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
- Whenever possible, resist an "anti-sandbagging"clause and insert "knowledge savings/anti-anti sandbagging" clause
- Choose governing law carefully; do not assume that a knowledge savings clause will protect the buyer automatically (e.g., no reliance argument in MN)
- Carve out special issues and cover them under a special indemnity provision
- Broadly exclude "fraud" from an exclusive remedies provision
- 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)
- Have Seller update disclosure schedules at the time of closing (allowing Buyer to walk away upon such update)
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