“Sandbagging” in M&A Transactions

“Sandbagging” in M&A Transactions

2021-02-18T15:52:10+00:00 February 18th, 2021|Deal Flow, Deal Flow Articles|

By Thomas R. Taylor

The term “sandbagging” in merger and acquisition (“M&A”) transactions refers to a practice often employed by buyers to claim a breach of a seller representation or warranty (a “rep or warranty”) and seek indemnification post closing from the seller, in spite of the buyer having known about the breach. Sandbagging claims can arise irrespective of the transaction structure – whether a stock purchase, an asset purchase or a merger. Buyers often argue for a sandbagging provision, in the transaction agreement, whereas sellers will want to include an “anti sandbagging” provision.

“Sandbagging” Provisions
A sandbagging provision provides that the buyer will be entitled to indemnification post closing for any breaches of the seller’s reps and warranties, whether or not the buyer knew of the breach or the fact that a particular rep or warranty was false. A sandbagging provision reads as follows:

The rights of Buyer to indemnification 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 provision provides that a buyer’s remedies against the seller are not impacted even if the buyer knew at the closing of the breach.

“Anti Sandbagging” Provisions
Sellers, on the other hand, 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 rep or warranty that the buyer knew about at the closing. An anti sandbagging provision reads as follows:

Buyer acknowledges and agrees that it has had an opportunity to conduct a thorough due diligence investigation on Seller, 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 Closing Date.

An anti sandbagging provision prohibits the buyer from sandbagging or seeking indemnification post closing against the seller for a breach of a rep or warranty that the buyer knew about at the closing. An anti sandbagging provision is a seller favorable provision and should be resisted by buyers.

Trends in Usage
The American Bar Association (the “ABA”) publishes a Private Target Mergers and Acquisitions Deal Point Study 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 reviewed:

42% contained a sandbagging provision,
6% contained an anti sandbagging provision, and
51% were silent on the issue.

Consequences of Remaining
Silent In many transactions the parties are not able to agree on the sandbagging issue, so the agreement will simply be left silent on the issue, in which case the choice of law governing the agreement becomes critical. The parties should carefully consider the legal consequences of remaining silent and evaluate how the sandbagging issue will be addressed under the law governing the transaction agreement.

Two General Rules
The rules applied by courts to M&A agreements that are silent on the sandbagging issue vary among the states. Accordingly, it’s critical to carefully select what law will govern the agreement and understand how courts will treat an agreement that is silent on the sandbagging issue. Courts have developed two different rules—the so called “Modern Rule” and the “Traditional Rule.”

The Modern Rule. The “Modern Rule” permits a buyer to bring an indemnification claim for a false rep or warranty, regardless of whether the buyer knew about breach at the closing. These courts hold that reps and warranties are negotiated contractual obligations upon which the buyer had the right to rely. Among the states that follow the Modern Rule are Delaware and New York. The Modern Rule is a buyer favorable rule because it does not require the buyer to show reliance on the false rep or warranty in order to obtain indemnification.

The Traditional Rule. Under the Traditional Rule, a buyer must prove reliance on the rep or warranty as an element of its indemnification claim. California is the leading state that follows the Traditional Rule. This Rule is seller favorable because the buyer will be required to prove reliance on the seller’s false rep or warranty in order to obtain indemnification.

There is no Utah case that addresses the sandbagging issue or the consequences of the transaction agreement being silent on the issue. However, based on a 1976 the Tenth Circuit Court of Appeals case (the Circuit in which Utah sits), it appears the Tenth Circuit adopted the Traditional Rule, or the seller favorable position of requiring the buyer to prove reliance on the seller’s false rep or warranty in order to obtain indemnification.

About Thomas R. Taylor
Thomas R. Taylor is a corporate and M&A lawyer and a shareholder in the Salt Lake City office of the law firm of Durham, Jones & Pinegar, P.C.