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Avoid Getting Blindsided by a Sandbagging Buyer

Lerch Early's Legal Update 2018, Vol. 1

Imagine you just closed on the sale of your business. Finally finished with the long and arduous sale process, you are about to breathe a sigh of relief when you receive notice that the buyer has brought an indemnification claim for breach of one of your warranties in the acquisition agreement. You are surprised to learn that while the buyer became aware of a material inaccuracy with respect to the warranty during its due diligence process, it decided to close on the deal anyway and then bring a post-closing claim for breach of warranty – a practice referred to as “sandbagging.” It may seem unscrupulous, but depending on the terms and governing law of the acquisition agreement, the buyer may be well within its rights to sandbag you, the seller.

Addressing the Sandbagging Issue

Parties generally have three options to address sandbagging in their acquisition agreement: (1) include a pro-sandbagging provision expressly allowing the parties to recover for breach of a representation or warranty notwithstanding the party’s knowledge that the representation was inaccurate prior to closing, (2) include an anti-sandbagging provision expressly prohibiting such claims, or (3) remain silent.

Where the acquisition agreement is silent on the subject, the parties are at the mercy of the default rules in the jurisdiction governing the agreement—with some states being pro-sandbagging and others being anti-sandbagging. Recent years have seen a trend towards pro-sandbagging default rules (e.g., Delaware, Connecticut, and Pennsylvania, among other jurisdictions). Notably, Maryland (along with California, Texas, and few other jurisdictions) is an anti-sandbagging default jurisdiction, meaning, a party to an acquisition agreement governed by Maryland law that does not include a pro-sandbagging provision generally cannot bring a post-closing indemnification claim for breach of warranty predicated on a falsity the party was aware of pre-closing.

The Silence Option: Strategy, Oversight, or Failure to Negotiate a Compromise?

A Practical Law Company survey of private acquisition agreements with postclosing indemnification entered into in 2016 found a similar percentage of silence with respect to sandbagging in agreements governed by pro-sandbagging Delaware law as in agreements governed by the laws of anti-sandbagging jurisdictions (43% and 39% of agreements surveyed in each category, respectively). While opting for silence may be strategic for certain parties (e.g., a buyer in a pro-sandbagging jurisdiction), the consistent percentage of silence across pro- and anti-sandbagging jurisdictions suggested to those performing the survey that many parties are not tailoring their approach to the acquisition agreement’s governing law.

Given that more often than not, parties select the agreement’s governing law based on considerations unrelated to sandbagging (e.g., choosing Delaware for its well developed and predictable business law framework), one would expect to see a higher percentage of parties contracting around sandbagging default rules. The relatively high percentage of silence across jurisdictions may be a byproduct of the difficulty of negotiating sandbagging provisions – compromise or hybrid approaches can prove difficult to develop and sellers seeking anti-sandbagging provisions can find themselves accused by the buyer of not standing behind their representations.

An experienced transactional attorney can help navigate this negotiation process, advise on the risks of staying silent given the agreement’s governing law, and could ultimately save his or her client the hassle and expense of defending a sandbagging claim.

Emily Hagan is a corporate attorney who helps businesses with corporate governance and transactions. Prior to joining Lerch Early, she was an associate in the Corporate Counseling Group of a firm based in Wilmington, Delaware, where she worked with publicly traded and privately held Delaware corporations, as well as their boards or special committees of the board in cases of potential transactions, conflicts of interest, or fiduciary duty issues. For more information on sandbagging, please contact Emily at 301-347-1267 or ebhagan@lerchearly.com.

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This content is for your information only and is not intended to constitute legal advice. Please consult your attorney before acting on any information contained here.

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