By G. Mark Edgarton and Kevin C. Quigley, Choate Hall & Stewart LLP
Sandbagging disputes are among the most contentious issues in M&A litigation. These issues matter to private equity sponsors, particularly in the growing middle market, as they pursue attractively priced deals in an increasingly competitive environment.
Sandbagging in M&A refers to a situation where the buyer knows (or should know) that the seller’s representation in a purchase agreement is false, but closes the transaction anyway and then seeks to hold the seller liable for breach of that representation.
While one might expect that the winners in these legal contests are those that can prove they acted in good faith, a recent Delaware Supreme Court decision serves as a reminder that a favorable jurisdiction may matter most in a dispute over a negotiated purchase agreement.
By understanding the different legal standards, PE firms can better protect themselves in M&A negotiations and post-closing indemnification disputes.
Sandbagging provisions, or the lack thereof
In some M&A transactions, a buyer may negotiate for a so-called pro-sandbagging provision, which expressly allows a buyer with pre-closing knowledge of the breach to bring a post-closing indemnity claim against the seller.
Conversely, a seller may negotiate for an anti-sandbagging provision, which expressly precludes a buyer from obtaining post-closing indemnification based on facts the buyer knew before the closing.
In many deals, however, the purchase agreement is silent on the issue of sandbagging.
In 2016-2017, for example, a Deal Points Study by the American Bar Association found that 51 percent of surveyed acquisition agreements were silent on sandbagging, while 42 percent contained pro-sandbagging clauses and 6 percent contained anti-sandbagging clauses.
Thus, indemnification disputes often turn on the default rules of the applicable jurisdiction. The differences in the sandbagging law of two common transactional jurisdictions — Delaware and New York — illustrate the potential consequences of agreements that are silent on sandbagging.
For at least the past decade, Delaware has been widely understood by both corporate practitioners and litigators to be a pro-sandbagging state.
Absent an express anti-sandbagging provision, Delaware law holds sellers to the terms of their representations, and buyers may prevail on a claim for breach regardless of their pre-closing knowledge of the breach.
As one Delaware Chancery Court decision explained: “A breach of contract claim is not dependent on a showing of justifiable reliance. … Having contractually promised [the buyer] that it could rely on certain representations, [the seller] is in no position to contend that [the buyer] was unreasonable in relying on [the seller’s] own binding words.” Cobalt Operating, LLC v. James Crystal Enterprises, LLC, 2007 Del. Ch. LEXIS 108, *89-90 (Del. Ch. July 20, 2007).
New York, like Delaware, holds sellers accountable for their representations — but with an important caveat. Unlike Delaware, some New York courts will evaluate the source of a buyer’s pre-closing knowledge of the asserted breach.
If the buyer’s knowledge is based on facts affirmatively disclosed by the seller, as opposed to facts uncovered through the buyer’s own due diligence, then the buyer may not be able to recover for breach absent an express pro-sandbagging provision. See, e.g., Galli v. Metz, 973 F.2d 145 (2nd Cir. 1992).
Eagle Force Holdings
While the Delaware trial courts have addressed sandbagging, the Delaware Supreme Court had not weighed in on the issue until recently.
In Eagle Force Holdings, LLC v. Campbell (May 24, 2018), the court observed in a footnote that “a majority of states have followed the New York Court of Appeals’ decision in CBS Inc. v. Ziff Davis, which holds that traditional reliance is not required to recover for breach of an express warranty.”
The Delaware Supreme Court further suggested that if presented with the issue, it, too, would follow CBS. (2018 Del. LEXIS 233, at FN 185). The top Delaware court did not cite the extensive pro-sandbagging Chancery Court case law in Delaware, and it did not mention the New York cases after CBS that narrowed New York’s pro-sandbagging stance by taking into account the source of the buyer’s knowledge.
Some commentators have suggested that the Eagle Force footnote casts doubt on Delaware’s pro-sandbagging reputation.
While a full analysis is beyond the scope of this article, given the robust body of Chancery Court case law and the jurisdiction’s longstanding embrace of freedom of contract between sophisticated corporate parties, Delaware courts appear likely to continue to affirm a strict pro-sandbagging approach.
Lessons for buyers and sellers
Regardless of how one interprets Eagle Force, the case underscores the importance of choosing a favorable jurisdiction when negotiating a purchase agreement.
The selection of Delaware or New York law (or California law, for instance, which is anti-sandbagging) can have important implications for post-closing indemnification disputes.
Whether attempting to negotiate a pro- or anti-sandbagging provision, or choosing silence on the issue, buyers and sellers should weigh their jurisdiction’s default rules in evaluating and allocating risk.
Mark Edgarton is a partner at Choate Hall & Stewart LLP, specializing in intellectual property and complex commercial legal matters. Kevin C. Quigley is an associate and member of the firm’s litigation department, focusing on intellectual property and commercial litigation. Reach Mark at +1 617-248-5101 or email@example.com.