Article by Luke P. Iovine, III1
"Sandbagging" is a concept that refers to the practice of one party to an acquisition agreement (most often a buyer) seeking post-closing indemnification for breaches of representations and warranties, which breaches that party was aware of prior to signing the acquisition agreement or, in some cases, closing the transaction.2 This includes circumstances in which the seller is not aware of the breach and therefore did not properly disclose the breach or relevant exception on the disclosure schedules. Although sandbagging is not a new concept, it is an issue that continues to elicit emotional reactions and intense negotiation from both buyers and sellers. Should the buyer be permitted to close the transaction without alerting the seller to a potential breach and then seek damages post-closing for the breach? Or, as sellers argue, should the agreement effectively provide that a buyer that closes over a known breach has waived its rights to post-closing indemnification? Interestingly, more than half of acquisition agreements completed in 2010 were silent on this issue.3
Sellers view sandbagging as an issue of fundamental fairness and have a tendency to impute bad motives to buyers that insist on a provision permitting sandbagging. To sellers, sandbagging is a patently unfair and ethically questionable practice. This perspective is relevant, whether or not one believes that a buyer would actually proceed to close the transaction in the face of a known breach and assume the risk that it will be able to establish the breach and damages after the closing (and then collect those losses from the seller).
For their part, buyers tend to look at sandbagging as merely a matter of ensuring that they receive the benefit of their bargain. Buyers believe they are bargaining - and paying - for the right to rely on the representations provided by their sellers and to enforce indemnification obligations for breaches of those representations, regardless of whether someone involved in an extensive due diligence process had, or should have had, knowledge of facts or circumstances that made those representations untrue. Furthermore, buyers often argue that including a provision prohibiting sandbagging undermines the disclosure scheduling process and encourages sellers to "dump" diligence documents on the buyer at the last minute in an attempt to get the benefit of a later argument that the buyer had knowledge of matters not otherwise disclosed in the seller's final disclosure schedules.4
Despite the somewhat stark ethical terms in which the issue of sandbagging is often discussed during negotiations, sellers are often surprised to learn that only a small minority of acquisition agreements actually contain provisions expressly prohibiting the practice. In 2010, only 5% of private acquisition agreements included an anti-sandbagging provision5, while 41% contained a provision expressly permitting sandbagging.6 The remaining 54% of agreements were silent on the issue.7 Perhaps more surprising is the fact that, even absent a pro-sandbagging provision, the majority of buyers will have some sandbagging rights under common law.
The default rule under both Delaware and New York common law - two jurisdictions that are chosen as the governing law for arguably the majority of M&A transactions8 - is, generally, that a buyer is not required to establish that it relied on a seller's representation in order to recover post-closing damages as a result of a breach of that representation.9 In other words, a buyer's pre-closing knowledge of a breach does not necessarily preclude post-closing recovery. In contrast, sellers negotiating agreements governed by California law are somewhat better off, as California common law generally views reliance as an essential element of the claim and will protect sellers from sandbagging, absent the inclusion of a pro-sandbagging provision in the agreement.
Even though this so-called "pro-sandbagging" default rule in Delaware and New York may mean that a majority of buyers will have some right to sandbag, even if an acquisition agreement is silent on the issue, buyers should be aware that sandbagging case law has only recently started to evolve and these default rules continue to have some ambiguities.
First, cases permitting sandbagging typically involve instances in which the buyer discovers the existence of a breach after signing but before closing. In contrast, absent a pro-sandbagging clause, it is not entirely clear that sandbagging would be permitted if the buyer knew of the breach before it even signed the agreement. A buyer that conducts substantial due diligence prior to signing an agreement should be careful to bring to the seller's attention any perceived inaccuracies in the disclosure schedules and representations and negotiate the appropriate economic adjustments prior to signing, as that buyer may not have a post-closing claim for indemnification.
Second, in New York, courts also will evaluate the source of a buyer's knowledge in determining whether to allow post-closing recovery for breaches of which the buyer was aware at closing. If the seller affirmatively discloses the existence of the breach (as opposed to the buyer discovering the breach itself or through a third party) then the premise that the buyer believed it was purchasing the seller's promise as to the truth of the representations is not as solid and the buyer may not be permitted to recover for that breach if the buyer elects to close anyway.10
Lastly, relevant New York case law suggests that buyers should consider expressly reserving their rights to obtain indemnification for known breaches prior to closing the transaction (although it does not appear that this is required in order for a buyer to prevail). This can be accomplished either through the inclusion of a pro-sandbagging provision in the agreement or by an explicit reservation of rights at closing with respect to specific matters.11
Although applicable common law in Delaware and New York may provide some basis on which to evaluate negotiating positions with respect to sandbagging, both buyers and sellers should exercise caution in allowing an agreement to remain silent on the issue. Even in pro-sandbagging default regimes, such as Delaware and New York, the rule is far from absolute and the specific facts vary from case to case, so buyers may prefer to argue for the inclusion of a pro-sandbagging provision in order to expressly reserve their rights. Even though silence may seem preferable to a pro-sandbagging provision from a seller's perspective, a buyer may nonetheless have sandbagging rights under common law, so sellers should continue to exercise care in negotiating representations and warranties and producing disclosure schedules .
1 Heather Davis, a former associate at Paul Hastings, co-authored this article.
2 For example, a buyer's due diligence investigation may have revealed that certain material contracts of the seller had expired by their terms. However, the seller may have inadvertently included those contracts on a disclosure schedule as valid and enforceable contracts (and, as a result, breached the seller representation regarding material contracts).
3 American Bar Association, 2011 Private Target Mergers & Acquisitions Deal Points Study.
4 This issue also implicates other acquisition agreement terms, including those that require or permit a seller to update disclosure schedules between signing and closing.
5 An anti-sandbagging provision provides that "no party shall be liable for any losses resulting from or relating to any inaccuracy in or breach of any representation or warranty in the acquisition agreement if the party seeking indemnification for such losses had knowledge of such breach before closing." American Bar Association, 2011 Private Target Mergers and Acquisitions Deal Points Study.
6 A pro-sandbagging provision provides that a party's right to indemnification based on the inaccuracy or breach of any representation or warranty "shall not be affected by any investigation conducted or knowledge acquired at any time", whether before or after the signing of the acquisition agreement or the closing of the transaction. American Bar Association, 2011 Private Target Mergers and Acquisitions Deal Points Study (ABA Model Stock Purchase Agreement, Second Edition).
7 American Bar Association, 2011 Private Target Mergers & Acquisitions Deal Points Study.
8 See Charles K. Whitehead, Sandbagging: Default Rules and Acquisition Agreements, 36 Del. J. Corp. L. 1081, 1093 (reviewing 884 acquisition agreements entered into between July 2007 and June 2011 of which 587 (66%) were governed by New York or Delaware law).
9 CBS, Inc. v. Ziff-Davis Pub. Co., 75 N.Y.2d 496 (N.Y. 1990); Interim Healthcare, Inc. v. Spherion Corp., 884 A.2d 513 (Del. Super. Ct. 2002). This position is often based on the application of pure contract law principles, as opposed to concepts of tort and other claims that are based on reliance. In addition, acquisition agreements include other negotiated terms and conditions that limit a buyer's right to seek indemnification (baskets, buckets, caps, survival periods, etc.). In that regard, the argument is that a seller should be able to rely on the full set of negotiated agreement terms, whether or not it relied on any particular representation or warranty (or, alternatively, knew of its inaccuracy).
10 Galli v. Metz, 973 F.2d 145 (2d Cir. 1992).
11 For example, a buyer may include language in the acquisition agreement that explicitly reserves the buyer's right to "rely on the representations and warranties in the acquisition agreement, notwithstanding any investigation conducted by the buyer or any knowledge the buyer may possess relating to the inaccuracy of the seller's representations and warranties.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.