“Sandbagging” and “Knowledge” Clauses in M&A Agreements
Significant Risk Allocation Addressed in These Often Ignored Clauses
A purchaser will usually conduct extensive due diligence on a target company prior to signing a definitive agreement to purchase that target company with the goal of both validating the value of the business to be acquired and uncovering any previously unknown risks associated with that business. The parties will then usually negotiate an M&A agreement including both (i) the amount and type of consideration payable and (ii) vendor representations, warranties, covenants and indemnities regarding the target company and its business.
If the purchaser learns, prior to closing, that the vendor has breached one of these negotiated representations, warranties or covenants but goes ahead and closes the deal anyway with the intention of making a claim for indemnification (referred to as “sandbagging”), can it still make such a claim for indemnification?
That will depend on what the M&A agreement says including the “sandbagging” clause (if one is included), the “knowledge qualification” clause (if one is included) and the “governing law” clause.
Purchaser Preference – A Pro-Sandbagging Clause
Purchasers will want to include a pro-sandbagging clause that reads similar to the following:
- “The right to indemnification, payment, reimbursement, or other remedy based upon any such representation, warrant, covenant, or obligation will not be affected by any investigation conducted or any knowledge acquired by the Purchaser, at any time, whether before or after the execution and delivery of this Agreement or the Closing Date, with respect to the accuracy or inaccuracy of, or compliance with, such representation, warranty, covenant, or obligation.”
With this clause, the purchaser gets to rely on the negotiated representations, warranties, covenants, and obligations contained within the M&A Agreement regardless of its “knowledge” prior to closing.
As such, the purchaser will not need to worry about any information (i) that the vendor has “dumped” in the due diligence data room that it did not have the opportunity to fully review, (ii) that was provided by the vendor to a junior person within the organization but not relayed to the proper senior persons with decision making authority or (iii) that may have been reviewed but not properly understood by the purchaser.
Vendor Preference – An Anti-Sandbagging Clause
Vendors will want to include an anti-sandbagging clause that reads similar to the following:
- “The Vendor shall not be liable for any losses or damages resulting from or relating to any inaccuracy in or breach of any representation, warranty, covenant or obligation in this Agreement if the Purchaser seeking indemnification for such losses or damages had knowledge of such inaccuracy or breach before Closing.”
This anti-sandbagging provision provides protection to the vendor as it requires the purchaser to:
- prove the existence of a breach; and
- refute any assertion by the vendor that the purchaser had knowledge of the breach prior to closing,
Since the existence or absence of “knowledge” is critical in anti-sandbagging provisions, and since it can be difficult to prove that someone did or did not know something, the parties will also want to include a clause setting out what constitutes knowledge.
Vendors want a broad definition of "knowledge" that includes any and all information provided by the vendor to the purchaser, whether in the due diligence materials provided or otherwise, whether provided verbally or otherwise, and whether provided to any employee or agent of the purchaser.
Purchasers want a narrow definition of "knowledge" that only includes the actual knowledge of certain senior officers involved in the deal review that is obtained from disclosure provided in writing by the vendor or its representatives to those senior officers or their authorized representatives.
There is very little Canadian judicial interpretation on “sandbagging” although the limited jurisprudence suggests that the Canadian courts will enforce pro-sandbagging clauses if contained in an M&A agreement. However, if the M&A agreement is silent on “sandbagging”, then it remains an open question as to which authorities the Canadian courts will follow.
Under New York case law, unless there is an effective pro-sandbagging clause in the M&A agreement, a purchaser's knowledge prior to closing of a breach of a representation, warranty or covenant contained in an M&A agreement will prevent that purchaser from seeking damages or indemnification post-closing IF the purchaser is aware of such breach as a result of the vendor's disclosure.
Conversely, under Delaware case law, unless there is an effective anti-sandbagging clause in the M&A agreement, a purchaser's knowledge prior to closing of a breach of a representation, warranty or covenant contained in an M&A agreement will NOT prevent that purchaser from seeking damages or indemnification post-closing.
Under UK case law, a purchaser is always prevented from seeking damages or indemnification post-closing if that purchaser had knowledge prior to closing of the breach of a representation, warranty or covenant contained in an M&A agreement.
The Key Lesson:
A purchaser should include an effective pro-sandbagging clause in an M&A agreement and narrowly define its "knowledge" in order to preserve the value of the negotiated representations, warranties, covenants and indemnities obtained from the vendor in the M&A agreement.
Invitation for Discussion:
If you would like to discuss any aspect of your next M&A deal, please do not hesitate to contact one of the lawyers in the Business Law group at Nerland Lindsey LLP.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.