Sandbagging Clauses

Summary

This clause provides both a pro-sandbagging provision and an anti-sandbagging provision. This clause includes practical guidance and drafting notes. Click on the links to see recent examples of pro-sandbagging and anti-sandbagging provisions in Market Standards—M&A, the searchable database of publicly filed M&A deals from Practical Guidance that enables users to search, compare, and analyze its comprehensive database of transactions using over 150 detailed deal points to filter search results. "Sandbagging," in the context of an M&A transaction, occurs when a buyer makes a claim against a seller after the closing of an acquisition based upon the seller's breach of obligations or warranties under, or an inaccuracy in one or more of the seller's representations contained in, the applicable purchase agreement, even though the buyer knew of the breach or inaccuracy before closing. At first blush, such a claim might seem unfair to a seller, and even the name "sandbagging" suggests an inherent unfairness to this practice. Moreover, the concept of sandbagging might appear to be at odds with the element of reliance in a breach of contract claim. However, there are many practical considerations with respect to risk allocation and expediting contract negotiations that might justify allowing the buyer to sandbag the seller post-closing. In addition, depending on the jurisdiction, the applicable law might or might not permit sandbagging absent an explicit provision in the agreement. There are two ways in which sandbagging can be addressed in a purchase agreement. An anti-sandbagging provision expressly prohibits the buyer from bringing a claim against the seller for breaches or inaccuracies that the buyer knew of before closing. On the other hand, a pro-sandbagging provision expressly permits the buyer to bring such a claim. Arguments against Sandbagging A seller will often insist on including an anti-sandbagging provision in an M&A contract to preclude a buyer from bringing an indemnification claim based on a breach of a seller warranty or obligation or an inaccuracy in a seller's representation that the buyer knew about before closing. The seller may raise one or more of the following arguments when seeking to include an anti-sandbagging provision: Sandbagging Stifles Disclosure. One argument that a seller might make against sandbagging is that it tends to stifle the due diligence process. The seller is not inclined to provide fulsome disclosure or access to the buyer if the buyer could use the knowledge that it gains against the seller. The buyer would be incentivized to go on a "fishing expedition" as part of its due diligence process, which dis-incentivizes the seller from being open about the asset being acquired. Anti-sandbagging Fosters Pre-closing Collaboration. Under an anti-sandbagging regime, it is more likely that a buyer and seller would be incentivized to collaborate pre-closing to address any issues regarding the acquired assets or business. A buyer acquiring knowledge of a deficiency would need to be forthright about its concerns, negotiate with the seller openly regarding those concerns, and include appropriate provisions in the M&A contract that allocate the risks and costs associated with those concerns. Fairness. Finally, a seller can attempt to appeal to notions of "fairness." Specifically, a seller will sometimes claim that it is unfair for a buyer to purchase an asset from the seller when the buyer knows that the asset is not what the seller claims it to be; in that instance, the buyer is not truly relying on the seller's representations under the contract. This is not a particularly strong argument, since sophisticated parties are free to allocate risk as they see fit (and since, from the buyer's perspective, an anti-sandbagging approach seems unfair). However, one context in which this argument might have greater influence is if the buyer group involves members of the seller's management. In that case, the buyer is in the best position to have knowledge of any inaccurate seller representation contained in, or of the seller's breach of any provision of, the purchase agreement. Arguments for Sandbagging The buyer in a purchase agreement has several arguments for adopting a pro-sandbagging provision or, at the very least, against adopting an anti-sandbagging provision. If the buyer and seller are both sophisticated parties, these arguments might be more convincing than the seller's arguments in favor of an anti-sandbagging approach. Risk Allocation. Representations and warranties in a purchase agreement are not used simply as statements for the buyer to rely upon; they are mechanisms to apportion risk between a buyer and a seller. When representations and warranties are viewed in this light, reliance upon their accuracy or fulfillment becomes less important than determining who should be held liable for breaches or inaccuracies. Existing Protections in the Indemnification Provision. The seller's indemnification obligations often already contain provisions that reduce or, in certain circumstances, eliminate the seller's liability for breaches of obligations and warranties and inaccuracies in representations. For example, the seller's indemnification obligations are typically subject to buckets and caps and a limited survival period. Additionally, the purchase agreement will often contain an express acknowledgment from the buyer that the written representations and warranties in the purchase agreement are the only representations and warranties upon which the buyer can assert a claim. Last-minute "Data Dump." If the buyer were precluded from bringing a claim because of its knowledge of breaches and inaccuracies, then a seller could reveal those breaches and inaccuracies to the buyer moments before the transaction was scheduled to close. The buyer would then be in the unpleasant (and unfair) position of deciding whether to proceed with the transaction but be foreclosed from bringing claims relating to the disclosed information, prolonging negotiations to address any issues, or walking away from what the buyer had thought was a "done deal." Benefits of the Bargain. The buyer is negotiating for and buying the asset as represented in the purchase agreement and should not be deprived of the benefits of that negotiation. Each Indemnification Claim Becomes a Protracted Process. With an anti-sandbagging approach, indemnification becomes a much more uncertain, time-consuming, and costly process since, with respect to each claim, there is a threshold question as to what the buyer "knew" (and, potentially, what the source of the buyer's knowledge is). Import of "Knowledge." Even if it is demonstrated that the buyer did have knowledge of a particular fact, it will not always be apparent that the buyer was in a position to understand the impact of that knowledge. For example, the buyer might have access to technical knowledge with respect to the seller's business, but not be able to determine the import of what is disclosed in that report. Or the information disclosed to the buyer could present a clear set of facts, but be ambiguous as to its impact. For example, a buyer might discover that the seller took certain specific actions, but it might not be clear whether those actions constitute a breach under the seller's vendor contracts. Disclosure Schedules. The seller is in the best position to understand and make representations and warranties with respect to its business, and the disclosure schedules in a purchase agreement afford the seller with an opportunity to fully disclose exceptions to its representations and warranties. "Hidden" Disclosure. Under an anti-sandbagging regime, a buyer could be charged with knowledge of any information contained within a data room. A buyer should not be precluded from making an indemnification claim if a particular fact is disclosed in the sea of information contained in a data room, which could be updated throughout the negotiation process. Incentive Not to Conduct Rigorous Due Diligence. If the buyer's knowledge can hamper or prevent the buyer from bringing an indemnification claim after the closing, then the buyer is incentivized to forgo a rigorous due diligence process and to "stick its head in the sand." However, both the buyer and the seller benefit from the due diligence process since the process can serve to help the parties best structure a deal and address any issues prior to closing rather than through a costly post-closing battle. Silence on Sandbagging While the parties to a purchase agreement are free to negotiate whether to include a pro- or anti-sandbagging provision, a common middle ground is to remain silent on the issue. However, courts have taken various positions on what this contractual silence means and practitioners should understand what silence means under the law of the jurisdiction governing the purchase agreement at issue. In New York, the general rule is that, in the absence of an anti- or pro-sandbagging provision, the relevant question is not whether a buyer claiming breach relied on the truth of the seller's representation or warranty, but whether the buyer relied on the seller's promise that a representation or warranty was true. For example, in CBS Inc. v. Ziff-Davis Publishing Co., 553 N.E.2d 997 (N.Y. 1990), the court held that a buyer could bring a claim for breach of warranty post-closing even though the buyer became aware prior to the closing that the warranty was inaccurate. Evaluating the claim as a contractual claim (rather than as a tort claim), the court held that whether the buyer believed the warranty was accurate was irrelevant; the relevant question was whether the buyer believed it was purchasing the seller's promise that the warranty was true. New York cases since Ziff-Davis have echoed Ziff and have also held that a buyer cannot credibly claim that it relied on the seller's promise that a warranty was true when the seller itself was the source of the buyer's knowledge that the warranty was false. See, e.g., Galli v. Metz, 973 F.2d 145 (2d Cir. 1992); Rogath v. Siebermann, 129 F.3d 261 (2d Cir. 1997); Coastal Power Int'l Ltd. v. Transcontinental Capital Corp., 10 F.Supp.2d 345 (S.D.N.Y. 1998); Promuto v. Waste Management, Inc., 44 F.Supp.2d 628 (S.D.N.Y. 1999); NSA Investments II LLC v. SeraNova, Inc., 227 F.Supp.2d 200 (D. Mass. 2002) (analyzing New York law); Paraco Gas Corporation v. AGA Gas, Inc., 253 F.Supp.2d 563 (S.D.N.Y. 2003); Gusmao v. GMT Group, Inc., 2008 U.S. Dist. LEXIS 58462 (S.D.N.Y. Aug. 1, 2008). However, if the seller merely provides a "mountain of data" to support a conclusion that a warranty is false and does not disclose its conclusion that a warranty is false, a buyer will not be precluded from claiming that it relied on the seller's promise as to the accuracy of that warranty. Assured Guaranty Municipal Corp. v. Flagstar Bank, FSB, 892 F.Supp.2d 596 (S.D.N.Y. 2012). In Delaware, the court in Kelly v. McKesson HBOC, Inc., 2002 Del. Super. LEXIS 39 (Del. Super. Ct. Jan. 17,2002) unpublished opinion of the Superior Court of Delaware, issued January 17, 2002 (Docket No. CIVA 99C-09-265WCC), held that the buyer's reliance on a warranty was a prerequisite for the buyer's ability to successfully make a claim for breach of that warranty. Subsequent Delaware cases, however, have held that reliance is not required. See, e.g., Gloucester Holding Corp v. US Tape & Sticky Products, LLC, 832 A.2d 116 (Del. Ch. 2003); Interim Healthcare, Inc. v. Spherion, 884 A.2d 513 (Del. Super Ct 2005); Eagle Force Holdings, LLC v. Campbell, 187 A.3d 1209 (Del. 2018). California appears to require reliance in order for a buyer to make a successful breach of warranty claim, at least outside of the context of a sale of goods. See Kazerouni v. De Satnick, 279 Cal. Rptr. 74 (Cal. Ct. App. 1991). The holding in Kazerouni, however, is to be contrasted with that of Telephia, Inc. v. Cuppy, in which the court noted that a clear non-reliance provision in a stock purchase agreement obviates the need to show the buyer's reliance when making a breach or warranty claim, even where both parties were aware of a breach of warranty as of the signing of the stock purchase agreement. 411 F.Supp.2d 1178 (N.D. Cal. 2006). In light of varying case law on the issue (and the potential uncertainty within a given jurisdiction), practitioners should include language in the purchase agreement that addresses the issue of sandbagging head on, be it through a pro-sandbagging provision or an anti-sandbagging provision. If that approach is not practical, however, and if the parties elect to remain silent on the issue of sandbagging, then practitioners should have a firm understanding of how the impact of the governing law of the purchase agreement impacts the buyer's ability to bring a successful claim under that agreement. The Florida Supreme Court has not ruled directly on whether proof of reliance on a representation is required to recover for breach of an express written warranty, however, various courts have examined related Florida precedent to conclude that the Florida Supreme Court would most likely hold that reliance on the truth of a representation or warranty is not necessary to maintain a contract claim alleging the breach of that representation or warranty, and that is only necessary that the representation or warranty was part of the parties' agreement (i.e., the representation or warranty was part of the written acquisition agreement). See S. Broad. Grp. v. Gem Broad., 145 F. Supp. 2d 1316, 1324 (M.D. Fla. 2001) (holding that the Florida Supreme Court would embrace a view that reliance is not a necessary component of a contract claim for a breach of a representation or warranty) (''The reliance required, if any, to support a breach of warranty claim is reliance on the warranty at the time the contract is formed, not later at some time prior to closing the deal . . . . the Florida Supreme Court would embrace the modern view that express warranties are bargained-for terms of a contractual agreement, any breach of which is actionable notwithstanding proof of non-reliance at the time of closing on the contract.'') (internal citations omitted). See also Lennar Homes, Inc. v. Masonite Corp., 32 F. Supp. 2d 396, 398—400 (E.D. La. 1998). Note, however, that the reasoning behind the S. Broad. Grp. decision may not be persuasive in two-step (separate signing and closing transactions) that include a bring-down closing condition. In support of its decision, the court explicitly notes ''The fact that [plaintiff] discovered the breach after entering into the Agreement but prior to closing does not change the analysis. Otherwise, a seller could breach its warranties with impunity by simply disclosing its breach prior to closing and thus deny the buyer the benefit of its bargain.'' Note further that knowledge of a fact prior to the ''beginning of a transaction'' may disqualify a statement from constituting an express warranty. See Thursby v. Reynolds Metals Co., 466 So. 2d 245, 250 (Fla. Dist. Ct. App. 1984) (addressing express warranties in contracts for the sale of goods) (''An express warranty is generally considered to arise only where the seller asserts a fact of which the buyer is ignorant prior to the beginning of the transaction"). See also Representations and Warranties in Acquisition Agreements and Silence on Sandbagging in Private Acquisitions Chart (CA, DE, NY, TX, FL). For guidance in drafting indemnification provisions generally, see Indemnification Claims in Acquisitions; Indemnification Provisions in Private Acquisition Agreements; and Key Drafting Considerations for Indemnification Provisions (Chart). To explore market trends and view representative transaction agreements of publicly filed transactions, see Market Trends 2023: Sandbagging Provisions. Click here to see recent examples of both pro- and anti-sandbagging provisions in publicly filed transaction agreement in Market Standards—M&A, the Practical Guidance database of publicly filed M&A deals that enables users to search, compare, and analyze transactions using 150+ M&A deal points to filter search results. You can customize any search to your needs by adding filters or modifying the search criteria. Drafting Pro-sandbagging and Anti-sandbagging Provisions If the parties to a purchase agreement intend to address the issue of sandbagging directly (which is the preferred approach for practitioners), then there are several nuances to consider in connection with drafting an anti-sandbagging provision or a pro-sandbagging provision. Considerations for drafting an anti-sandbagging provision include the following: Definition of "Knowledge." How should "knowledge" be defined for the purposes of a sandbagging claim? The buyer will want to limit its "knowledge" to actual knowledge. The seller will want to expand the buyer's "knowledge" to include constructive or inquiry knowledge, whereby the buyer is deemed to possess knowledge that it could have acquired after reasonable inquiry into the subject matter at issue. Click here to see recent examples of Knowledge definitions in publicly filed transaction agreement in Market Standards—M&A, the Practical Guidance database of publicly filed M&A deals that enables users to search, compare, and analyze transactions using 150+ M&A deal points to filter search results. You can customize any search to your needs by adding filters or modifying the search criteria. Knowledge Persons. Whose "knowledge" is relevant for determining whether the anti-sandbagging provision applies to exclude an indemnification claim? The seller will want to have a broad list of individuals associated with the buyer whose knowledge can be used to impute knowledge of a given fact to the buyer. For example, an aggressive seller position might be to include representatives from the buyer's legal counsel as included within the applicable list of individuals. On the other hand, the buyer will want to limit the individuals to which the test applies, potentially to the "buyer indemnified party" (often defined in purchase agreements to include a director, officer, shareholder, or other affiliate of the buyer) making the particular claim at issue. Considerations for drafting a pro-sandbagging provision include the following: Inclusion of Extrinsic Facts. Should references to the buyer's "knowledge" include, in addition to the buyer's knowledge of the inaccuracy of assertions in the seller's representations and warranties, the buyer's knowledge of extrinsic circumstances and events? A buyer would want to draft the pro-sandbagging provision to exclude the buyer's knowledge of any fact or matter, not just the buyer's knowledge of the breach of an obligation or warranty or the inaccuracy of a representation. Timing of Knowledge. Does the timing of when the buyer's knowledge was obtained matter? For example, for an M&A transaction with a "split" signing and closing, a seller might seek to carve out of a pro-sandbagging provision any knowledge that the buyer acquired prior to entering the purchase agreement. Buyer Indemnified Parties. Should the pro-sandbagging provision apply not only to the buyer's knowledge, but also to the knowledge of any buyer indemnified party (which would be favorable to the buyer)? Sandbagging and Non-Reliance Clauses Because the buyer's reasonable reliance on representations and warranties is integral to the analysis of any claims in a document with a pro-sandbagging provision or which is silent, the question of sandbagging should always be addressed along with any reliance or non-reliance provisions in the acquisition agreement. For further discussion of these provisions, see Non-reliance Clause (Acquisition Agreements). Click here to see recent examples of non-reliance clauses in Market Standards—M&A, the searchable database of publicly filed M&A deals from Practical Guidance that enables users to search, compare, and analyze its comprehensive database of transactions using over 150 detailed deal points to filter search results.