Sandbagging In M&A Deals: What Does Silence Mean?
Sandbagging in billiards and other games happens when someone pretends to be a worse player in order to trick their opponent into accepting a higher stakes bet, or to gain extra handicap strokes to increase their chances of winning a match.
The term is also used in the M&A context to describe a situation where a buyer becomes aware that a representation made by the seller in the acquisition agreement isn’t true, closes the deal anyway and then later tries to hold the seller liable for such a breach. Sometimes, the parties will negotiate around this sort of maneuver by including an”anti-sandbagging” provision in the agreement, limiting the buyer’s ability to assert claims in cases where it knew of a seller's breach prior to closing. Conversely, a pro-sandbagging clause states the buyer’s remedies against the seller won’t be impacted, even if it knew of the problem at hand.
Recent American Bar Association surveys of M&A transactions suggest agreements are increasingly silent on the topic of sandbagging. In 2010, just 5% of purchase agreements included an anti-sandbagging provision, while 41% contained a provisions expressly permitting sandbagging. The remaining 54% of agreements were silent on the issue, up from 41 percent of deals completed in 2006. In these situations, the state law governing the agreement will determine whether this silence permits or disallows sandbagging.
Delaware and New York
Delaware and New York, the two jurisdictions which are often controlling law for M&A transactions, have taken a similar “pro-sandbagging” view, which means a majority of buyers will have some right to sandbag even when the agreement is silent on the issue.
In 2005, for example, the Delaware Superior Court ruled in Interim Healthcare v. Spherion that a buyer is not required to show that it relied on a seller’s representation and can hold the seller accountable for the accuracy of the representations and warranties in the acquisition agreement. This contract-based approach was later affirmed by the Delaware Court of Chancery in Cobalt Operating v. James Crystal Enterprises, which held that a breach of contract claim arising out of an acquisition agreement doesn’t depend on the buyer showing reliance.
Cobalt involved claims of fraud and breach of contract after the buyer purchased a radio station for $70 million. It claimed the seller artificially inflated the station’s cash flow before the same, causing the buyer to overpay. The seller argued, in part, that the buyer discovered the discrepancy during its due diligence review and new the financial representation in the purchase agreement was incorrect. It contended the buyer couldn’t establish that it reasonably relied on any of the financial representations and was therefore not harmed.
Ruling Cobalt’s breach of contract claim didn’t depend on it showing justifiable reliance, the court noted that due diligence is expensive and “parties to contracts in the mergers and acquisitions transactions often negotiate for contractual representations that minimize a buyer’s need to verify every minute aspect of a seller’s business.” It added that the seller, having contractually promised the buyer that it could rely on certain representations, was in no position to contend that the buyer was “unreasonable in relying on [the seller’s] own binding words."
New York takes a similar view as the Delaware courts, having decided that a buyer isn’t required to show reliance. But NY courts will also take into consideration the source of a buyer’s knowledge in determining whether to allow recovery for breaches of which the buyer was aware at closing. For example, in Galli v. Metz, the Court of Appeals for the Second Circuit said that if a buyer “closes on a contract in the full knowledge and acceptance of facts disclosed by the seller which would constitute a breach of warranty under the terms of the contract, the buyer should be foreclosed from later asserting the breach,” unless the buyer expressly preserves that right. The court indicated that if the information was disclosed by a third party or is common knowledge, the buyer would have a stronger argument.
In contrast to New York and Delaware, California generally requires a buyer show that it relied on the truth of the representation in order to bring a claim for breach of warranty. This “anti-sandbagging” approach can better protect sellers in the absence of a sandbagging provision in the agreement.
Courts have repeatedly followed this general rule, but a recent decision in Telephia v. Cuppy shows that California courts will uphold a specific pro-sandbagging clause. In this case, the “pro-sandbagging” clause stated that:
"No information or knowledge obtained in any investigation pursuant to this Section 6.1 shall affect or be deemed to modify any representation or warranty contained in this Agreement. . . ."
It also provided that, "no investigation made by or on behalf of [the buyer] with respect to [the target company] shall be deemed to affect the [buyer’s] . . . reliance on the representations, warranties, covenants, and agreements made by [the target company].”
The court held that the contractual language was clear and the seller could be held accountable to the warranties in the agreement, regardless of whether the buyer relied on those warranties. It said the two sides reached “a bargain where defendants bore the risk of unexpected problems.”
Addressing the issue of sandbagging during negotiations is critical for both the buyer and seller. As evidenced above, Delaware and New York law might be preferable to buyers as controlling law of an acquisition agreement. Still, whenever possible buyers should negotiate for a pro-sandbagging provision. It sometimes is not enough to leave the agreement silent on the issue because in some jurisdictions, like California, silence might be equal to agreeing to broad “anti-sandbagging” standards. If a buyer is forced to compromise and agree to some form of an “anti-sandbagging” provision, it should push to limit the standard of proof to “actual” knowledge, as opposed to constructive or implied knowledge. Doing so can minimize the impact of the provision.