Congratulations! You just closed an M&A acquisition on behalf of your private equity fund. You spent weeks negotiating the representations and warranties and indemnification provisions with care. You know that they will come into play soon as the seller disclosed to you at the closing table that a significant litigation arose with respect to the target business prior to closing. You decided that it would be best to close the transaction and then determine the amount of the buyer’s indemnification claim post-closing for the seller’s breach of the representation regarding litigation as the seller did not update the disclosure schedules to reflect the new litigation. Unfortunately, you fell into a trap for the unwary, and you may be precluded from recovering any indemnification for that breach. Under New York law, in certain circumstances, a buyer will be precluded from recovering for a breach of representation or warranty if the buyer knew of facts giving rise to the breach prior to closing unless the buyer’s recourse is expressly preserved in the acquisition agreement.
This article explores how, in an M&A deal, buyers should address their pre-closing knowledge of inaccurate seller representations and the effect that such knowledge may have on their ability to later bring a successful indemnification claim with respect to that breach.
What is Sandbagging?
In a typical M&A transaction, a buyer will conduct a substantial amount of due diligence on its target from preliminary negotiations through closing. As a supplement to the buyer’s diligence, a seller will make representations and warranties concerning the target business and, in connection therewith, will set forth on a disclosure schedule certain exceptions to those representations and warranties. The seller’s representations and warranties are commonly viewed as both a promise that something is true and an express allocation of risk. Accordingly, the question arises as to what happens when a buyer becomes aware, after signing but prior to closing, that a specific representation or warranty of the seller has been breached. The conditions to closing may be satisfied notwithstanding the breach depending on the severity of the breach and the standard used in the condition.
In such a case, the buyer may determine that in order to obtain the benefit of the bargain it contemplated when signing, the best course of action would be to close on the transaction despite its knowledge of such breach, and to thereafter hold the seller liable for its breach of representation and warranty post-closing. This concept, known as “sandbagging,” refers to the right of a buyer to bring an indemnity claim based on known seller breaches prior to closing.
Contractual Approaches to Sandbagging
Generally speaking, there are three drafting techniques to address sandbagging in an acquisition agreement: the seller-friendly “anti-sandbagging” provision; the buyer-friendly pro-sandbagging” provision; and lastly, silence on the issue. As this article will explain further below, silence should not be misconstrued as a middle-ground, but rather risks being interpreted as beneficial towards the seller by New York courts.
Anti-Sandbagging. The seller-friendly anti-sandbagging provision expressly limits the buyer’s remedies for an inaccuracy of a seller’s representation or warranty or breach by the seller by prohibiting indemnification in respect of any matter as to which the buyer had knowledge prior to closing. An anti-sandbagging provision may appear in an acquisition agreement as follows: “No claim for indemnity for a breach of a particular representation, warranty or covenant shall be made after the Closing if the Buyer had Knowledge (including by virtue of any Disclosure Schedule) of such breach as of the Closing.”
Inclusion of an anti-sandbagging clause will result in an inquiry as to what the buyer knew about the subject matter of the breach and when, practically guaranteeing a lengthy discovery process in any dispute. While buyers should resist anti-sandbagging clauses altogether, if a buyer is forced to accept one, the buyer would be well-advised to limit the knowledge standard to “actual” knowledge (as opposed to constructive, implied or imputed knowledge) and ensure that the burden of proving knowledge of such breach falls on the seller.1
Pro-Sandbagging. In contrast, the buyer-friendly pro-sandbagging provision is aimed to reinforce the buyer’s bargained-for recourse against a seller’s breach of representation, warranty or covenant notwithstanding any knowledge or awareness the buyer may have obtained. The ABA Model Asset Purchase Agreement contains the following pro-sandbagging provision: “The right to indemnification, reimbursement or other remedy based upon such representations, warranties, covenants and obligations shall not be affected by any investigation (including any environmental investigation or assessment) conducted with respect to, or any Knowledge acquired (or capable of being 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 any such representation, warranty, covenant or obligation.”
American Bar Association and Kramer Levin Deal Point Studies
The ABA’s 2004 Public Acquirer-Private Target Survey showed that 56% of participating transactions contained a pro-sandbagging clause and only 5% included anti-sandbagging provisions. The remaining 39% were silent on the issue. According to Kramer Levin’s 2008 Deal Points Study on Middle-Market Private Targets,2 21% of the acquisition agreements analyzed contained prosandbagging provisions, compared to 14% of the agreements with anti-sandbagging clauses. A majority of agreements (65%), however, remained silent on the issue. The increase in anti-sandbagging provisions over the past several years reflects sellers’ enhanced market power during the build-up of the last business cycle. Furthermore, the greater frequency in keeping silent on the issue also comes largely at the buyers’ expense as further described below.
New York Case Law
New York courts first addressed sandbagging in CBS Inc. v. Ziff-Davis Publishing Co.3 Here, a buyer became aware, prior to closing, of the seller’s breach of a warranty. The buyer alerted the seller of such facts (the seller denied the existence of a breach) and, ultimately, the parties closed the transaction with the buyer asserting that closing would not constitute a waiver of its right to seek recovery for the breach. The buyer subsequently sued the seller, and the court held that knowing that the warranty was breached did not preclude the buyer from seeking indemnification. However, in four cases decided by federal courts applying New York law since Zjff-Davis, the courts consistently have held that in situations where the seller discloses an inaccuracy before closing, the buyer is not entitled to indemnification for misrepresentations that it knew of before closing.4
Most recently, in Gusmao v. GMT Group, Inc.,5 which was decided in August 2008, the federal court in the Southern District of New York restated the general rule, derived from Galli and its progeny: “‘that a buyer may enforce an express warranty even if it had reason to know that the warranted facts were untrue.’” However, “[t]he ‘critical question is not whether the buyer believed in the truth of the warranted information..., but whether it believed it was purchasing the seller’s promise as to its truth.’”6 Accordingly, “where a buyer ‘closes ... [with] the full knowledge and acceptance of facts disclosed by the seller which would constitute a breach of warranty ..., the buyer should be foreclosed from later asserting the breach ... unless the buyer expressly preserves his rights under the warranties.’”7 But “where the ‘seller is not the source of the buyer’s knowledge, e.g., if it is merely ‘common knowledge’ that the facts warranted are false, or the buyer has been informed of the falsity of the facts by some third party, the buyer may prevail in his claim for breach of warranty.’”8
While each sandbagging case is ultimately fact-specific, a general theme has emerged where a seller will not be liable for breach if a buyer closes with full knowledge of facts disclosed by the seller that affect the accuracy of a seller representation or warranty (even if not a part of the disclosure schedules) unless the buyer has expressly preserved its rights in the acquisition agreement. Gusmao serves as a reminder of the uncertainty that accompanies a buyer’s closing of an M&A transaction with the expectation of seeking indemnification from the seller for breaches of representations or warranties that the buyer knew of prior to closing. In addition to the practical difficulties of proving knowledge, courts must also face questions such as the source and timing of a buyer’s knowledge and the extent of a seller’s disclosures, essentially guaranteeing a lengthy and costly discovery process. However, these burdens can be avoided if the buyer expressly reserves its sandbagging rights by including a pro-sandbagging provision such as the one included earlier in this article.
The tremendous prosperity generated during the last business cycle naturally favored sellers. In today’s economic climate, however, buyers are well-positioned to insist on pro-sandbagging provisions. In light of New York case law on the subject, buyers would be well-advised to exert their enhanced bargaining power to obtain a pro-sandbagging provision in their acquisition agreements.