Legal Matters: What you should know about ‘sandbagging’ in M&A transactions

The term “sandbagging” is commonly used in merger and acquisition (M&A) transactions. The term refers to a practice often employed by buyers to claim a breach of a seller representation or warranty (rep or warranty) in the transaction agreement and seek indemnification from the seller, in spite of the buyer having known about the breach or the fact that a particular rep or warranty was not true. Sandbagging claims can arise irrespective of the transaction structure — whether a stock purchase, an asset purchase or a merger.

Indemnification provisions are among the most heavily negotiated provisions in M&A agreements. Sellers will seek to limit the scope, duration and amount of damages subject to indemnification claims, while buyers attempt to expand their indemnification rights as much as possible. Buyers often argue for a sandbagging provision in the transaction agreement, whereas sellers will want to include an antisandbagging provision.

Sandbagging Provisions

A sandbagging provision (sometimes referred to as a prosandbagging provision) provides that the buyer will be entitled to postclosing indemnification for any breaches of the seller’s reps and warranties, whether or not the buyer knew of the breach or the fact that a particular rep or warranty was false.

A sandbagging provision may read as follows:

“The rights of buyer to indemnification under this agreement shall not be impacted or limited by any knowledge that buyer acquired, or could have acquired, whether before or after the closing or the closing date, nor by any investigation or due diligence inquiry conducted by buyer. Seller hereby acknowledges that, regardless of any investigation or due diligence inquiry conducted by or on behalf of buyer, and regardless of the results of any such investigation or inquiry, buyer has entered into this agreement and the transaction in express reliance upon the representations and warranties of seller made in this agreement.”

Simply stated, a sandbagging provision provides that a buyer’s remedies against the seller are not impacted regardless of whether the buyer had knowledge, at or prior to closing, of the facts or circumstances giving rise to an indemnification claim.

Antisandbagging Provisions

Sellers, on the other hand, will sometimes request an antisandbagging provision, which is a proseller provision that prevents the buyer from being indemnified for the breach of any rep or warranty that the buyer had knowledge of at or prior to the closing.  An antisandbagging provision may read as follows:

“Buyer acknowledges and agrees that it has had an opportunity to conduct a thorough due diligence investigation on the [company] [seller], and in no event shall seller have any liability to buyer with respect to the breach of any representation or warranty in this agreement to the extent buyer knew of such breach as of the closing or closing date.”

An antisandbagging provision, as the name suggests, prohibits the buyer from sandbagging or seeking postclosing indemnification against the seller for any breaches of its reps or warrant of which the buyer had knowledge at or prior to the closing.  An antisandbagging provision is a sellerfavorable provision and should be resisted by buyers and their counsel.  

Trends in Usage

The American Bar Association (ABA) publishes a Private Target Mergers and Acquisitions Deal Point Study every other year that analyzes various terms in middle-market M&A transactions. In the ABA’s 2017 study (the most recent available), the ABA found the following in the M&A agreements it reviewed:

• 42 percent contained a sandbagging provision,

• 6 percent contained an antisandbagging provision, and

• 51 percent were silent on the issue.

Consequences of Remaining Silent

In many transactions, the parties are not able to agree on the sandbagging issue and the agreement will simply be left silent on the issue, in which case the choice of law governing the agreement becomes critical. The parties should carefully consider the legal consequences of remaining silent and evaluate how the sandbagging issue will be addressed under the law governing the transaction agreement.

While, as noted above, the ABA’s 2017 study found that 51 percent of the M&A agreements it reviewed were silent on the sandbagging issue, other studies have found that up to 75 percent of the M&A agreements that were reviewed were silent.

Two General Rules

The rules applied by courts to M&A agreements that are silent on the sandbagging issue vary among the states.  Accordingly, it’s critical to carefully select the law that will govern the agreement and understand how courts will treat an agreement that is silent on the sandbagging issue. Courts have developed two different rules: the so-called “Modern Rule” and the “Traditional Rule.”

The Modern Rule  

The Modern Rule permits a buyer to bring an indemnification claim for a false rep or warranty, regardless of the buyer’s know-ledge of the inaccuracy prior to closing. These courts hold that the reps and warranties are negotiated contractual obligations upon which the buyer had the right to rely. Among the states following the Modern Rule are Delaware and (with one limited exception) New York. The Modern Rule is a buyer-favorable rule because it does not require the buyer to show reliance on the false rep or warranty in order to obtain indemnification.

The Traditional Rule 

Under the Traditional Rule, a buyer must prove reliance on the rep or warranty as an element of its indemnification claim. California is the leading state that follows the Traditional Rule. This rule is seller-favorable because the buyer will be required to prove reliance on the seller’s false rep or warranty in order to obtain indemnification.

There is no Utah case that addresses the sandbagging issue or the consequences of the transaction agreement being silent on the issue. However, based on a 1976 10th Circuit Court of Appeals case (the circuit in which Utah sits), it appears that the 10th Circuit adopted the Traditional Rule, or the seller-favorable position of requiring the buyer to prove reliance on the seller’s false rep or warranty in order to obtain indemnification.

Thomas R. Taylor is a corporate and M&A lawyer and shareholder in the Salt Lake City office of the law firm of Durham, Jones & Pinegar, PC. He is a member of the firm’s Business and Finance section.