That story is basically true. The movie was not developed for them - I made the short film it was based on in college, and I wrote the feature on spec. They lost the lawsuit with New Line, and part of the settlement was them doing a film for them. So the studio pitched them.
I liked the idea, but only would want to cast them if they wanted to be in the movie. Working because you lost a lawsuit could lead to a lackluster performance.
I spoke to their manager at the time, Russell Simmons, who told me Jon Peters was developing some movie for them set at summer camp. It was clear he wasn't taking my little movie seriously.
So I pitched Kid and Play to the studio, who took some convincing but they eventually accepted them. Will eventually burned off his commitment to New Line by doing that movie based on the play....basically, it's the "Will Smith kisses a man" movie.
HOUSE PARTY did great, and Will went on to be the biggest movie star on the planet. But what if we had done it together? Who knows....?