When I was a summer associate at Greenberg Traurig in Chicago, I took part in the firm’s annual corporate mock deal for its summer associates. Our summer class split into two teams that were involved in a fictional transaction involving the sale of a diamond business and its property, with one team representing the buyer and one team representing the seller. We were guided by shareholders and associates who served as our mentors, and at the end of the summer we had to present the various positions that we had taken in the transaction documents to a group of seasoned GT attorneys. During our presentation, my co-counsel and I answered many of the questions that the attorneys peppered us with, including a number of the toughest ones that came from David Schoenberg, a highly-regarded and longtime M&A practitioner who unfortunately passed away last year. The zinger came when David asked us whether we had inserted a sandbagging provision in the purchase agreement. After a long pause, I mustered enough strength to respond that we actually were quite sure that there were no environmental liabilities with the property that the store sits on and it was nowhere near the beach, and thus no sandbagging to protect the building from floods or rain were necessary. Let’s just say that even David was amused by that answer!
Now what exactly is “sandbagging” and how does it appear in transaction documents? The term sandbagging refers to a situation in which the buyer knows that a certain representation and warranty made by the seller in a purchase agreement might in fact be untrue, yet the buyer still closes the transaction despite having knowledge of such breach. Post-closing, the buyer then seeks to hold the seller liable for such breach (i.e., the buyer, knowing that the building had a leak, still proceeded to close on the leaky purchase, but following the closing then demands to be indemnified by the seller for the leak).
A sandbagging or “pro-sandbagging” clause will protect the buyer in such a scenario, and a typical clause reads as follows: “The right to payment, reimbursement, or other remedy based upon any such representation, warrant, covenant, or obligation will not be affected by any knowledge acquired by the Buyer, 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.” According to Charles Whitehead in his article “Sandbagging: Default Rules and Acquisition Agreements,” the term of sandbagging itself appears to have originated from the use of a bag of sand as a weapon, often in a surprise attack. Thus by inserting a sandbagging provision, the Buyer has fortified his position. The sandbagging clause commonly appears in purchase agreements of all kinds, including stock purchase agreements, asset purchase agreements, merger agreements and real estate acquisition agreements.
However, as with Newton’s laws, for every pro-clause, there always comes an equal but opposite anti-clause, and sandbagging is no different. Indeed many sellers try to include an anti-sandbagging clause which prohibits the buyer from seeking indemnification in respect of any matter as to which the buyer has knowledge of prior to the closing. Interestingly, according to the ABA’s Deal Points Study that reviewed 117 acquisition agreements of private targets that were acquired by public companies in 2014, while 35 percent of deals had a pro-sandbagging clause, only 9 percent of deals had an anti-sandbag clause.
So what about the remaining 56 percent? They took the silent approach by leaving out a pro or anti clause. The question is what occurs in the absence of a clause?
For the most part, the default position when the agreement is silent regarding sandbagging is that the buyer must have justifiably relied on the accuracy of a representation and warranty in order to recover any claims. Thus, this would mean that a buyer should not be able to bring post-closing claims for a breach of a representation and warranty that the buyer was aware of, because in such circumstance the buyer will not be able to demonstrate reliance on the breached representation.
However, the law is not completely settled on this matter and there are differences among various jurisdictions. Notably, Delaware and New York are generally seen as pro-sandbagging jurisdictions, while California generally is seen as an anti-sandbagging state. It is important to realize that there are still differences between Delaware and New York courts. In Delaware, when the contract is silent as to express provisions permitting sandbagging, buyer’s pre-closing knowledge of a breach will generally not preclude it from claiming a breach post-closing. In New York, however, the case law is less clear and generally a buyer can bring a claim for a breach if it’s pre-closing knowledge comes from a source other than the seller (i.e., a third party or public information), but not if the information comes from the seller itself.
As shown by the sandbagging example, the drafting and review of U.S. commercial agreements is highly dependent on market practices and the specific jurisdiction governing the agreement. With offices across the United States, and specifically in Delaware, New York, and California–all states with highly sophisticated and oft-invoked commercial laws–Greenberg Traurig is uniquely situated to offer high value legal services to our Israeli clients.