Sandbagging in M&A Deals: Is Silence Golden For Buyers?

Sandbagging in M&A Deals: Is Silence Golden For Buyers?

Imagine this scenario: You have signed a purchase agreement to acquire a business and the parties are now driving to close the deal. The eleventh hour has arrived, and the seller proceeds with a “data dump” of documents that should have been disclosed prior to signing. During your review of the documents provided at this late hour, you learn of the inaccuracy of one of the seller’s representations regarding the business. Nevertheless, you believe that any losses sustained by the business as a result of the breach will be minimal and you have come too far to walk away from the deal now. You have an out, but you would prefer to close the deal and then potentially bring a claim against the seller to recover if problems develop. What you are contemplating at the moment is sometimes called “sandbagging.”

The issue of whether or not to include a pro-sandbagging provision or an anti-sandbagging provision in the purchase agreement had been raised during negotiations. The inclusion of a pro-sandbagging provision would have made it clear that any pre-closing knowledge of circumstances giving rise to a claim would not impact your ability to recover. Conversely, an anti-sandbagging provision would have limited your ability to make a claim based on facts that were known by you prior to closing. Sandbagging was one of the last issues negotiated, and, rather than fight it out, the parties agreed to remain silent on this point. You ultimately decide to go forward with the closing believing that you can recover any losses arising from the breach. Silence on this issue will work in your favor, you reason.

Your intentions are not sinister. Indeed, you have decided to defer what you believe to be a minor issue until after the closing so that the deal can be consummated and everyone can celebrate at the closing dinner. Do you have a full understanding of the consequences of the breach? Not really, but you do not expect the losses to be significant. In fact, the potential losses may not even be calculable until a later date or until other events occur. Is the seller even aware that the newly provided documents reveal circumstances that result in a breach of one of the warranties negotiated at signing? Perhaps, but to raise the point now would mean the parties would have to address the matter in some way. This could involve you waiving your ability to walk away, allowing the representation to be amended or the related schedule to be updated to “cure” the breach, or otherwise giving up your right to recovery. On the other hand, you could seek an amendment to the purchase agreement that would specifically provide you with indemnification for claims arising out of the recently disclosed facts. Any of these paths, however, would require further evaluation and negotiation, and the parties are on the verge of closing the deal.

Now, fast forward past the closing and you are facing substantially more losses than you anticipated based on the breach that you were fully aware of prior to closing. To your disappointment, you discover that you are precluded from recovery because the law chosen by the parties to govern the purchase agreement requires you to have believed the representation to be correct in consummating the transaction. Your pre-closing knowledge of the breach prevents you from proving that you relied on the truth of the representation. The losses are mounting and you now have no ability to recover from the seller with respect to this matter.

Does this sound like a risky scenario? It can be. And parties are choosing to remain silent on sandbagging in purchase agreements more than ever before. According to the American Bar Association 2011 Private Target Mergers & Acquisitions Deal Points Study, which examined purchase agreements for transactions completed in 2010 that involved private targets being acquired by public companies, 54% of purchase agreements were silent on the sandbagging issue. This is up from 41% in deals completed in 2006 and 53% in deals completed in 2008 based on similar studies by the American Bar Association. The Deal Points Study also found that 41% of purchase agreements contained a pro-sandbagging provision (down from 50% in 2006 and up from 39% in 2008) and that 5% of purchase agreements included an anti-sandbagging provision (down from 9% in 2006 and 8% in 2008). Therefore, although buyers are expressly protecting their right to obtain recovery based upon facts known to them prior to closing more often than they are expressly giving it up, the majority of purchase agreements continue to remain silent on sandbagging.

Now, why are parties remaining silent on sandbagging? More often than not, the issue of sandbagging is one of the last points negotiated at the end of what can be a long, drawn out process. Rather than debate whether to include a provision that covers sandbagging, the parties decide to remain silent and allow the law chosen by the parties to govern the purchase agreement to control the matter. The problem is that governing law is more often evaluated with respect to other matters in the purchase agreement – such as the enforceability of a non-competition covenant – rather than its effects on sandbagging by the buyer. It may be that inadequate attention is being given to the law that will impact the buyer’s ability to make a claim based on circumstances known prior to closing.

Are the states uniform regarding what a buyer must show in order to successfully make a claim for the breach of a representation in the purchase agreement? The short answer is absolutely not. The elements of a claim for breach of contract vary between jurisdictions and, consequently, so does the effect of having prior knowledge of the circumstances giving rise to the claim. When a claim involves sandbagging, whether or not the claim is successful often turns on whether reliance is a component of the claim in the particular jurisdiction. That is, does the state require the buyer to have relied on the truth of the representation that it now claims was breached in consummating the deal? Some states take the view that the buyer bargained for the warranties and should not be deprived of the benefit of the deal that was struck, and, therefore, reliance is not an element of a breach of contract claim against the seller. Other states take the view that the buyer must demonstrate that it relied on the truth of the representation to have a breach of warranty claim against the seller – reasoning that the buyer that closed with full knowledge of the breach has essentially waived the breach.

Delaware, for example, has taken a contract-based approach and not required a buyer to show reliance in order to successfully assert a breach of contract claim – the representations in the purchase agreement serve a risk allocation function. California, on the other hand, has required a buyer to demonstrate that it relied on the truth of the representation in order for it to bring a successful breach of warranty claim. New York, a common choice for the governing law of purchase agreements, takes a hybrid approach. Although reliance is an element of a breach of contract claim, if a buyer can show that it believed that it was purchasing the truth of the warranty – not that it believed in the truth of the warranty – the buyer may be able to recover. The question turns on how the buyer learned of the breach. If the seller made the buyer aware of the circumstances that give rise to the breach, then the buyer will be deemed to have waived the breach because the buyer, it is thought, did not think it was purchasing the truth of the warranty in question. If, on the other hand, the buyer discovered the breach as a result of its review of information provided by a third party or information that is common knowledge, then the buyer has a strong argument that it did think it was purchasing the truth of the warranty. Not surprisingly, recovery depends on the facts.

How can a buyer protect its right to recover with respect to claims that are based on facts known prior to closing? Addressing the issue of sandbagging and devoting the necessary time to evaluating and negotiating the point prior to signing is critical. A buyer can push in negotiations for a pro-sandbagging provision. If, however, the bargaining positions are such that the seller has more leverage and insists on an anti-sandbagging provision, the buyer should try to limit the definition of “knowledge” in a similar manner as the seller does with respect to its warranties in the purchase agreement. By limiting “knowledge” to actual knowledge – as opposed to constructive knowledge – and to a small group of “knowledge” parties, the buyer can minimize the impact of the anti-sandbagging provision. If the parties agree to remain silent on sandbagging, the buyer should review the law of the jurisdiction proposed to govern the purchase agreement to determine whether reliance is an element of a breach of contract claim. If it is, the buyer should consider having the law of another jurisdiction apply – there may be a multitude of other reasons for doing this in addition to dealing with the issue of sandbagging. In addition, the buyer can seek line item indemnities in the purchase agreement with respect to specific matters that are disclosed by the seller prior to signing.

What can a buyer do when the deal is already signed, the purchase agreement is silent as to sandbagging, and the closing is looming as described in this scenario? The buyer can attempt to use the leverage it has to walk away from the deal, assuming, of course, that the buyer properly protected that right during the negotiation of the purchase agreement. It is, however, better to anticipate these types of scenarios in negotiations prior to signing. The purchase agreement should be clear as to the effect of the disclosure of documents and information by the seller between signing and closing – whether it is something that should have been disclosed prior to signing or something that arose following signing. Particular attention should be given to provisions relating to updates to disclosure schedules and the effect not only on the ability of the buyer to seek indemnification following closing, but also on the buyer’s ability to walk away from the deal. In the absence of buyer-friendly provisions on these points, the buyer may best be served by using any leverage it may have to walk away from the deal to reach a satisfactory resolution.

A buyer should always negotiate for a pro-sandbagging provision, but, if the parties choose to remain silent on sandbagging, the buyer should understand the consequences of this choice under state law. Simply remaining silent – or in the dark – may not be golden.