A Little Knowledge Can Be A Dangerous Thing: Sandbagging Clauses In Acquisition Agreements

In an M&A transaction, the purchaser will usually conduct due diligence on the target, gaining insight into its operations and uncovering any risks. Such risks are then typically dealt with by means of negotiated vendor representations, warranties, covenants and indemnities. But what happens if the purchaser learns, prior to closing, that the vendor has breached one of these negotiated representations but goes ahead and closes the deal anyway, without saying anything? In such a case, what rights do the purchaser and vendor have? Specifically, is the purchaser offside if it fails to inform the vendor of the perceived misrepresentation prior to closing and then, once the deal is closed, turns around and demands indemnification? The answer to this question can frequently be found within the four corners of the contract, if the parties turned their mind to the possibility of such an event and negotiated a suitable "sandbagging" clause. Otherwise, it generally falls to the common law of the governing jurisdiction, or to the Civil Code in the case of Quebec.

An Overview of Sandbagging and how it can be addressed in Acquisition Agreements

OVERVIEW

In everyday language, "sandbagging" means to conceal or understate the strength of one's position so as to gain an advantage over a competitor. The term applies in the M&A context when (as described above) the purchaser learns of a breach of a representation, warranty or covenant before closing but says nothing about it until the deal has closed - at which point it brings an indemnity claim under the agreement. In order to clarify the parties' expectations as to how such circumstances are to be addressed, purchasers and vendors typically take one of three approaches in the acquisition agreement:

Include a pro-sandbagging clause; Include an anti-sandbagging clause; or Remain silent on the issue. The approach taken will be transaction specific and is generally determined by the (i) complexity of the transaction and the related diligence materials, and (ii) relative strength of each party.

PRO-SANDBAGGING CLAUSES

A pro-sandbagging provision is purchaser-friendly, typically allowing the purchaser to pursue post-closing remedies even if it knew about the breach prior to closing. The following is a typical example:

The right to indemnification, payment, reimbursement, or other remedy based upon any such representation, warrant, covenant, or obligation will not be affected by ... any investigation conducted or any knowledge acquired at any time, whether before or after the execution and delivery of this Agreement or the Closing Date, with respect to the accuracy or inaccuracy of, or compliance with, such representation, warranty, covenant, or obligation.

In addition to clarifying how an indemnity claim will be addressed, the presence of a pro-sandbagging provision also removes the need for a purchaser to refute any assertion by the vendor that the purchaser had prior knowledge of facts pertaining to the actual breach (as discussed below).

ANTI-SANDBAGGING CLAUSES

An anti-sandbagging provision is vendor-friendly inasmuch as it limits the purchaser's post-closing remedies for a vendor's breach of a representation, warranty or covenant if the purchaser had knowledge of such breach prior to the closing (typically through knowledge gained pursuant to the due diligence process). The following is a typical anti-sandbagging provision:

No party shall be liable . for any Losses resulting from or relating to any inaccuracy in or breach of any representation or warranty in this Agreement if the party seeking indemnification for such Losses had knowledge of such Breach before Closing.

In the event of a indemnification claim, the inclusion of an anti-sandbagging provision will require the purchaser to (i) prove the existence of a breach; and (ii) refute any assertion by the vendor that it (the purchaser) had knowledge of the breach prior to closing, before the merits of an indemnity claim can be considered. Because it can be difficult to prove that someone did or did not know something, the definition of "Knowledge" typically becomes a key point in negotiations around an anti-sandbagging clause. Purchasers and vendors should seek to define "Knowledge" in a way that...