Consequential Damages: Identification and Recovery of Lost Profits in NY

To recover "consequential" damages (defendant would argue that the damages sought by plaintiff are consequential), plaintiff must prove that (i) the damages sought by plaintiff were within the contemplation of the parties at the time of contracting as one of the remedies for the breach, (ii) the injury was actually caused by the breach, and (iii) the amount of the damages can be shown with reasonable certainty.

The very first argument by defendant would be that the type of injury alleged by plaintiff is consequential.

NY courts historically have had this bright-line rule that direct damages arise only where the lost profits were to be realized out of the transactions between the contracting parties under the contract.

In Biotronik, the highest court in NY stated that lost profits are direct damages when lost profits are natural and probable consequence of the breach under the contract. So, you cannot assume that lost profits are consequential damages.

In a reseller agreement, under which the reseller purchases products from the manufacturer, pays for the product transfer fee upon sale, and takes profits from the sale, lost profits of the reseller due to the manufacturer's recall of inventory were determined by the NY court to be direct damages because the contract would not work unless the reseller was engaged in the resale of the products (recall resulted in no resale, which resulted in lost profits).

A contract clause excluding "consequential damages" would not necessarily bar lost profits claims at least in NY.

One Rule: "Everyone is willing to give you something, ready to give you something. Whatever it is they are hungry for."

What is it that I am hungry for? Lying is a cooperative act. We are filling these gaps in our lives with lies. We are deeply ambivalent about the truth. And we don't understand the gaps in our lives. Freud said "no mortal can keep a secret." We all chatter with our fingertips.

• non-contracted denial (formal language - over-determined) - "did not"
• distancing language: "that woman"
• qualifying language: "in all candor"

Real smiles are in the eyes, not cheeks. We rehearse our words but not gestures. Withdrawn, looking down, pause, pepper it with way to much detail, in a very chronological order. Head shakes. They then get away with, known in the trade, duping delight. Making one expression, while masking another that is just leaking an expression of anger in a flash. 

Watch out for an expression of contempt. When anger turns into contempt, you are dismissed. It is associated with moral superiority. Marked by one lip corner pulled up and in. It is the only asymmetrical expression. In the presence of contempt, look the other way, go the other direction, reconsider the deal.

Shift their blink rate. Point their feet towards the exit. Take a barrier object and put it in front. Change and lower vocal tone. When you see a cluster of them, beware. Walk into that curiosity mode.

Stockholder Approval of Interested Party Transactions under DGCL 144

Here are certain sample recitals/stockholders resolutions that are useful in approving a charter amendment in compliance with Section 144 of DGCL to increase authorized capitalization of an issuer company in a subsequent round of a private placement transaction:

"WHEREAS, pursuant to Section 144 of the Delaware General Corporation Law, no contract or  transaction between the Company and any other corporation, partnership, association or other organization in which one or more of the officers or directors of the Company is an officer or director, or has a financial interest (any such contract or transaction is referred to herein as an “Interested Party Transaction”), shall be void or voidable solely for that reason, or solely because the director or officer is present at or participates in the meeting of the Board, at which the Board authorized the Interested Party Transaction or solely because the vote of any such director is counted for such purpose, if: (a) the material facts as to the relationship or interest and as to the contract or transaction are disclosed or are known to the Board, and the Board in good faith authorizes the contract or transaction by affirmative votes of a majority of the disinterested directors, even though the disinterested directors be less than a quorum, (b) the material facts as to the relationship or interest and as to the contract or transaction are disclosed or are known to the stockholders entitled to vote thereon, and the contract or transaction is specifically approved in good faith by the requisite vote of the stockholders, or (c) the contract or transaction is fair as to the Company as of the time it is authorized, approved or ratified by the Board or the stockholders;

WHEREAS, it is hereby disclosed or made known to the undersigned that:

• ___________, a director of the Company, is a principal of and has a financial interest in the _______________, L.P. and its affiliates (the “Existing Investor Entities”) and the Existing Investor Entities have expressed an interest in purchasing _________ shares of Company stock;
• [Or any other transactions that amount to Interested Party Transactions

NOW THEREFORE BE IT RESOLVED, that Company’s _____ Amended and Restated Certificate of Incorporation (the “Restated Certificate”) in substantially the form as set forth in Exhibit A hereto, is hereby approved and adopted in all respects.

RESOLVED FURTHER, that the Board may elect to abandon the financing and/or the Restated Certificate, before or after stockholder approval thereof, without further action by the stockholders at any time prior to the effectiveness of the Restated Certificate.

RESOLVED FURTHER, the foregoing resolutions may be executed in separate counterparts, each of which shall constitute an original, but all of which together shall constitute one and the same instrument."

And don't forget to obtain waivers from the existing investors/stockholders (certain qualified investors) regarding their right of first offer and notice requirements of the issuer company to purchase the pro rata share of the shares to be issued in the later rounds (most commonly found in NVCA styly Investors Rights Agreement).

Materiality Scrape

What is it?

A materiality scrape is a provision in an acquisition agreement that effectively eliminates, for indemnification purposes, any materiality qualifiers in a representation/warranty or covenant in determining (i) whether or not a breach has occurred, and/or (ii) the amount of indemnifiable losses resulting from that breach. When it is applied with the conjunctive word above, it is a double materiality scrape. With the disjunctive word above, it is a single materiality scrape, which is not uncommon.

The qualifiers most commonly subject to a scrape are "material," "materiality," and "material adverse effect." Less often seen is a "knowledge scrape," which eliminates knowledge qualifiers.

What is the point of inserting materiality qualifiers and then delete them or replace them with "any and all?"

Because the materiality scrape may eliminate SOME but NOT ALL effects/purposes of the materiality qualifiers, for example in the following contexts:

1. Singling out the question of whether closing conditions have been met and treating it differently one way (leave materiality qualifier) or the other (scrape materiality qualifier)
2. Fine-tuning the scope of seller disclosure schedule (e.g., disclose (only) all "material" contracts)
3. Determining whether a breach has occurred (e.g., compliance with all applicable laws in "all material respects")
4. Determining the losses resulting from a breach (e.g., seller's obligation to indemnify purchaser against only those losses above a "material amount"

Where to put it?

A materiality scrape provision is commonly found in the indemnification provisions or as a separate stand-alone provision.

Language

"The Seller shall indemnify, defend and hold harmless the Purchaser and its Affiliates and their respective employees, officers, directors, stockholders, partners and representatives from and against any losses, assessments, liabilities, claims, damages, costs and expenses (including reasonable attorneys’ fees and disbursements) incurred by such indemnified party as the result of any misrepresentation in, breach of or failure to comply with, any of the representations, warranties, covenants or agreements of the Seller contained in this Agreement, in each case, as each such representation, warranty, covenant or agreement would read if all qualifications as to knowledge or materiality, including each reference to the defined term “Material Adverse Effect,” were deleted therefrom."

"For purposes of determining whether there has been a breach and the amount of any losses that are the subject matter of a claim for indemnification, each representation and warranty in this Agreement will be read without regard and without giving effect to the term “material” or “material adverse effect” (fully as if any such word or phrase were deleted from such representation and warranty)."

Purchaser's Arguments For Scrape

1. To aggregate immaterial breaches and the losses resulting therefrom and count them toward the basket, that is, to eliminate the effect of "double materiality threshold." A typical acquisition agreement contains a basket, which is intended to provide the seller as the indemnifying party with protection from general indemnity claims below a certain negotiated amount, that is, immaterial claims. Without a materiality scrape, the buyer may incur many losses as a result of unrelated breaches of the seller's representations and warranties that are not individually material (not rising above the materiality threshold and not being treated as an indemnifiable loss) but are material in the aggregate, and therefore, such losses would not count toward the basket (because the basket contain only those indemnifiable losses), resulting in a double materiality threshold (such lossess not counting toward, and then what is in the basket not indemnified). Sometimes, an acquisition agreement may also include a "de minimis threshold" (a so-called mini-basket) (e.g., "an individual claim of less than $__ is not covered by indemnification (drop out from any calculation) and does not count towards the basket"), resulting in a triple materiality threshold.
2. To expand the applicability of a materiality scrape into calculating losses from determining whether a breach has occurred, and eliminate the uncertainty.

Another double materiality issue occurs when one of the closing conditions is tied to seller's representations and warranties being true in all material respect, and some of those representations and warranties may already have their own materiality qualifiers. To address this issue, a buyer would have to bifurcate the closing condition into two closing conditions: i) the reps and warranties that are not qualified by materiality qualifiers must be true and correct in all material respects, and ii) the reps and warranties that are qualified by materiality qualifiers must be true and correct in all respects.

Seller's Arguments Against Scrape

1. Being forced into a breach when the purchaser's use of the scrape was to distinquish the question of whether closing conditions have been met from the question of whether a breach has occurred, and leave materiality qualifier in the closing conditions but scrape materiality qualifier in the representations and warranties
2. Unreasonable risk allocation: nickeling and diming of the purchaser
3. Unreasonable disclosure burden (imagine a disclosure schedule setting forth all contracts (as compared to all "material" contracts) or responding to a representation that the seller has complied with all applicable laws (as compared to "all applicable laws in all material respects")
4. Drafting issues (seller representing that there has been no MAE since ____, F/S reps tied to GAAP standard that the F/S fairly present in all material respects the financial condition of the seller, reps tied to Rule 10b-5 language, that is, not containing any untrue statement of material fact or not omitting to state a material fact necessary to make any of the statements, in light of the circumstances in which they were made, not misleading, reps not tied to any basket)

Negotiation and Compromise

1. Seller may accept a scrape in exchange for the use of a true deductible basket where the basket amount is never recoverable and serves as a deductible against buyer claims) instead of a tipping basket where the basket amount is recoverable from dollar one once the aggregate buyer claims exceed the basket amount
2. Seller may accept a scrape in exchange for an increased basket amount
3. Specify the materiality threshold in each representation and warranty using a dollar threshold
4. Seller may want to have the scrape apply to the calculation of losses but not to the determination of whether a breach occurred (single scrape instead of double scrape)
5. Carve out disclosure obligations of the seller so it need not disclose immaterial matters on the schedules
6. Carve out F/S reps (GAAP standard) and reps that are not subject to materiality qualifiers

Section Section 4(1½) Exemption

Section 4(1½) exemption is a hybrid exemption developed through case law and SEC No-Action Letters that is commonly referred to as the “Section 4(1½) exemption” (referred to as such because such case law and No-Action Letters predated the revision to the Securities Act of 1933 (the "Act") pursuant to Section 201 of the Jumpstart Our Business Startups Act), under which a person purchasing securities from an issuer is not an underwriter for purposes of Section 4(a)(1) of the Act if such person resells the securities in transactions that would meet the exemption under Section 4(a)(2) of the Act so long as the purchaser did not originally purchase with a view to distribution.  The inquiry as to the availability of the Section 4(1½) exemption requires the analysis of the following factors:

1. Holding Period of Securities being Sold.  The longer the holding period, the greater the likelihood that the Section 4(1½) exemption applies.

2. Amount Sold.  Sales of large blocks of stock are permissible if the other requirements of the exemption are met.

3. Purchasers.  Each offeree should be sophisticated with respect to business and financial matters, as well as with respect to the particular investment being offered.  Also, the fewer the number of offerees, the greater the chance for an exemption.

4. Access to Information.  Each offeree should have access to the type of information that would be disclosed in a private placement memorandum.

5. Manner of Offering.  General solicitations and advertising should be avoided.

6. Restrictions on Resale.  The securities received by the purchasers should be restricted as to their transfer and should bear an appropriate legend reflecting this fact.

Section 4(a)(1) Exemption for an affiliated charity foundation

Section 4(a)(1) provides exemptions for transactions by any person other than an issuer, underwriter, or dealer.  Under the Act, a “dealer” means any person who engages for all or part of his time, directly or indirectly, as agent, broker, or principal, in the business of offering, buying, selling, or otherwise dealing or trading in securities issued by another person. A charitable foundation that is affiliated with an issuer (the "Foundation"), when trying to offer and sell shares of the issuer it received from the issuer, is not a dealer because it does not engage in the business of offering, buying, selling, or otherwise dealing or trading in securities issued by another person and is unlikely to be considered the “issuer” in the offering.  As a result, whether the Section 4(a)(1) exemption is available for the such offering turns on the question of whether the Foundation is considered an “underwriter.” Under the Securities Act of 1933, an “underwriter” means any person who (i) has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, (ii) participates or has a direct or indirect participation in any such undertaking, or (iii) participates or has a participation in the direct or indirect underwriting of any such undertaking.  The longer the Foundation has held such shares the less it is likely that the Foundation is considered to have had the intent to distribute the shares when it acquired those shares. The question then, is whether the Foundation is participating “in any such undertaking.”  One can argue that this language refers to an undertaking involving the purchase of shares from an issuer with a view to distribution.

Rule 701 Exemption in a Nutshell

Rule 701 of the Securities Act of 1933, as amended (the “Act”), exempts offers and sales of securities pursuant to a written compensatory benefit plan or a written compensation contract established by an issuer for the participation of its employees, directors, general partners, trustees (where the issuer is a business trust), officers, or consultants and advisors, and their family members who acquire such securities from such persons through gifts or domestic relations orders. 

Rule 701 also exempts offers and sales to former employees, directors, officers, consultants and advisors but only if such persons were employed by or providing services to the issuer at the time the securities were offered.  

A “compensatory benefit plan” is any purchase, savings, option, bonus, stock appreciation, profit sharing, thrift, incentive, deferred compensation, pension or similar plan.  A stock-based plan established for employees is generally considered “compensatory” if it is not used as a capital raising device.

The issuer should be aware of the limitation on aggregate sales price of securities that may be sold in reliance on Rule 701 during any consecutive 12-month period.  That limit is the greatest of the following:

1. $1,000,000
2. 15 percent of the total assets of the issuer measured at the issuer’s most recent annual balance sheet date (if no older than its last fiscal year-end); or
3. 15 percent of the outstanding amount of the class of securities being offered and sold in reliance on Rule 701, measured at the issuer’s most recent annual balance sheet date (if no older than its last fiscal year-end).  For this purpose, different classes of stock of the employer may be aggregated in certain circumstances.

Amounts of securities sold in reliance on Rule 701 do not affect “aggregate offering prices” in other exemptions, and amounts of securities sold in reliance on other exemptions do not affect the amount that may be sold in reliance on Rule 701.

The issuer must deliver to investors a copy of the compensatory benefit plan or the contract, as applicable. In addition, if the aggregate sales price or amount of securities sold during any consecutive 12-month period exceeds $5 million, the issuer must deliver certain additional disclosure to investors a reasonable period of time before the date of sale, including certain financial statements of the issuer.

Offers and sales exempt under Rule 701 are deemed to be a part of a single, discrete offering and are not subject to integration with any other offers or sales, whether registered under the Act or otherwise exempt from the registration requirements of the Act.

Securities issued under Rule 701 are deemed to be “restricted securities” as defined in Rule 144 and resales of such securities must be in compliance with the registration requirements of the Act or an exemption from those requirements. Ninety days after the issuer becomes subject to the reporting requirements of section 13 or 15(d) of the Exchange Act, securities issued under Rule 701 may be resold by persons who are not affiliates in reliance on Rule 144, without compliance with paragraphs (c) and (d) of Rule 144, and by affiliates without compliance with paragraph (d) of Rule 144.

Business Acquisition and Item 2.01 on Form 8-K Disclosure

Form 8-K Item 2.01 requires certain disclosure “if the registrant or any of its majority-owned subsidiaries has completed the acquisition or disposition of a significant amount of assets, otherwise than in the ordinary course of business.” This requirement on its face only refers “a significant amount of assets,” as the basis of the triggering event, but instruction 4 thereto further elaborates that the disclosure requirement is triggered under either one of the two circumstances:

"Instruction 4. An acquisition or disposition shall be deemed to involve a significant amount of assets:

(i) if the registrant’s and its other subsidiaries’ equity in the net book value of such assets or the amount paid or received for the assets upon such acquisition or disposition exceeded 10% of the total assets of the registrant and its consolidated subsidiaries; or

(ii) if it involved a business (see 17 CFR 210.11-01(d)) that is significant (see 17 CFR 210.11-01(b))."

(i) above talks about “assets (hereinafter referred to as the “asset test”),” but interestingly, (ii) above introduces the term, “business,” with references to Reg. S-X sections (hereinafter referred to as the “business test”).

Reg. S-K 11-01(d) explains the meaning of “business” to be considered under our Item 2.01 test:

"(d) For purposes of this rule, the term business should be evaluated in light of the facts and circumstances involved and whether there is sufficient continuity of the acquired entity's operations prior to and after the transactions so that disclosure of prior financial information is material to an understanding of future operations. A presumption exists that a separate entity, a subsidiary, or a division is a business. However, a lesser component of an entity may also constitute a business. Among the facts and circumstances which should be considered in evaluating whether an acquisition of a lesser component of an entity constitutes a business are the following:

(1) Whether the nature of the revenue-producing activity of the component will remain generally the same as before the transaction; or

(2) Whether any of the following attributes remain with the component after the transaction:

(i) Physical facilities,

(ii) Employee base,

(iii) Market distribution system,

(iv) Sales force,

(v) Customer base,

(vi) Operating rights,

(vii) Production techniques, or

(viii) Trade names."

Once one concludes whether the transaction contemplated is considered a transaction involving a business as defined by Reg. S-X 11-01(d), then one should analyze whether such business is considered “significant” under Reg. S-X 11-01(b).

Reg. S-K 11-01 (b) provides “a business combination or disposition of a business shall be considered significant if:

(1) A comparison of the most recent annual financial statements of the “business acquired or to be acquired” and the registrant's most recent annual consolidated financial statements filed at or prior to the date of acquisition indicates that the business would be a significant subsidiary pursuant to the conditions specified in §210.1-02(w), substituting 20 percent for 10 percent each place it appears therein; or

(2) The business to be disposed of meets the conditions of a significant subsidiary in §210.1-02(w).”

Reg. S-K 1-02(w) further provides the meaning of “significant subsidiary.” The term significant subsidiary means a subsidiary, including its subsidiaries, which meets any of the following conditions:

(1) The registrant's and its other subsidiaries' investments in and advances to the subsidiary exceed 10 percent of the total assets of the registrant and its subsidiaries consolidated as of the end of the most recently completed fiscal year (for a proposed combination between entities under common control, this condition is also met when the number of common shares exchanged or to be exchanged by the registrant exceeds 10 percent of its total common shares outstanding at the date the combination is initiated); or

(2) The registrant's and its other subsidiaries' proportionate share of the total assets (after intercompany eliminations) of the subsidiary exceeds 10 percent of the total assets of the registrants and its subsidiaries consolidated as of the end of the most recently completed fiscal year; or

(3) The registrant's and its other subsidiaries' equity in the income from continuing operations before income taxes, extraordinary items and cumulative effect of a change in accounting principle of the subsidiary exclusive of amounts attributable to any noncontrolling interests exceeds 10 percent of such income of the registrant and its subsidiaries consolidated for the most recently completed fiscal year.

Note to paragraph (w): A registrant that files its financial statements in accordance with or provides a reconciliation to U.S. Generally Accepted Accounting Principles shall make the prescribed tests using amounts determined under U.S. Generally Accepted Accounting Principles. A foreign private issuer that files its financial statements in accordance with IFRS as issued by the IASB shall make the prescribed tests using amounts determined under IFRS as issued by the IASB.

Interestingly, the Financial Reporting Manual seems to contradict Form 8-K Item 2.01 or the instruction thereto:

2040.1 of the Financial Reporting Manual with respect to Form 8-K Item 2.01 states “a) Item 2.01, Form 8-K reporting the transaction is required within 4 business days of the consummation of any business acquisition exceeding 20% significance or for any asset purchase exceeding 10% significance that does not meet the definition of a business.”

...
c) If the required financial statements of the business acquired are not required to be provided with the initial report, they must be filed by amendment within 71 calendar days after the date that the initial report on Form 8-K must be filed.

NOTE: While an Item 2.01 Form 8-K is not required for business acquisitions at or below 20% significance, registrants may elect to report business acquisitions at or below 20% significance pursuant to Item 8.01 of Form 8-K even if financial information is not provided."

Both the Office of Chief Accountant and the Office of Chief Counsel at CorpFin of SEC confirmed that this Note is the interpretation of Item 2.01 requirement by both offices as of June 2016.

Sandbagging and Anti-sandbagging

Sandbagging?

In the context of a U.S. business acquisition, “sandbagging” typically refers to a situation in which the buyer is or becomes aware (through its own diligence or superior knowledge, either as of signing or between signing and closing) that a specific representation and warranty by the seller in the acquisition agreement is untrue, signs and/or closes the transaction despite the knowledge, and then seeks to hold the seller liable for such breach post closing. (from M & A Lawyer Jan. 2007).

A “sandbagging” or "knowledge savings" provision (sometimes referred to as a “pro-sandbagging” provision) in a mergers and acquisition agreement (asset purchase agreement, stock purchase agreement, or merger agreement) states that a buyer’s remedies against the seller under the agreement will not be impacted by whether or not the buyer had knowledge, prior to closing the deal, of the facts or circumstances giving rise to the claim. In other words, even if the buyer knew of the problem at hand―whether it be the company’s non-compliance with applicable laws, a breach of a customer contract, or other breach of a representation, warranty or covenant―it could decide to complete the acquisition with that knowledge, and then proceed against―or “sandbag”―the seller for recourse under the agreement. Reasons for sandbagging include i) it may be unclear to Purchaser whether a breach occurred, ii) the materiality of such breach may be unclear to the Purchaser, iii) the right of Purchaser to treat such breach as an unfulfilled condition to closing may be unclear, iv) Seller may have tried to do information dumping in its disclosure schedule at the 11th hour, or v) Seller may have already made it clear its unwillingness to a purchase price adjustment for such breach, etc. A Purchaser's options include termination, price adjustment (concession from the Seller) or close the transaction and seek indemnification to enforce the benefit of the bargain it negotiated with the Seller.

An “anti-sandbagging” clause prohibits the buyer from “sandbagging” the seller, by contractually limiting the buyer’s ability to seek recourse with respect to matters which the buyer knew about at or prior to closing (from Bloomberg Law Reports).

Language

A typical pro-sandbagging provision could read as follows:

"The rights of the Purchaser to indemnification or any other remedy under this Agreement shall not be affected, limited or deemed waived by reason of any knowledge that the Purchaser may have acquired, could have acquired or should have acquired, whether before or after the closing date, nor by reason of any investigation made (or not made) or diligence exercised (or not exercised) by any of the Purchaser, or its advisors, agents, consultants or representatives. The Seller hereby acknowledges that, regardless of any investigation made (or not made) by or on behalf of the Purchaser, and regardless of the results of any such investigation, the Purchaser has entered into this transaction in express reliance upon the representations and warranties of the Seller made in this Agreement. The Seller further acknowledges that, in connection with this transaction, the Purchaser has furnished to the Seller good and sufficient consideration in exchange for the Seller’s representations and warranties made herein."

Another example of knowledge savings clause is:

"No Waiver of Contractual Representations and Warranties — Seller has agreed that Buyer’s rights to indemnification for the express representations and warranties set forth herein are part of the basis of the bargain contemplated by this Agreement; and Buyer’s rights to indemnification shall not be affected or waived by virtue of (and Buyer shall be deemed to have relied upon the express representations and warranties set forth herein notwithstanding) any knowledge on the part of Buyer of any untruth of any such representation or warranty of Seller expressly set forth in this Agreement, regardless of whether such knowledge was obtained through Buyer’s own investigation or through disclosure by Seller or another person, and regardless of whether such knowledge was obtained before or after the execution and delivery of this Agreement."

A typical anti-sandbagging provision could read as follows:

"The Purchaser acknowledges that it has had the opportunity to conduct due diligence and investigation with respect to the Seller, and in no event shall the Seller have any liability to the Purchaser with respect to a breach of representation, warranty or covenant under this Agreement to the extent that the Purchaser knew of such breach as of the Closing Date. The Purchaser further acknowledges that, to the extent the Purchaser, or any of the Purchaser's advisors, agents, consultants or representatives, by reason of such due diligence and investigation, whether or not undertaken, knew, could have or should have known that any representation and warranty made herein by the Seller is or might be inaccurate or untrue, this constitutes a release and waiver of any and all actions, claims, suits, damages or rights to indemnity, at law or in equity, against the Seller by the Purchaser arising out of breach of that representation and warranty. Nothing herein shall be deemed to limit or waive the Purchaser's rights against the Seller arising out of any other representation and warranty made herein by the Seller."

Another example is:

"Effect of Buyer’s Knowledge — Notwithstanding anything contained herein to the contrary, Seller shall not have (a) any liability for any breach of or inaccuracy in any representation or warranty made by Seller to the extent that Buyer, any of its Affiliates or any of its or their respective officers, employees, counsel or other representatives (i) had knowledge at or before the Closing of the facts as a result of which such representation or warranty was breached or inaccurate or (ii) was provided access to, at or before the Closing, a document disclosing such facts; or (b) any liability after the Closing for any breach of or failure to perform before the Closing any covenant or obligation of Seller to the extent that Buyer, of its Affiliates or any of its or their respective officers, employees, counsel or other representatives (i) had knowledge at or before the Closing of such breach or failure or (ii) was provided access to, at or before the Closing, a document disclosing such breach or failure."

Sandbagging is usually not applicable to (i) a transaction where the Company/Seller is a public company because the representations and warranties typically terminate at the closing of the transaction (Survival Clause issue), or (ii) the Purchaser's breach of its representations and warranties to the extent the Buyer pays the negotiated price under the transaction agreement. Therefore, sandbagging has a significant implication in the negotiation of private equity acquisition agreements.

Choice of Law

• Minnesota (Seller-friendly): If a Purchaser acquires knowledge of a breach from any source before the closing, the Purchaser waives its right to sue. To prove a misrepresentation, the Purchaser must prove it relied on the misrepresentation. (Hendricks v. Callahan, 8th Cir. 1992) (Burden of Proof on Purchaser regarding Knowledge; Fraud Exception; Makes Sense in Management or Insider Buy-Out)
• Delaware: A Purchaser can sandbag unless an anti-sandbagging provision is in the agreement. Where the agreement is silent, the Seller’s representations and warranties are unaffected by the Purchaser's due diligence. (Interim Healthcare, Inc. v. Spherion Corp., Del Super. Ct. 2005)
• New York (Purchaser-friendly): The court will review whether the Purchaser believed that it was purchasing the Seller’s promise to indemnify the Purchaser should a particular representation and warranty of the Seller turns out to be untrue. (CBS Inc. v. Ziff-Davis Publishing Co.,  N.Y. 1990) The court will also examine whether the Purchaser waived its rights to sue on the known breach or not---the Purchaser should specifically preserve its rights to so sue prior to closing. (Carefully-Negotiated Indemnification Package issue; Unqualified Reps and Warranties; Reps and Warranties Should Not Merge with Sale of Assets).

Origin of the Contortion of Tort-based Cause of Action and Contract-based Cause of Action

• Tort Theory Behind Seller's Story - A tort claim is extra-contractual, meaning it is based not on a bargain between parties, but on a wrongful act committed by another that resulted in injury to the claimant. In commercial relationships, that wrongful act is typically an intentional, reckless or negligent misrepresentation of fact intended to induce the claimant to act in a manner detrimental to such person. Reliance by the claimant has always been an element of a tort claim for fraud based on intentional or reckless misrepresentation of fact. Note that courts historically considered mere "representations" as mere affirmations of fact (as inducements) and not as promises or the equivalent of promises. Therefore, the introduction of warranties, as contractual promises that the stated facts are true occurred in modern U.S. practice. Note that in most U.K. acquisition agreements only warranties appear without the representations.
• Contractual Claim by Purchaser - The court should enforce the expectations of the parties according to the bargain made by the parties. Offer, acceptance and an exchange of consideration. A claim for breach of contract requires ONLY that the claimant prove that i) the other party to the agreement failed to perform its promises pursuant to the bargain made by the parties, the contract and ii) the claimant incurred damages. There is no such concept as "reliance by the claimant" in breach of contract claims. In modern U.S. practice, contractual indemnification is provided explicitly for breaches of representations and warranties as well as for specifically identified matters for which a bargained-for special indemnity has been given. Both kinds of indemnifiable matters are all expressly made a part of contract and subject to the exclusive contractual remedies provided in the contract.

Buyers Beware

1. Whenever possible, resist an "anti-sandbagging"clause and insert "knowledge savings/anti-anti sandbagging" clause
2. Choose governing law carefully; do not assume that a knowledge savings clause will protect the buyer automatically (e.g., no reliance argument in MN)
3. Carve out special issues and cover them under a special indemnity provision
4. Broadly exclude "fraud" from an exclusive remedies provision
5. If forced to allow anti-anti sandbagging provision, limit the standard of proof to "actual" knowledge of a fixed number of identified persons, and exclude constructive, implied or imputed knowledge (advisors' or attorneys' knowledge)
6. Have Seller update disclosure schedules at the time of closing (allowing Buyer to walk away upon such update)