In an agreement for the sale of a business, there will
be a number of representations and warranties by the seller across the spectrum
of the company’s business, including its ownership of assets, its financial
condition, its compliance with a variety of laws (among others, employment and
environmental laws), and the existence of any adverse material events. If an
issue arises post-closing that violates the representations and warranties, then
the indemnity provisions in the agreement will dictate that the seller must
compensate the buyer for any resulting loss, including payment of attorneys’
fees, settlements, judgments, etc.

A sandbagging clause refers to a provision in an
M&A agreement that addresses whether a buyer’s pre-closing knowledge about
the cause of a subsequent loss will have on the buyer’s indemnity claim. The
colloquial term “sandbagging” refers to whether or not the buyer can know about
the facts giving rise to the loss and still claim indemnity, or “sandbag” the
seller by moving ahead with knowledge of a material issue.

There are two types of sandbagging clauses, a pro-sandbagging
clause that allows the buyer to have knowledge of the facts giving rise to the
loss and still receive indemnification, or an anti-sandbagging clause, which
prohibits buyer from receiving indemnity if it knew of the facts giving rise to
the loss.

Although it may seem counter-intuitive to allow for
pro-sandbagging clauses where a buyer can recover despite closing with
knowledge of the problem, there are good reasons for such a clause to be
included. One is that prohibiting buyer from recovering would provide a
disincentive to conduct thorough due diligence, as the buyer would not want to
discover facts that could later bar indemnification. Anti-sandbagging clauses will
also give rise to disputes regarding buyer’s knowledge before closing. Perhaps
the buyer’s best argument, however, is that listing the problematic matter in
the disclosure schedule is the best way to address any post-closing issues, as the
parties can negotiate appropriate provisions ahead of time if necessary, e.g.,
buyer can either accept the disclosure and bear the risk going forward, or
require that seller provide express indemnity for the matter so listed.

A seller’s rebuttal on this issue is that a
pro-sandbagging clause would allow the buyer to discover an issue in due
diligence and not inform the seller, which could provide a disincentive to the
buyer to raise the issue ahead of time and address with the seller in the agreement.

In terms of market prevalence, pro-sandbagging clauses
are far more common in M&A agreements, generally due to the fact that buyers
hold the keys (i.e., money) to the deal and are generally not inclined to
restrict their rights on important issues like indemnification. Although recent
statistics show that it is quite common for M&A agreements not to address
sandbagging at all, that should not be taken as an indicator that the concept
is often ignored. Many state laws themselves provide an answer as to whether a
buyer can “sandbag” the seller if the agreement does not address the issue, and
buyers will generally choose a state law that is pro-sandbagging.

Although a seller will generally be faced with an
agreement that will allow for sandbagging, either by express clause or application
of state law, being armed with that knowledge will help the seller focus more
intently on its due diligence process, and negotiate appropriate provisions for
any items that do arise. And those sellers in a strong negotiating position can
look at an anti-sandbagging clause as a good “get” in negotiating the transaction.

Jeffrey Petersen

This blog is for informational purposes
only and does not constitute legal advice.