Negotiations over issues like the precise language of the seller's representations and warranties or the definition of Material Adverse Effect can be contentious enough. But for many, the idea that the buyer can sit on a claim and bring it after the closing smacks of a certain unfairness. Even the term for bringing such a claim—"sandbagging"—nods at a vague sense that the buyer is doing something untoward. In the seller's view, sandbagging amounts to lying in wait solely for the sake of bringing a claim and effectively adjusting the purchase price unilaterally. A more appropriate course of action, in the seller's opinion, is to bring up any problems before closing and work out a solution. Failing that, the buyer should be deemed to have waived its claim once it proceeds to closing.
The buyer takes a different view. In its opinion, it purchases the seller's representations and warranties as part of the overall transaction, which allocates to the seller the risk that one of its representations or warranties is false. That the buyer obtains its own knowledge about the business is to its own credit and should not be held against it, particularly because the seller is in a better position to know about the business and stand behind its own representations and warranties.
With the two views in stark opposition and a drafting compromise not readily available, many agreements stay silent on the issue altogether rather than choose one approach or another. There are different possible explanations for how counsel can justify that outcome in spite of the uncertainty it creates:
- Counsel may assume that the governing law on default rules for sandbagging is clear, leaving little to lose if the agreement stays silent. In some jurisdictions, this assumption is justified, though if this were the main driver of the decision, different market practices in different jurisdictions should be observed. In any event, the governing law is not always as unambiguous as counsel may assume.
- The issue is both fraught and zero-sum. Sellers sometimes resist sandbagging provisions by complaining that the buyer is asking for a right to ambush it, to which buyers respond by asking caustically if the seller is not prepared to stand behind its representations and warranties. In this situation, counsel may decide that the best course of action is to leave the agreement silent rather than choose between these arguments.
- In pro-sandbagging jurisdictions (and jurisdictions that counsel assume to be pro-sandbagging), it is hard for a seller to ask for an anti-sandbagging provision without having to give up something of value to the buyer in return.
- The decision to stay silent may be strategic. The inclusion by the buyer of an express pro-sandbagging clause in its draft or the inclusion by the seller of an express anti-sandbagging clause in its draft inevitably draws the counterparty's attention and likely result in the striking of the original clause and the insertion of the opposite provision in its place. The thinking may be that if that is the case, better to remain silent and rely on the governing law.
With this background in mind, this Article has two goals:
- To describe the common law on sandbagging in Delaware, New York, and Texas (along with other anti-sandbagging jurisdictions).
- To ascertain market practice in those jurisdictions and determine if counsel and M&A parties are adjusting their approach to sandbagging depending on the default rules of the particular jurisdiction.
For examples of express pro-sandbagging and anti-sandbagging provisions, see Standard Clause, Purchase Agreement: Sandbagging and Anti-Sandbagging. Throughout this Article, references to pro-sandbagging and anti-sandbagging provisions can be taken to mean provisions similar to those.
Sandbagging under Delaware Law
The prevailing assumption among M&A practitioners is that the default rule in Delaware is in favor of a sandbagging right in the absence of a contractual provision to the contrary. This assumption is well-founded, though based on surprisingly few decisions that explicitly address the issue.
The underlying principle that reliance is not a necessary element for a claim of contractual indemnification has been expressed by the Delaware courts several times (for example, see Gloucester Holding Corp. v. U.S. Tape and Sticky Products, LLC, 832 A.2d 116, 127 (Del. Ch. 2003), addressing breach of a representation in an asset purchase agreement; Interim Healthcare, Inc. v. Spherion Corp., 884 A.2d 513, 548 (Del. Super. 2005), addressing breach of a representation in a stock purchase agreement). However, the Delaware judiciary has had few occasions to apply that principle to a typical sandbagging scenario. One such occasion arose in a 2007 decision, in which the Delaware Court of Chancery specifically allowed a buyer to bring a claim for indemnification in spite of the fact that its due diligence investigation would likely have uncovered the breach giving rise to the claim (Cobalt Operating, LLC v. James Crystal Enters., LLC, 2007 WL 2142926, at *28 (Del. Ch. July 20, 2007), aff'd without op., 945 A.2d 594 (Del. 2008)). In Cobalt, the Chancery Court detailed the rationale that buyers make when negotiating for a sandbagging right:
"Due diligence is expensive and parties to contracts in the mergers and acquisitions arena often negotiate for contractual representations that minimize a buyer's need to verify every minute aspect of a seller's business. In other words, representations like the ones made in the Asset Purchase Agreement serve an important risk allocation function. By obtaining the representations it did, Cobalt placed the risk that WRMF's financial statements were false and that WRMF was operating in an illegal manner on Crystal. Its need then, as a practical business matter, to independently verify those things was lessened because it had the assurance of legal recourse against Crystal in the event the representations turned out to be false."
This is a clear statement by the Chancery Court, upheld by the Delaware Supreme Court, that a buyer can rely on the seller's explicit representations and warranties in spite of the buyer's own due diligence investigation and knowledge. Interestingly, though, the Chancery Court's decision does not stop there, but adds that the asset purchase agreement contained a pro-sandbagging provision:
"[H]aving given the representations it gave, Crystal cannot now be heard to claim that it need not be held to them because Cobalt's due diligence did not uncover their falsity. This point is, in fact, made clear in the Asset Purchase Agreement itself, which provides that 'no inspection or investigation made by or on behalf of [Cobalt] or [Cobalt's] failure to make any inspection or investigation shall affect [Crystal's] representations, warranties, and covenants hereunder or be deemed to constitute a waiver of any of those representations, warranties, or covenants.' Having contractually promised Cobalt that it could rely on certain representations, Crystal is in no position to contend that Cobalt was unreasonable in relying on Crystal's own binding words."
In this portion of its decision, the Chancery Court apparently bases its ruling in part on the fact that the seller agreed to a pro-sandbagging provision. Although the better reading of the decision is that the court was likely to have upheld the buyer's indemnification claim even without the provision, the issue is less than Crystal clear.
Market Practice in Delaware
To determine market practice in Delaware on the issue of sandbagging, Practical Law surveyed every publicly filed private acquisition agreement entered into in 2016 that contemplates post-closing indemnification and is summarized in the What's Market database as of publication of this Article. The scope of the private acquisitions database includes all publicly filed acquisition agreements (whether a stock purchase, asset purchase or merger agreement) with a signing value of at least $25 million that documents the acquisition of either:
- All or substantially all of the assets of a private US company.
- At least a majority of the outstanding stock of a private US company.
- A complete business unit of a US company.
The database excludes bankruptcy sales and certain outlier transactions. Based on these parameters, the survey sample consisted of 119 acquisition agreements with Delaware governing law. All 119 surveyed agreements are detailed here. The results are summarized in Figure A.
As shown, a substantial portion of agreements with Delaware governing law stayed silent on the issue of sandbagging. This makes sense for buyers if they are willing to rely on the assumption that Delaware allows sandbagging by default in the absence of contracting to the contrary. Of the 51 agreements that remained silent, two of them—both with the same buyer—spelled out that the seller has no sandbagging right with respect to the buyer's tax representation. This can be read to imply that the parties intend to retain sandbagging rights with respect to all other representations and warranties.
The next most common approach in the survey sample was to explicitly contract for sandbagging, using language that makes clear that the buyer can bring a post-closing claim in spite of any knowledge it had before closing. The fact that as many as 39 percent of agreements with Delaware governing law explicitly contracted for sandbagging rights might reflect the Cobalt decision's slight ambiguity on the question of sandbagging by default, or might simply reflect that counsel to buyers tend to negotiate for a pro-sandbagging provision regardless of the particular transaction's governing law.
The What's Market database distinguishes, and the survey distinguished, provisions that state that the buyer retains its contractual rights despite its investigation or that the seller's representations and warranties survive closing despite the buyer's investigation, if the provision does not make clear that the buyer can bring a post-closing claim despite the knowledge it had before closing concerning the representation or warranty. The survey found 12 agreements, or 10 percent of the Delaware survey sample, with this type of murky provision. As shown in Figure B and Figure C below, this percentage is substantially higher in Delaware than in other jurisdictions, which may reflect (assuming statistical significance) a more relaxed approach to negotiating sandbagging provisions in Delaware, given the assumption that sandbagging is permitted in Delaware by default.
Of the 119 surveyed agreements, only seven included an explicit anti-sandbagging provision. This low number—in a jurisdiction in which remaining silent likely means allowing sandbagging—provides powerful evidence that the pro-seller position that buyers should not be permitted to lie in wait until the closing is not a winning argument. In particular where, as in Delaware, a buyer has a right to sandbag and therefore surrenders something of value if it agrees to an anti-sandbagging provision, the more common resolution that sellers acquiesce to is to stay silent on the issue altogether. However, as discussed, sellers should realize that staying silent on sandbagging under Delaware law is likely tantamount to agreeing to a sandbagging right for the buyer.
Two of the agreements with anti-sandbagging provisions are worth highlighting for their definition of the buyer's knowledge:
- In one agreement, the buyer is deemed to have knowledge if its CFO has actual knowledge of the breach because of information communicated to the CFO at a meeting of the board of the target business, as reflected by a written agenda for the meeting or given to the CFO in writing.
- In another agreement, the buyer must be aware not only of the underlying facts of the breach, but that those facts constitute a breach of the agreement.
Figure A also makes reference to an agreement with a mix of pro- and anti-sandbagging provisions. In that agreement, the buyer can sandbag, even if it had the knowledge in question before signing, if its claims concern the seller's representations and warranties pertaining to equipment and inventory and FCPA compliance. Regarding all other claims, the agreement provides that the buyer cannot sandbag if it had actual knowledge through information disclosed by the seller in the electronic data room at least two business days before the signing.
Finally, one agreement provided that the buyer can sandbag, yet the buyer also represented that none of its officers has actual knowledge that the sellers' representation and warranties are inaccurate or untrue in any material respect or that the sellers are in breach of any covenant. The combined effect of these provisions is that while the buyer can make a post-closing claim in spite of its pre-closing knowledge, it will be found in breach of its own representation when it is revealed how it came to know that the seller was in breach.
Cure Rights
Related to the issue of sandbagging is the matter of whether the seller can (or must) update the disclosure schedules to account for any event that arises after the signing (or that existed at signing but were unknown at the time) and which constitutes a breach to the acquisition agreement if not carved out of the relevant representation or warranty by including it on the disclosure schedule. Like sandbagging provisions, a covenant to update the disclosure schedules can be a contentious issue, as, depending on its wording, it can shift the risk for potential breaches away from the seller and on to the buyer. For a sample of a covenant to update the disclosure schedules and a discussion of the different pro-buyer and pro-seller permutations, see Standard Clause, Purchase Agreement: Covenant to Update the Disclosure Schedules.
For purposes of this survey, the focus is on those agreements that are silent on the issue of sandbagging. If the schedule-update covenant explicitly provides that scheduling the event or discovery that constitutes a breach does not cure that breach, the covenant effectively acts as a backdoor pro-sandbagging provision. This is because the buyer will have pre-closing knowledge of a breach, will be able to choose to close on that breach, and yet will continue to have a post-closing claim for indemnification. This is not exactly the same as providing that the buyer can bring a post-closing claim in spite of any pre-closing knowledge it gleaned from its own investigation, and counsel should not leave to logical argumentation that which can be spelled out in the contract. Nevertheless, the buyer can have an argument that if it can close and retain its post-closing remedies in spite of knowledge it receives directly from the seller, it should certainly retain its post-closing remedies if it obtained that knowledge on its own.
The table of Delaware transactions indicates which agreements that are silent on sandbagging provide that the seller's updates to the disclosure schedule do not cure the underlying breach. The survey found a total of 14 such agreements, or 27 percent of the 51 agreements that were silent on the issue of sandbagging.
Sandbagging under New York Law
New York law on sandbagging defies simple categorization. In CBS, Inc. v. Ziff-Davis Publishing Co., the Court of Appeals overturned the lower court's decision and allowed the buyer to bring a claim in spite of its knowledge that the seller's financial-statements representation was inaccurate. The appellate court explained that "the critical question is not whether the buyer believed in the truth of the warranted information," but whether the buyer "believed that it was purchasing the seller's promise as to its truth" (553 N.E.2d 997, 1000-01 (N.Y. 1990)).
On its own, this language seemingly constitutes a robust statement in favor of a default sandbagging right. However, the court also relied in part on the fact that the buyer, in correspondence with the seller before closing, had expressly reserved its rights regarding the alleged breach. This aspect of the decision received significant attention in New York case law in subsequent years. In Galli v. Metz, the Second Circuit Court of Appeals, interpreting CBS, held that parties cannot sandbag by default without expressly reserving their rights before closing. The court stated:
"Where a buyer closes on a contract in the full knowledge and acceptance of facts disclosed by the seller which would constitute a breach of warranty under the terms of the contract, the buyer should be foreclosed from later asserting the breach. In that situation, unless the buyer expressly preserves his rights under the warranties (as CBS did in Ziff–Davis), we think the buyer has waived the breach."
A later decision of the Second Circuit emphasized the phrase "disclosed by the seller" from the Galli v. Metz opinion. In Rogath v. Siebenmann, the court held that if the seller is not the source of the buyer's knowledge, but that the buyer has obtained knowledge either from a third party or simply because it is "common knowledge" that the seller's warranties are false, then the buyer can still prevail on its post-closing claim (129 F.3d 261, 265 (2d Cir. 1997)). In that situation, the Rogath court explained, it is "not unrealistic to assume" that the buyer purchased the seller's warranty "as insurance against any future claims," which fulfills the requirement described in CBS. This understanding has been followed in more recent cases, such as in Gusmao v. GMT Group, Inc., 2008 WL 2980039, at *5 (S.D.N.Y. Aug. 1, 2008).
In a recent decision, the district court explained that a pro-sandbagging provision also fulfills the requirement of demonstrating that the buyer believed itself to be purchasing the seller's promise as to the representations' truth. In Powers v. Stanley Black & Decker Inc., the court held that a "knowledge savings clause" in the transaction document at issue allowed the buyer to bring a post-closing indemnification claim (137 F.Supp.3d 358, 375 (S.D.N.Y. Sept. 28, 2015)).
What emerges from the case law is that a buyer can bring a post-closing claim in spite of its pre-closing knowledge if it expressly reserves its right to do so. This can be accomplished in one of two ways:
- Through an express pro-sandbagging provision, as highlighted in Powers.
- By explicitly doing so in separate correspondence with the seller before closing, as in CBS.
Less clear is whether the buyer can sandbag without having contracted for that right and without having reserved its rights separately before closing if its knowledge was not obtained directly from the seller. The Rogath and Gusmao decisions seemingly support that conclusion, but the Powers decision does not offer that alternative, instead emphasizing only the contract's pro-sandbagging provision.
Market Practice in New York
A key takeaway from the case law in New York is that a buyer leaving an acquisition agreement with New York governing law silent on the issue of sandbagging and that does not reserve its rights before closing essentially relies on two events that are out of its control:
- That the seller will not obtain the relevant information concerning the breach and notify the buyer of that information.
- That the court eventually deciding the litigation will accept the argument that under New York law, the buyer does not need to expressly reserve its rights in a written notification to the seller if the buyer's information came from a third party or from common knowledge.
Given this inherent uncertainty, parties to private acquisition agreements with New York governing law would be expected to contract explicitly either for or against a sandbagging right. To ascertain whether this is market practice in New York, Practical Law surveyed all private acquisition agreements in the What's Market database entered into in 2016 as of publication of this Article that contemplate post-closing indemnification. The survey parameters yielded a sample of 41 acquisition agreements, all of which are detailed here. The results are summarized in Figure B.
The survey results may fairly be described as perplexing. Nearly half of all New York agreements remained silent on the matter of sandbagging, despite all the uncertainty that this portends. These are agreements for transactions valued at $25 million or more and for which the parties contracted for indemnification rights. The sandbagging question is hardly peripheral to the buyer's post-closing remedies, yet many parties, presumably sophisticated, left this issue to chance. If this is a result of counsel using forms in New York that work for Delaware, then counsel must make itself aware of the significant distinction between Delaware and New York law on this point.
The percentage of agreements that included clear pro-sandbagging provisions was roughly the same in the Delaware and New York survey samples. In New York, however, 12 percent of the surveyed agreements contracted explicitly against a sandbagging right, compared to six percent in Delaware. One of these agreements specified that the buyer cannot sandbag specifically if the seller provides notice of the breach, the seller acknowledges that the breach represents a failure of a closing condition, and the buyer proceeds with the closing regardless.
Cure Rights
Of the 19 agreements with New York governing law that were silent on sandbagging, three provided that the seller's notification of a breach and update to the disclosure schedule does not cure the breach or affect the seller's representation. In the Delaware-law context, this could be taken as a backdoor sandbagging provision. However, its effect in New York can be the opposite—if the seller is the source of the buyer's knowledge, the buyer cannot sandbag unless it has explicitly reserved its rights.
Anti-Sandbagging Jurisdictions
Certain jurisdictions maintain that reliance is a necessary element for a breach-of-contract claim, not just a fraud claim. In these jurisdictions, the default rule is that the buyer cannot sandbag, because if it has knowledge that the seller's representation or warranty is untrue, then it cannot be said to have relied on the truth of the representation or warranty in deciding whether to close. Consequently, silence on the issue of sandbagging in the acquisition agreement has the opposite effect as it does in Delaware—the buyer will be assumed to have waived its right to sandbag.
California, Colorado, Kansas, Maryland, Minnesota, and Texas all require reliance for a contract claim (see Charles K. Whitehead, Sandbagging: Default Rules and Acquisition Agreements, 36 Del. J. Corp. L. 1081 (2011), for a summary of the relevant case law in these jurisdictions). The Practical Law survey aggregated all acquisition agreements entered into in 2016 from these jurisdictions with post-closing indemnification and collected in the What's Market database. The survey found 31 qualifying agreements, as follows:
- Twenty-one with Texas governing law.
- Six with California governing law.
- Three with Colorado governing law.
- One with Maryland governing law.
- None with Kansas or Minnesota governing law.
As illustrated, a significant percentage of agreements stayed silent on the question of sandbagging, despite that approach's implications for the buyer. Indeed, given the similar percentages for both pro-sandbagging and silence in Delaware, New York, and these anti-sandbagging jurisdictions, it is hard to escape the conclusion that many parties and their counsel are not tailoring their approach to this issue in recognition of the acquisition agreement's governing law.
Two agreements provided for a hybrid approach to sandbagging.
- In one agreement, the buyer negotiated a sandbagging right with respect to the seller's representations and warranties pertaining to: organization and authority; the target company's organization, authority and qualification; capitalization; subsidiaries; environmental matters; taxes; and brokers. For all other representations and warranties, the buyer may not sandbag.
- In the other agreement, the buyer obtained a sandbagging right except regarding environmental defects, liabilities, and conditions and title defects of which the buyer had knowledge before the one-month anniversary of the agreement and for which they did not provide notice to the sellers as required under the purchase agreement.
None of the 12 agreements that were silent on sandbagging provided that the seller's update to the disclosure schedule does not cure the underlying breach.
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