Agreement For The Sale Of A Business

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.

What Is A Sandbagging Clause?

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.

M&A Agreements & Pro-Sandbagging Clauses

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.

Representations and Warranties

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 anissue 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.

Because a breach of the seller’s representations and warranties can result in a costly indemnification obligation, the seller will be keenly interested in limiting its exposure to the extent possible. One way to do this is with a knowledge qualifier for certain representations and warranties, i.e., language which limits the extent of the representation and warranty on a specific matter to the actual or constructive knowledge of the seller.

Actual vs Constructive Knowledge

As an initial matter, the distinction between actual and constructive knowledge standards is an important one in this context. Actual knowledge of course means that the seller must actually know about the circumstances giving rise to the breach of the representation and warranty in order to be held liable for that breach. Constructive knowledge, on the other hand, will dictate that a breach will occur if seller either knew or should have reasonably known about the facts giving rise to a breach. Obviously, a seller much prefers an actual knowledge standard, as it precludes delving into the factual circumstances to determine whether a reasonable party should have known about the underlying facts of a breach.

To examine the effect of knowledge qualifiers in the M&A context, we’ll use the example a representation and warranty pertaining to existing lawsuits against a company, as well as any present basis for a legal claim to be brought in the future. This very common representation and warranty is generally bifurcated by a knowledge qualifier as follows: (1) the first clause relating to existing lawsuits is unqualified with regard to sellers knowledge; and (2) the second clause, pertaining to any current facts giving rise to a basis for a potential claim, is qualified or limited by the actual or constructive knowledge of the seller.

Breaking Down the Knowledge Qualifiers

Let’s begin by analyzing the first clause and the lack of any knowledge qualifier. If there is an existing lawsuit against the seller as of the time of closing, whether seller knows it or not, the seller will have breached the representation and warranty on absence of lawsuits unless that lawsuit is listed on a disclosure schedule to the agreement. The allocation of risk in this regard makes logical sense, because the suit has been filed before closing based on conduct of seller, and should be seller’s responsibility. In addition, with regard to the issue of knowledge, a lawsuit is a public record and generally needs to be served promptly after filing, so in most circumstances, seller is going to be aware of such litigation. And, if due to a quirk of timing, the seller is not so aware, a buyer is not willing to take on that liability by using a knowledge qualifier.

As for the second clause, however, the existence of any basis for a future claim, generally speaking this clause will be subject to an actual or constructive knowledge qualifier. The allocation of risk here is that if the seller did not actually know (under an actual knowledge standard) or reasonably know (under a constructive knowledge standard) of the basis for a subsequent claim, the seller will not have breached the representation and warranty, and will not owe an indemnity obligation. The reasoning behind the general use of the qualifier here is that a seller cannot be held to know everything about the company, and that some dividing line should be drawn with respect to unasserted claims.

The trend in M&A is for a constructive knowledge standard to be used as the knowledge qualifier. The buyer’s argument in this regard is straightforward: they are unwilling to make the substantial investment in purchasing a company or its assets while allowing a seller to avoid liability based on lack of actual knowledge of its errors or misconduct. Indeed, buyer
will argue, such a standard rewards neglect, in that an unknowing seller will escape liability while a more diligent company would have been aware of the
issue.

Defining Constructive Knowledge

There are a variety of ways to define constructive knowledge in an agreement. One common way is to define knowledge by connecting it to what specific individuals in the company, often the selling principals and officers or directors, knew or should have known in the exercise of reasonable diligence. A seller will want to pay careful attention to this definition to ensure that the constructive knowledge standard does not become overly broad so as to open the door too wide to potential liability. Seller and its attorney should also carefully review the agreement to confirm that knowledge qualifiers are being used appropriately throughout the representations and warranties to limit their scope.

A seller’s indemnity obligation is generally the chief source of liability after closing, so careful review of knowledge qualifiers during the drafting process is a key way for seller to effectively manage this potential exposure.