In virtually all transactions, parties make representations and warranties to build trust and induce contracting with each other, especially for facts not verifiable through due diligence.1 Representations are often subject to intense negotiations, and their accuracy is vital since untruths give rise to misrepresentation claims by the other party.
An issue can arise if a purchaser becomes aware, before closing, that a material representation of the vendor is inaccurate or untrue. Upon such a discovery, a purchaser has three options. It may (i) disclose this discovery to the vendor and terminate or (ii) disclose and seek to renegotiate the agreement based on the new facts, or (iii) it may remain silent on the discovery and commence an action after closing for the misrepresentation of the vendor.
The latter option is a tactic known as sandbagging. A sandbagging purchaser attempts to ambush the vendor, catching the vendor off guard. Parties may explicitly allow or prohibit the practice of sandbagging within the contract, or parties may remain silent on the issue altogether. How does the common law treat this practice and how should parties act to protect their interests?
The Effect of a Purchaser's Knowledge of an Untrue Representation
A party claiming misrepresentation must prove that the false representation was material and that it induced the claiming party through reliance to enter into the contract.2 This is a question of fact, often turning on what parties knew at the time. As a result, a party's knowledge is a critical factor in any claim for misrepresentation.
Purchasers who know that a representation of the vendor is false but proceed to close a deal in the face of it, may struggle to prove their reliance on that representation. For example, in one recent case, an experienced investor had knowledge of a company's financial viability and chose not to investigate further prior to buying shares. When the investor attempted to rely on false representations about share valuation made by the company's director, the Court ruled that it was not reasonable in the circumstances for the investor to rely solely on the director's representations.3
Similarly, purchasers cannot rely on wilful ignorance when a vendor discloses information that warrants reasonable enquiries, particularly where the conveyance of assets in a transaction is on an "as is" basis.4 This was the outcome where a sophisticated purchaser had knowledge of the possibility of landfill in the area being purchased, but did not bother to read the relevant materials.
Note however, that a purchaser's knowledge will not always excuse a vendor that fails to disclose all material facts. Where a vendor failed to disclose a reserve report showing a material and adverse change in the assets, it was unsuccessful in defending a misrepresentation claim by the purchaser, even though the purchaser had some awareness of the facts.5
Given uncertainty, parties may prefer to solve any ambiguities on pre-existing knowledge within the contract. In drafting a definition of knowledge, a vendor will want to negotiate to qualify its knowledge and to construe a purchaser's knowledge broadly. Purchasers, for their part, will want to seek to broaden the vendor's knowledge to make its representations absolute, while narrowing its own knowledge pertaining to any false representations unearthed. An effective definition of knowledge is thus a powerful tool. Common elements to defining parties' knowledge include:
- Knowledge by whom: Are all employees, representatives or agents included, or only the executive or specific individuals?
- Actual versus implied, imputed or constructive knowledge: Are the vendor, purchaser or both obligated to review all relevant records and make all reasonable diligent enquiries, and is the standard their actual knowledge at the time of execution or what they ought to have known as well?
- Method of proof: Is knowledge provable only by documentation, or is knowledge, however acquired or inferred, enough?
Drafting a Sandbagging Provision
A purchaser may wish to add a clause to the contract that explicitly permits some measure of sandbagging tactics.6 A vendor must be extremely cautious with such provisions and may instead seek to prohibit the practice, or even impose disclosure obligations if the purchaser learns of any representational inaccuracies. There is little Canadian judicial guidance on the interpretation of these provisions, yet courts in the United Kingdom tend to take a dim view of sandbagging tactics, which may carry over into Canada.7
A recent study indicated that Canadian transactions use sandbagging clauses less frequently compared to their American and European counterparts, which tended to be more in favour of and against the practice, respectively.8 If a purchaser seeks to employ a sandbagging clause, it should be clear with the intention to make the vendor's representations unqualified and absolute, with express reliance by the purchaser, and it should clearly define knowledge. Consider the elements in this sample clause:
The Vendor's representations are not to be affected or waived by reason of any investigation by or on behalf of the Purchaser, or by reason of the fact that the Purchaser knew or ought to have known that any such representation is or might be inaccurate or untrue. The Vendor acknowledges that the Purchaser enters into this Agreement in express reliance upon the Vendor's representations, and that the Purchaser has paid good and sufficient consideration in exchange for all such representations.
When a purchaser, before the closing date, becomes aware that a material representation of the vendor is false or inaccurate, it may disclose this fact to the vendor and renegotiate based on this new understanding, or even walk away from the transaction. Another option for the purchaser is to remain silent and sandbag the vendor by bringing a claim after closing.
Reliance by the purchaser on the false representation is a requirement to prove misrepresentation. Resolving these disputes often turns on what parties knew at the relevant times. Thus, a purchaser's knowledge of the inaccuracy of a representation may prevent the purchaser from establishing reliance on the misrepresentation. With this in mind, parties should consider defining knowledge in the contract to simplify such disputes.
Purchasers can also seek to allow sandbagging under the agreement, thereby permitting claims notwithstanding any knowledge on their part or duty to investigate. Counsel for the vendor should be wary of these provisions and negotiate to weaken them or seek significant concessions in exchange. Overall, effective negotiations around these issues are vital to safeguarding best interests.
1 Practically speaking, corporate transactions typically employ representations and warranties simultaneously, melding the distinction at law.
2 L.K. Oil & Gas Ltd. v. Canalands Energy Corp., 1989 ABCA 153, at paras 38, 46.
3 Strand v. Emerging Equities Inc., 2008 ABCA 23, at para 7; see also 35445 Alberta Ltd. v. Transamerica Life Insurance Co. of Canada, 1998 ABCA 110, at paras 10-11.
4 Motkoski Holdings Ltd. v. Yellowhead (County), 2010 ABCA 72, at paras 78-79.
5 Eagle Resources Ltd. v. MacDonald, 2001 ABCA 264, at paras 16-18.
6 See generally, Charles K. Whitehead, "Sandbagging: Default Rules and Acquisition Agreements" (2011), 36 Delaware Journal of Corporate Law 1081.
7 See for example, Infiniteland Ltd and another v. Artisan Contracting Limited and another,  EWCA Civ 758.
8 John F Clifford, Freek Jonkhart, and Jessica Pearlman, "What's the Market for that Cross-Border Deal? The European, US and Canadian Private Target M&A Deal Points Studies" (May 2011), 12 Business Law International 2 at 147.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.