Sandbagging: Who is Bludgeoning Whom?
by Ted Schweinfurth and Richard White
The term “sandbagging” derives from the practice of 19th Century street gangs utilizing socks filled with sand to physically punish members of rival gangs. To “sandbag” someone meant to use a seemingly innocuous object to impart a powerful blow without leaving a noticeable mark.
In an acquisition agreement, “sandbagging” typically refers to a buyer seeking post-closing indemnification from a seller for breaches of representations and warranties that the buyer knew of prior to closing. The buyer’s argument is that it bargained for the right to rely on the seller’s reps and warranties despite the fact that the buyer knew of the facts underlying the breach (for purposes of this article, we are assuming a simultaneous sign and close or that the buyer has chosen not to terminate the agreement, if permitted, and instead has elected to close and seek post-closing indemnification).
Sellers may ascribe ill-motives to a buyer seeking post-closing indemnification for matters it knew about prior to closing, viewing a buyer that “closes over” such issues as having waived its right to indemnification by closing.
“Sandbagging-related” provisions in an acquisition agreement may appear innocuous or even “boilerplate;” however, understanding and carefully crafting them is critical for both buyers and sellers. Similar to a 19th Century “sandbag,” such provisions can have a devastating effect on an unwary opponent.
Alternatives. There are generally three choices when dealing with “sandbagging” in an acquisition agreement: a pro-sandbagging provision, an anti-sandbagging provision or silence. A pro-sandbagging provision provides that a buyer may bring post-closing indemnification claims against the seller for breaches of representations and warranties known by the buyer prior to closing. An anti-sandbagging provision provides that a buyer cannot bring an indemnification claim based on a breach of a representation or warranty that the buyer knew prior to closing. The agreement may also be silent on the matter. According to a recent deal terms survey, 54percent of acquisition agreements were silent on the issue of sandbagging, 41 percent contained a pro-sandbagging provision and only 5 percent included an anti-sandbagging provision. If the agreement is silent on the issue of “sandbagging,” the governing law of the agreement will determine a buyer’s right to bring a post-closing indemnification claim regarding a matter that it knew about prior to closing. Below we look at the laws of Texas, New York and Delaware.
Texas law typically requires a buyer to have “relied” on the seller’s representation to maintain an indemnification claim. If a buyer is aware of a breach pre-closing, indemnification is likely unavailable (absent a pro-sandbagging provision), because the buyer cannot demonstrate “reliance.”
New York law is like Texas law but courts typically look to the source of the information to determine the buyer’s rights. If the buyer learned of the facts underlying a breach from the seller, a buyer typically cannot seek indemnification, but if the buyer obtains knowledge from a third party (or it is “common knowledge”), then a buyer will likely prevail in bringing an indemnification claim.
Delaware law generally does not require reliance for a buyer to succeed on an indemnification claim. However, based on potentially conflicting case law, some Delaware practitioners have posited that Delaware law may require a buyer’s “reliance” on the seller’s representation to maintain an indemnification claim. While most Delaware practitioners believe that a buyer’s reliance is not required under Delaware law, some Delaware practitioners recommend including a pro-sandbagging provision if the buyer has pre-closing knowledge.
Summary. Regardless of the governing law of an agreement, a buyer should seek to include a pro-sandbagging clause to preserve its rights and eliminate disputes regarding “knowledge.” However, if the source of “knowledge” with respect to a matter is a third party, under New York law, a buyer should still be able to seek indemnification from the seller with respect to the issue if the agreement is silent.
A seller might seek an anti-sandbagging provision in the agreement to incentivize collaborative disclosure between the parties and to give the seller more comfort that it is not closing into a lawsuit. However, as noted above, only 5 percent of reported deals in a recent survey included an anti-sandbagging provision.
Absent a provision governing the ability to sandbag, the governing law of the acquisition agreement generally controls the parties’ rights, remedies and, potentially, the economics of the transaction. “Sandbagging” provisions may appear harmless but they can be used as a weapon against an unsuspecting party if not properly understood.
Ted Schweinfurth, is a partner at Baker & McKenzie LLP, and can be reached at Ted.Schweinfurth@bakermckenzie.com. Richard White, is an associate at Baker & McKenzie LLP, and can be reached at Richard.White@bakermckenzie.com.