faith by directing R&H to engage in risky transactions with entities they or their family members owned or controlled," states the complaint.
Hughes, who once controlled 64 percent of the company's shares with Ts'o and Goldfarb each controlling 18 percent, is hit the hardest in the complaint.
The suit alleges Hughes transferred millions of dollars to CCCD Diagnostics, a biotech startup company founded by his father-in-law, in return for unsecured notes that were eventually sold to him for one dollar. This biotech company is said to have had no revenues and a business "wholly unrelated to R&H's business," and that despite conflicts of interest, Hughes funneled cash into CCCD without board approval, performance milestones or any adequate protections.
Hughes, Ts'o and Golfarb are also accused of transferring software rights critical to R&H as well as making a real estate transaction that was risky for the company but had millions of dollars of upside to them personally.
The downfall of Rhythm & Hues, and 20 other VFX houses, was covered in a documentary titled Life After Pi released last year.
In that film, which talked about the troubled business model of today's VFX firm, Hughes says, "We run this company for the people. To have hurt them so badly, it's really the antithesis what we wanted to do."
The newest lawsuit filed in bankruptcy court doesn't mention Life After Pi, but does seem to be aware of the way that Hughes has framed his story. "Ironically, while proselytizing about R&H’s special corporate culture and their concern for its labor force, Hughes, Ts’o and Goldfarb pillaged R&H with little concern about the consequences," says the complaint.
Besides questioning transactions that were made in alleged breach of the officers' fiduciary duties, the lawsuit also objects to how R&H, which once had 700 employees at its El Segundo headquarters and nearly $100 million in annual production revenue, was "grossly mismanaged."
About 97 percent of R&H's business came from just three studios — Universal, Fox and Warner Bros — and the directors and officers of R&H are said to have eschewed pursuing a more diversified customer base and accepted "harmful contract terms dictated to them by this handful of Studios." What's more, R&H focused on VFX and CG animation for feature films, "which are notoriously low-margin projects," 3 to 5 percent according the complaint.
"Because of this, if the project was substantially changed, delayed, or cancelled, the razor-thin profit margins would be eliminated, and the project would result in a loss to R&H," continues the complaint. "Even after R&H was hurt by numerous project changes, delays, or cancellations, the D&Os continued to carelessly pursue this business strategy, rather than delving into more commercially profitable business sectors, such as video games, television programs, commercials, and cinematics for special venues and theme parks."
The complaint — which also names other R&H board members as co-defendants including Lee Berger, Prashant Buyyala, Raymond Feeney and David Weinberg — suggests that R&H might have had better success if it focused more on negotiating for equity in films or co-producing films, like it did with Yogi Bear, which earned $200 million at the box office.
Instead, R&H bid aggressively for studio films, sometimes submitting bids below calculated out-of-pocket expenses, or other times not obtaining enough information for an informed bid. "These reckless and/or ignorant bidding practices ultimately led to R&H entering into numerous toxic contracts," says the complaint. "Whether done purposely or carelessly, according to Buyyala, the bidding process was 'flawed' because the bids did not accurately account for the work to be completed by R&H. By underbidding projects with the Studios, the D&Os severely damaged R&H as it caused the company to forgo potential profits and lose leverage with the Studios."
The suit goes on to fault R&H's officers with failing to negotiate for provisions protecting against additional work or delays from the studios and failing to monitor and obtain payments from studios overt these events. Anonymous managers at the company are quoted with suggestions that R&H let millions of dollars slide, and when things got tough in its liquidity crisis, R&H allegedly failed to take stock.
"In fact, R&H had hundreds of idle staff members who continued to collect salaries and benefits during R&H’s financial crisis," says the complaint. "In an interview regarding R&H, Hughes acknowledged that the D&Os were aware that they desperately needed to 'cut people’s salaries or to lay off a significant number of people or to work people overtime without paying them for overtime by restructuring their contracts' but explicitly chose not to make such changes in order to maintain the R&H 'culture.' "
The full complaint, which alleges that the actions by defendants caused a company worth well in excess of $100 million to have its assets sold for about $30 million, can be read below. Represented by Levene Neale attorney Gary Klausner, the Trustee seeks monetary damages for corporate waste and other causes of action plus the recovery of various rights transfers said to be fraudulent.
The defendants in the case knew this was coming because they've previously outlined the claims and sought defense costs advanced to them through their D&O insurance. An attorney representing Hughes and Ts'o wasn't available to comment, but The Hollywood Reporter will update with any response given.