“SANDBAGGING” IN M&A TRANSACTIONS

In golf, a “sandbagger” is a person who pretends to be a worse player than he or she really is in order to take advantage of and lie to other players in order to gain additional handicap strokes and increase his or her chances of winning. The term “sandbagging” is believed to have originated with 19th century street gangs who would fill socks with sand (hence, the term “sandbags”) and use them as weapons. The term “sandbagging” is commonly used in merger and acquisition transactions to refer to a practice employed by buyers to claim a breach of a representation or warranty in the transaction agreement and seek indemnification from the seller in spite of the buyer having known of the breach or the fact that a particular representation or warranty was not true at the time the governing agreement was signed or the transaction closed. Sandbagging claims can arise irrespective of the transaction structure—whether a stock purchase, an asset purchase or a merger, provided the seller’s representations and warranties survive the closing.

Indemnification provisions are among the most heavily negotiated provisions in M&A transactions, and sandbagging disputes are among the most contentious issues and costly to resolve in M&A transactions. Accordingly, sellers will seek to limit the scope, duration and amount of damages subject to indemnification claims, while buyers attempt to expand their indemnification rights as much as possible.

Buyers will argue for the inclusion of a “sandbagging” or “pro‑sandbagging” provision, in the governing agreement, whereas sellers will want to include an “anti‑sandbagging” provision.

“Sandbagging”/“Pro‑Sandbagging” Provisions

Buyers and sophisticated buyer counsel will often ask for a “sandbagging” provision (sometimes referred to as a “pro‑sandbagging” provision) that typically provides that the buyer will be entitled to post‑closing indemnification for any breaches of the seller’s representations and warranties in the transaction agreement, whether or not the buyer knew of any such breach or the fact that a particular representation or warranty was not true prior to signing the governing agreement or closing the transaction. A typical sandbagging or pro‑sandbagging provision may read as follows:

The rights of Buyer to indemnification or any other remedy under this Agreement shall not be impacted or limited by any Knowledge that Buyer acquired, or could have acquired, whether before or after the Closing or the Closing Date, nor by any investigation or due diligence inquiry conducted by Buyer. Seller hereby acknowledges that, regardless of any investigation or due diligence inquiry conducted by or on behalf of Buyer, and regardless of the results of any such investigation or inquiry, Buyer has entered into this Agreement and the Transaction in express reliance upon the representations and warranties of Seller made in this Agreement.

Simply stated, a “sandbagging” or “pro‑sandbagging” provision provides that a buyer’s remedies against the seller under the governing agreement are not impacted regardless of whether the buyer had knowledge, at or prior to closing, of the facts or circumstances giving rise to an indemnification claim.

Obviously, a “sandbagging” or “pro‑sandbagging” provision is a buyer‑favorable provision and should be resisted by sellers and their counsel. That said, depending on the study one reads, over the last several years “pro‑sandbagging” provisions are included in approximately 25% ‑ 58% of M&A agreements.

“Anti‑Sandbagging” Provisions

On the other hand, sellers will sometimes request an “anti‑sandbagging” provision, which is a pro‑seller provision that prevents the buyer from being indemnified for the breach of any representation or warranty that the buyer had knowledge of prior to signing the governing agreement or closing the transaction. A typical “anti‑sandbagging” provision may read as follows:

Buyer acknowledges and agrees that it has had an opportunity to conduct a thorough investigation and due diligence inquiry on the Company, and in no event shall Seller have any liability to Buyer with respect to the breach of any representation or warranty in this Agreement to the extent Buyer knew of such breach as of the Closing or the Closing Date.

An “anti‑sandbagging” provision, as the name suggests, prohibits the buyer from sandbagging or seeking post‑closing indemnification for any breaches of the seller’s representations or warrant of which the buyer had knowledge at or prior to the closing. An “anti‑sandbagging” provision is a seller‑favorable provision and should be resisted by buyers and their counsel. Recent studies have found that “anti‑sandbagging” provisions have been included in none and up to 42% of the M&A agreements that were surveyed.

Trends in Usage of Sandbagging and Anti‑Sandbagging Provisions

The American Bar Association (the “ABA”) publishes a Private Target Mergers and Acquisitions Deal Point Study every other year that analyzes various terms in middle‑market M&A transactions. In the ABA’s 2017 Study (the most recent available), the ABA found the following in the M&A agreements it surveyed:

  • 42% contained a sandbagging/pro‑sandbagging provision,
  • 6% contained an anti‑sandbagging clause, and
  • 51% were silent on the issue of sandbagging.

Another 2017 study found that 75% of the M&A agreements that were surveyed were silent on the sandbagging issue, that 25% contained a pro‑sandbagging provision, and none of the transactions it surveyed contained an “anti‑sandbagging” provision. Because buyers and sellers and their counsel are often not able to agree on the sandbagging issue, a high percentage of M&A agreements are silent on this issue.

Consequences of Remaining Silent

Addressing the issue of “sandbagging” during the negotiation of the letter of intent (“LOI”)) is critical for both the buyer and the seller. In many cases, however, the parties are not able to agree on the sandbagging issue, and the LOI or the definitive M&A agreement is left silent on the issue, in which case the choice of law governing the agreement becomes a key issue. The parties and their counsel should carefully consider the legal consequences of remaining silent and evaluate how the sandbagging issue will be addressed under the law governing the agreement.

Because sandbagging provisions are so heavily negotiated, often the parties will simply not address sandbagging in the LOI or the definitive agreement. Some recent studies have found that up to 75% of the M&A agreements that were surveyed were silent on the sandbagging issue. If the agreement is silent, care must be exercised by both parties and their respective counsel regarding what law will govern the agreement. In some jurisdictions (notably New York) there is a risk of a waiver if the buyer closes over a known breach of a representation or warranty by the seller unless the buyer’s rights are preserved in the agreement or an ancillary agreement.

Two General Rules

As with many areas of the law, there are “gray” areas and different rules applied in various states. The law governing sandbagging is no different, and it is critical to understand how courts will treat an agreement that is silent on the “sandbagging” issue. Broadly speaking, courts have developed two different rules when an M&A agreement is silent on the issue of “sandbagging”—the so‑called “Modern Rule” and the “Traditional Rule.” When indemnification disputes often turn on the default rules of the jurisdiction whose law governs the M&A agreement. Thus, parties to M&A transactions and their counsel should understand how different states treat a buyer’s indemnification rights in the absence of a sandbagging provision in the M&A agreement.

  • The Modern Rule. The “Modern Rule” permits a buyer to bring an indemnification claim for inaccurate representations and warranties in an M&A agreement, regardless of the buyer’s knowledge of the inaccuracies prior to closing. Courts following the “Modern Rule” hold that the representations and warranties are negotiated contractual obligations upon which the buyer had the right to rely. Among the states following the Modern Rule are Delaware, and, generally New York[1] (as well as Illinois, Florida, Connecticut and Indiana). The Modern Rule is a “pro‑sandbagging” rule and, therefore, is buyer‑favorable. Thus, a buyers likely will prefer the governing law of an M&A agreement to be a state that follows the Modern Rule, because in those states buyers are generally not required to show reliance in order to make an indemnification claim for a seller’s breach of a representation or warranty.The Traditional Rule. Under the Traditional Rule, a buyer must prove reliance on the representation or warranty as an element of its indemnification claim. California is the leading state that follows this rule, which requires buyers to prove that they relied on the representation or warranty that the seller breached. Kansas, Minnesota and Texas are among the states that follow the Traditional Rule. The Traditional Rule is an “anti‑sandbagging” rule and, therefore, is seller‑favorable. Thus, a seller likely will prefer the governing law of an M&A agreement to be a state that follows the Traditional Rule, because a buyer would be required to prove reliance on the seller’s inaccurate representation or warranty in order to prevail on a representation or warranty breach claim against the seller. There is no Utah case that addresses the issue of sandbagging. However, in a 1976 case, the Tenth Circuit Court of Appeals (the Circuit in which Utah sits), and the Colorado Supreme Court in a 1993 case (Colorado also sits in the Tenth Circuit), appear to have adopted the Traditional Rule. That said, there nevertheless remains risk in remaining silent on the issue of sandbagging in an M&A agreement that will be governed by Utah law.

Takeaways:

  • Address “sandbagging in the LOI, if possible.
  • If on the sell‑side, try to include an “anti‑sandbagging” provision.
  • If on the buy‑side, try to include a “sandbagging” or “pro‑sandbagging” provision and define “knowledge” as narrowly as possible and so as to include the actual knowledge of certain designated senior officers.
  • If on the buy‑side and are forced to compromise and agree to some form of an “anti‑sandbagging” provision, try to limit the standard of proof to “actual” knowledge, as opposed to constructive or implied knowledge.
  • If the parties are not able to agree how to handle the sandbagging issue, clearly understand the default sandbagging rule of the state whose law will govern the M&A agreement and argue for the governing law of a state that will likely uphold your preferred position.
  • A thorough due diligence investigation by buyers is critical.
  • Because buyers may have “sandbagging” rights under common law, sellers should exercise care in negotiating their representations and warranties and in preparing their Disclosure Schedules.

Readers should understand that this article only scratches the surface of the issues that need to be considered and addressed in M&A agreements in connection with indemnification claims. While certainly not an exhaustive list, other related issues that must be considered include indemnification exclusions, knowledge definitions, materiality scrapes, baskets and caps, “mini‑baskets” or sub‑baskets, the survivability period of representations and warranties, the survival period of carve outs, fundamental representations, the impact of “net of insurance” provisions, and whether representation and warranty insurance will be obtained.

This article is provided for educational and informational purposes only and is not intended to, and should not be construed as, legal advice. Readers should consult their lawyer regarding the applicability of the information discussed herein to their particular situation and facts.

[1]   While a discussion of the one exception under New York law is beyond the scope of this article. Briefly, however, New York courts will evaluate the source of a buyer’s knowledge in determining whether to allow post‑closing recovery for a seller’s breach of its representations or warranties of which the buyer was aware at the time of closing. This exception often surprises unwary buyers.

 

Thomas R. Taylor is a corporate and M&A lawyer and shareholder in the Salt Lake City office of the law firm of Durham, Jones & Pinegar, P.C. Tom is listed as one of the leading M&A lawyers in the United States by both Chambers & Partners and Super Lawyers, as one of the Best Lawyers in America in the areas of Corporate Law, Corporate Compliance Law, and M&A Law by Best Lawyers, as a Top Attorney in Utah, Nevada, Montana, Idaho and Wyoming in Mergers & Acquisitions by American Registry, LLC, and as one of the leading Corporate and Transactional Lawyers in the State of Utah by Utah Business magazine. In addition, he is the recipient of a Lifetime Achievement Award from, and is listed as being among America’s Top 100 Attorneys by, America’s Top 100 Attorneys.com. Tom maintains an “AV”/Preeminent Rating with Martindale‑Hubbell, which is the highest rating awarded to attorneys for professional competence and ethics. Tom can be reached at (801) 297‑1370 or [email protected].

2019-06-12T16:21:53+00:00