Recent Case Law Clarifies Delaware's Position As A Pro-Sandbagging State
The term “sandbagging” generally carries a negative connotation, as it can be used to refer to the concealment or misrepresentation of one's true position or intent in order to gain an advantage over another. However, in the context of an M&A transaction, whether sandbagging carries a negative or positive connotation depends on who you ask. In this context, “sandbagging” occurs when (1) a buyer becomes aware that a representation or warranty made by the seller is false, (2) the buyer continues with the transaction despite discovering such breach, and (3) after consummating the transaction, the buyer seeks damages against the seller for such breach. So, although a seller might view this as inherently unfair, a buyer would simply consider this practice as getting the benefit of the bargain by enforcing the terms of the negotiated contract.
Although the parties to the transaction can address the concept of sandbagging contractually, by expressly allowing or prohibiting the practice in the purchase agreement, the growing trend in private M&A deals is to remain silent on the subject. Am. Bar Ass’n Mergers & Acquisitions Comm., Private Target Mergers & Acquisitions Deal Points Study, 79 (2021) (reporting that the percentage of purchase agreements remaining silent on the topic has increased from 41% in 2006 to 68% in 2021). When a contract is silent with regard to sandbagging, the default state rules governing such contract apply. Because Delaware corporate law is generally regarded as robust and well-developed, it is often used as the governing law in M&A transactions, which begs the question: What is Delaware’s position on the practice of sandbagging?
A recent Delaware case confirms the Chancery Court’s pro-sandbagging position. In Arwood v. AW Site Services, No. 2019-0904-JRS, WL 705841 (Del. Ch. 2022), the buyer, an experienced private equity firm, offered to purchase a waste management brokerage business from the seller, an unsophisticated businessman who lacked the ability to prepare the business’s financial statements. As part of the due diligence process, the buyer was granted unfettered access to the business’s raw financial data to enable the buyer to prepare its own financial statements and valuation of the company. However, after consummating the transaction, the buyer realized that the seller was engaging in deceptive billing practices that overstated its financial performance. As a result, the buyer argued, among other things, that the seller breached its representations regarding the financial condition and lawful operations of the business. In response, the seller attempted to raise sandbagging as a defense by suggesting that the buyer knew the seller’s representations were false and should be barred from seeking indemnification for such claims.
In light of the facts of the case and the related precedent in the state, the Court stated that, “Delaware is, or should be, a pro-sandbagging jurisdiction. The sandbagging defense is inconsistent with our profoundly contractarian predisposition.” Id. at 3. Although the purchase agreement in the case specifically provided that a party may be entitled to indemnification even if it knew a representation was false, the Court states that Delaware’s default common law would lead to the same result. The Court references Delaware’s contractarian regime and discusses how representations and warranties serve an important risk allocation function in order to justify the enforcement of the express representations and warranties negotiated and agreed to by the parties in the purchase agreement. Put another way, the Court stated that:
When parties choose not to (or fail to) allocate the risk of sandbagging in their contract, the buyer may rest on its reasonable belief that it has acquired as part of the transaction the seller's implicit promise to be truthful in its representations...“Stated otherwise, the fact that the buyer has questioned the seller's ability to perform as promised should not relieve the seller of his obligations under the express warranties when he thereafter undertakes to render the promised performance.” Id. at 31 (citations omitted).
Overall, the Court concluded the seller could not use sandbagging as a defense to its indemnification obligations for breaching the representations made in the purchase agreement. Further, the Court stated that “[e]ven if Delaware were an anti-sandbagging jurisdiction, I am not satisfied that a buyer’s reckless, as opposed to knowing, state of mind would trigger the doctrine in any event.” Id. At 3. According to this case, an argument that a buyer should have known or was reckless in not discovering a false representation would not be sufficient to raise sandbagging as a defense, even if it were permitted. It is important to recognize that the buyer in this case had extraordinary access to the seller’s financial information, yet even such an in-depth look into seller’s business practices was insufficient to demonstrate that the buyer had actual knowledge of the false representations.
Although commentators disagree on whether sandbagging should be permitted, buyers in Delaware can rest assured that sellers will be held to the representations made in the purchase agreement, regardless of how thorough an approach a buyer takes in the due diligence process.
If you’re considering an M&A transaction, reach out to our team today for assistance conducting due diligence and negotiating a purchase agreement to adequately protect your interests.
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