A new flashpoint for dueling Redstones

(Fortune) -- Sumner Redstone may be best known as the feisty chief of the Viacom and CBS media empires, but it was his holdings in the lesser-known Midway Games company that helped settle his 2002 divorce and allegedly facilitated his 1993 takeover of Paramount.

Now Midway is just one more component of the deep rift with his daughter that has put a cloud over the succession at one of the world's largest media conglomerates.

The Redstone family's long association with Midway Games -- the Chicago-based videogame company has been part of the 84-year-old Sumner's stock portfolio for nearly 25 years -- has contributed to the rupture between Sumner and his daughter, and once-presumed heir apparent, Shari, as the two have fought over the sale of Midway shares from Sumner's personal accounts to the family holding company, National Amusements, Fortune has learned.

That family drama, which raises doubts about the future control of one of the world's largest media empires, had ebbed and flowed privately for months before it became public about two weeks ago when Fortune first reported on the details. Father and daughter have sparred over corporate governance issues at CBS (Charts, Fortune 500) and Viacom (Charts), as well as how money is spent by National Amusements, the family holding company that owns movie theater chains.

With Midway, which produced the hit game "Mortal Kombat," sources familiar with the matter say Shari objected to a large transaction in February in which Sumner sold about 12.4 million shares of Midway to a subsidiary of National Amusements, for about $85 million, or $6.87 per share -- roughly the market price at the time.

Shari, according to a source, was opposed to using National Amusements' funds to buy out Sumner's shares in Midway, and this disagreement became one facet of the larger fallout between the two. Sumner and Shari are the only two shareholders of National Amusements, with Sumner controlling 80% and Shari the remaining 20%.

The deal in February was in line with an earlier move by Sumner to consolidate much of his personal holdings in Midway under National Amusements. In December 2005 Sumner transferred nearly 33 million shares in Midway to a new shell company, called Sumco Inc., set up by National Amusements, in exchange for National assuming responsibility for a $425 million personal loan Sumner had with Citigroup. According to a filing with the Securities and Exchange Commission, the deal was designed "to allow him to engage in tax and estate planning and reduce certain personal indebtedness."

It was language in the agreement from the 2005 deal -- which gave Shari control over National's investment in Midway -- that apparently was invoked by her in the recent feud. That agreement, according to a filing with the SEC, stated that Shari "will have sole authority to make decisions with respect to National's and Sumco's existing and further investments in Midway."

A source familiar with the matter, speaking of the 2005 Midway transaction, said, "Shari was very supportive of it."

This person said of the more recent transaction: "It wasn't the second transaction itself that caused friction, but it came in the context of the rift. The underlying issue was that she was trying to assert herself as a confidante with Sumner in terms of all his businesses. She was pushing to be publicly named his successor. This Midway transaction comes in that context."

While Sumner had said publicly in 2005 that his daughter would likely become controlling shareholder of Viacom and CBS "when I'm gone," this source said Shari had been pushing for something more definitive.

Through spokespeople, Shari and Sumner declined comment.

Sumner's history with Midway extends back to 1983 -- four years before he took control of Viacom -- when he reportedly first began buying shares in the videogame maker's predecessor company, WMS Industries, a slot machine and pinball game maker. In 1993 he set his sights on Paramount, which he won after a protracted takeover battle with home shopping network QVC.

During that raucous fight for Paramount, Sumner had roughly a 25% stake in WMS Industries and WMS chief executive Louis Nicastro began buying shares in Viacom, which QVC lawyers at the time claimed was an attempt "by Redstone of Viacom to inflate the value of Redstone's acquisition currency." (No wrongdoing was ever discovered, and Sumner said publicly at the time that he had no knowledge of WMS' purchases of Viacom shares.)

Nevertheless, Wall Streeters noted that when Midway was spun off from WMS in 1996, and Sumner later began steadily buying up shares, the stock price soared and Nicastro was eventually able to sell out. "Clearly, Midway's valuation has been dramatically affected by what Sumner was doing," said Edward Williams, an analyst at BMO Capital Markets.

Shares in Midway closed Wednesday at $5.84 a share in trading on the New York Stock Exchange, but in late 2005, just before he transferred a large chunk of his personal holdings to National Amusements, the stock was over $23 a share.

"His Midway stake is really an odd story," said Michael Pachter, an analyst at Wedbush Morgan Securities.

In 2002, Sumner transferred some 3.7 million shares of Midway, representing an 8.4% stake, to his ex-wife Phyllis as part of their divorce settlement. "No one really understood why he gave her his stock," said Pachter. "For some reason, with all his billions of dollars, he divided his stock in Midway."

After the divorce, Sumner went on a buying spree, steadily increasing his shares in the unprofitable Midway, and today holds a roughly 90% stake in the company, through three entities: his personal accounts, National Amusements, and a subsidiary, Sumco Inc. "He just kept going and going," said Pachter.

While Sumner was buying shares personally over that time, he was also directing National Amusements to buy in to Midway. According to Midway's 2005 proxy, before the deal in that same year in which Sumner transferred a large chunk of his own stake to National, Sumner owned 57.5 million shares of Midway, while National owned 11.5 million.

Sumner's accumulation of Midway became a point of contention in a 2006 lawsuit filed by his son Brent, in which he argued he was frozen out of the family business and sought to dissolve National Amusements. "Sumner Redstone acquired large amounts of Midway Games stock for himself in competition with purchases by [National Amusements]," according to the complaint. (The lawsuit was eventually settled, and Sumner bought out his son's share of National for about $240 million.)

In the feud with Shari, it appears father and daughter are at the point of no return, with litigation looming on the horizon. The two sides have discussed a deal in which Shari would leave the boards of both Viacom and CBS, where she sits as vice chairman of each board, in exchange for a financial settlement.

But that appears unlikely given that Shari believes if she can hang on to her board seats she would automatically become chairman of both companies after Sumner is gone. One point of wrangling is language in a trust Sumner established in 2002 that some interpret as unequivocally stating that Shari is designated the successor as long as she is on the boards of CBS and Viacom when Sumner passes away.

"This is all about when Sumner dies," is how one source close to the matter put it.

Another source familiar with the matter described the situation as "volatile" and predicted that it will play out this way: the two sides will reach an impasse in settlement talks, and Sumner will attempt to forcibly remove Shari from the boards, prompting Shari's lawyers to file a lawsuit and seek an injunction to keep her as a director of CBS and Viacom.

Then, once again for the Redstone family, it would be up the courts to settle matters.