What is “sandbagging”?
The concept of sandbagging is simple: one party has a strength, an advantage, or is in a position of power, which is concealed or downplayed in order to take advantage of the other party later. In the context of M&A deals, this is when the buyer learns the seller has breached a term in the agreement prior to closing, but does not raise the issue until after closing when it seeks indemnification from the seller for the breach.
In the course of negotiating M&A deals, it is in the buyer’s best interest to include a pro-sandbagging provision in the purchase and sale agreement. Such a clause allows the buyer to seek indemnification from the seller for any losses suffered by the buyer due to a breach by the seller of a representation, warranty or covenant – even if the buyer had knowledge of the breach prior to closing. Buyers argue that pro-sandbagging provisions encourage thorough disclosure and protect them from unexpected issues that arise between the signing and the closing.
Sellers, in contrast, prefer anti-sandbagging provisions. These provisions explicitly prohibit a buyer from commencing a post-closing claim for indemnification where the buyer had knowledge of a breach by the seller prior to closing, yet proceeded to close the transaction without addressing the issue. Sellers argue that anti-sandbagging provisions encourage all due diligence issues to be resolved prior to closing.
The buyer’s knowledge
The standard of the buyer’s knowledge is a key element in anti-sandbagging provisions. The standard may be actual knowledge (the buyer had a clear understanding of the breach), or constructive knowledge (the buyer, being diligent, ought to have known about the breach). When a buyer agrees to include an anti-sandbagging provision in the purchase and sale agreement, the buyer can mitigate its risk by narrowing the scope of knowledge to its actual knowledge, so that it may still seek indemnification in situations where it may have had constructive (but not actual) knowledge of the breach.
Conclusion
As the above implies, balancing the interests of both buyer and seller in a sandbagging provision is difficult. That being said, when an anti-sandbagging clause is included in a purchase and sale agreement, the buyer can level the playing field somewhat by qualifying its knowledge of the seller’s breach to “actual knowledge” (as opposed to constructive and actual knowledge). When parties are not able to reach an agreement on sandbagging, the only alternative is to remain silent. Next week we will discuss the implications of staying silent on sandbagging in M&A transactions.
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