By Todd Reece & Spencer Crichett
Several years ago our firm published an article in the Deal Flow Report regarding sandbagging provisions, and tips for buyers and sellers in M&A transactions. Since that article was published, there have been recent developments which parties to M&A transactions should be aware of, and should be taken into consideration when negotiating indemnification provisions in M&A transaction documents.
As a brief summary, indemnification is a contractual remedy for losses incurred after the closing of an M&A transaction, which result from breaches by a transaction party (typically the seller) of representations, warranties and covenants contained in the definitive M&A document. Associated with indemnification is the concept of sandbagging, which means one transaction party’s (typically the buyer) remedies against the other party (typically the seller) are not impacted regardless of whether the initial transaction party had knowledge of a breach prior to the closing of the transaction.
Buyers prefer, and often negotiate strongly for, the inclusion of “prosandbagging” provisions in the transaction agreement, that makes
it explicit that its rights to indemnification will not be affected based upon whether or not it was aware of a breach by the other party prior to the closing. Alternatively, sellers prefer to include “anti-sandbagging”provisions in the transaction agreement, which prevents the buyer from bringing an indemnification claim if the buyer (i) knew of a potential breach by the seller, and (ii) chose to close the transaction despite its knowledge of the potential breach.
Given the significant implications, this is a heavily negotiated topic, and therefore a majority of transactions surveyed for the American
Bar Association’s most recent deal points study were silent on this issue, and contained neither a “pro-sandbagging” provision nor an
“anti-sandbagging” provision. As noted in our firm’s prior article, if the transaction agreement is silent on the issue of sandbagging, the governing law of the transaction agreement will dictate whether sandbagging is permitted. Delaware law is the governing law for many M&A transaction agreements, and Delaware law is also an influential source in the interpretation of transaction agreements governed by the laws of other states for many reasons.
In a 2015 oral ruling, influential Vice Chancellor (i.e., judge on the Delaware Chancery Court) declared that “Delaware is what is affectionately known as a ‘sandbagging’ state” and many decisions handed down by the Delaware courts up to this point confirmed that view, which is that an M&A transaction agreement governed by Delaware law which is silent on the issue of sandbagging is effectively an invitation for buyers to engage in sandbagging. This is a reason many transaction agreements are silent on the issue of sandbagging, since it makes no sense to use negotiating capital to include a provision in the transaction agreement which is unnecessary.
However, on May 24, 2018 the Delaware Supreme Court’s decision in Eagle Force Holdings, LLC v. Stanley Campbell created confusion on this issue. In a footnote, it was noted that there is a debate regarding whether a buyer can recover for a breach when the buyer knew at signing that the representation was not true. In addition, while the decision observed that most states follow the notion that sandbagging is permitted, the majority did not decide this issue because the claims were not before the court, and concluded that Delaware “had not yet resolved this interesting question.”
Following the Eagle Force holding, some practitioners believe that Delaware may turn out to be an “anti-sandbagging” state when it comes
to enforcing contractual representations and warranties, and therefore remaining silent on the sandbagging issue in transaction agreements governed by Delaware law may result in a buyer being required to dispute what it knew prior to the closing of the transaction, and therefore
further requiring the buyer to prove that it did not have knowledge of a breach prior to the closing.
The concept of sandbagging in M&A transaction agreements affects parties’ ability to seek indemnification and alternatively, it affects parties’ defense against indemnification claims. While it was previously assumed by many that Delaware was a “pro-sandbagging” state, and silence on the issue of sandbagging in transaction agreements governed by Delaware law was in essence the same as inserting a pro-sandbagging provision in the Agreement, the Eagle Force decision casts doubt on that assumption. Moving forward, when negotiating M&A transaction agreements which are governed by Delaware law, it would be wise to think twice when determining whether to remain silent on the issue of sandbagging, or to include a pro- or anti-sandbagging provision in the transaction agreement. Given the recent ambiguity created by the Delaware Supreme Court, the latter seems to be the more prudent approach.
ABOUT THE AUTHORS
TODD REECE – Todd is a partner in the Business and Finance Department at Ballard Spahr LLP. He advises clients on transactional matters including mergers, acquisitions, financings (venture capital and private equity), securities, joint ventures, licensing matters, business formation issues, internal restructurings and related matters.
SPENCER CRICHETT – Associate General Council of Visible Supply Chain Management, a client of Ballard Spahr LLP.