Source: https://www.stikeman.com/en-ca/kh/canadian-ma-law/sandbagging-clauses-in-acquisition-agreements-a-little-knowledge-can-be-a-dangerous-thing
Timestamp: 2019-04-25 20:09:06+00:00

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In an M&A transaction, the purchaser will usually conduct due diligence on the target, gaining insight into its operations and uncovering any risks. Such risks are then typically dealt with by means of negotiated vendor representations, warranties, covenants and indemnities. But what happens if the purchaser learns, prior to closing, that the vendor has breached one of these negotiated representations but goes ahead and closes the deal anyway, without saying anything? In such a case, what rights do the purchaser and vendor have? Specifically, is the purchaser offside if it fails to inform the vendor of the perceived misrepresentation prior to closing and then, once the deal is closed, turns around and demands indemnification?
The answer to this question can frequently be found within the four corners of the contract, if the parties turned their mind to the possibility of such an event and negotiated a suitable “sandbagging” clause. Otherwise, it generally falls to the common law of the governing jurisdiction, or to the Civil Code in the case of Quebec.
Remain silent on the issue.
The approach taken will be transaction specific and is generally determined by the (i) complexity of the transaction and the related diligence materials, and (ii) relative strength of each party.
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 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.
In addition to clarifying how an indemnity claim will be addressed, the presence of a pro-sandbagging provision also removes the need for a purchaser to refute any assertion by the vendor that the purchaser had prior knowledge of facts pertaining to the actual breach (as discussed below).
No party shall be liable . for any Losses resulting from or relating to any inaccuracy in or breach of any representation or warranty in this Agreement if the party seeking indemnification for such Losses had knowledge of such Breach before Closing.
In the event of a indemnification claim, the inclusion of an anti-sandbagging provision will require the purchaser to (i) prove the existence of a breach; and (ii) refute any assertion by the vendor that it (the purchaser) had knowledge of the breach prior to closing, before the merits of an indemnity claim can be considered. Because it can be difficult to prove that someone did or did not know something, the definition of “Knowledge” typically becomes a key point in negotiations around an anti-sandbagging clause. Purchasers and vendors should seek to define “Knowledge” in a way that makes clear how any claim regarding knowledge is to be proven, i.e. by identifying a source, scope and standard of proof.
A well drafted anti-sandbagging provision should therefore be clear about what constitutes pre-closing knowledge of the purchaser. Vendors will wish to keep the definition of “Knowledge” broad and purchasers will wish to keep the definition narrow. A standard approach taken by vendors seeking to broaden the definition of “Knowledge” is to include constructive, implied or imputed knowledge of the purchaser (i.e. the inclusion of an “after due inquiry” concept as opposed to simple actual knowledge). Vendors will also seek to broaden the definition of “Knowledge” by broadening the type of disclosure that is sufficient to imply knowledge (e.g., any disclosure vs. written disclosure). Purchasers, on the other hand, will seek to narrow the applicable definition of “Knowledge” to include only actual knowledge on the part of a narrowly-defined group of individuals derived from written documents disclosed in the applicable data room.
Remaining silent in the agreement about sandbagging leaves the issue to be determined by the governing law of the agreement – generally speaking, by the courts. This approach is sometimes taken by parties that cannot agree how to address sandbagging and want to move on with transaction negotiations. While such a stance may seem reasonable, it is not without risk, depending on the treatment of sandbagging by the governing law of the applicable agreement. As described below, parties that choose to remain silent on the issue of sandbagging would be well-advised to consider the law governing their agreement as well as the default common law (that is, case law) position with respect to sandbagging, which varies across jurisdictions (especially foreign jurisdictions). In Quebec, parties should also call their attention to the applicable provisions of the Civil Code.
Whether courts will enforce a pro-sandbagging or anti-sandbagging provision, and whether either is worth bargaining for from the respective perspectives of purchasers and vendors (rather than remaining silent on the issue), primarily depends on the construction of the provision and the governing jurisdiction in question.
Canadian, U.S. and English courts tend to uphold pro-sandbagging or anti-sandbagging provisions so long as they meet the requirements of the governing jurisdiction. It is therefore prudent for purchasers to expressly reserve their sandbagging rights under an M&A agreement, by way of a pro-sandbagging provision, and for vendors to expressly resist sandbagging rights, by way of an anti-sandbagging provision, rather than remaining silent on the issue.
Despite the fact that there is no case law to date substantially ruling on the issue of sandbagging in Canada, the Ontario Court of Appeal has tangentially dealt with the issue.1 As with similar judgments in the U.S. and England, the relevant Ontario ruling suggests that sandbagging is permissible in M&A transactions and that Canadian courts will enforce an explicitly bargained-for pro-sandbagging or anti-sandbagging provision that sets out the respective rights of each of the parties.
Looking to jurisprudence from other jurisdictions, and in light of the fact that reliance is an essential element for a successful breach of warranty claim in Canada, any pro-sandbagging provision should state: (1) that the representations and warranties are absolute and unqualified, meaning that a purchaser’s due diligence investigation will not affect any of the representations and warranties contained in the agreement; (2) that the purchaser’s actual (as opposed to constructive, implied or imputed) knowledge of any inaccuracy or untruth does not adversely affect the purchaser’s ability to subsequently bring an action; and (3) that the purchaser specifically paid for the representations and warranties contained in the agreement. Similarly, any anti-sandbagging provision should be clear as to what constitutes pre-closing “Knowledge”.
In addition to the foregoing, it is worth noting that under the law of Quebec, which is a civil code jurisdiction rather than a common law jurisdiction, there is a good faith requirement that applies broadly to exercises of contractual and extra-contractual rights. “Good faith” in this context requires inter alia that such rights be exercised in good faith and not be exercised abusively. While this aspect of Quebec law has not been directly tested in a sandbagging situation, it is likely that, in the absence of a pro-sandbagging provision in the relevant contract, the good faith requirement/abuse of rights doctrine would pose a significant problem for enforcement where actual knowledge had existed prior to closing. Where a pro-sandbagging provision did exist, the chances of enforcement would likely be much higher, although, as noted, there are not as yet any decided cases directly on point.
U.S. case law suggests that sandbagging is permissible in M&A transactions. Express pro-sandbagging and anti-sandbagging provisions will generally be enforceable. Where an agreement is silent, however, purchasers and vendors must carefully consider the governing law of the agreement and particularly whether that law imposes reliance requirements in breach of warranty claims. While we have not reviewed the relevant position of every U.S. state for the purposes of this article, a comparison of two widely-used jurisdictions – New York and Delaware – shows how significant the differences can be.
Despite the varying percentages of pro-sandbagging and anti-sandbagging provisions across Canada, the U.S. and Europe, in each case a very significant percentage of agreements are silent on the issue. Why would parties who have put their minds to sandbagging in negotiating and drafting their M&A agreements end up saying nothing about it? As indicated above, parties at an impasse in M&A transactions may agree as a compromise to remain silent on the issue of sandbagging. Having said that, according to a cross-section of case law on the subject, what is settled is that depending on the applicable jurisdiction, silence is not necessarily a compromise between purchasers and vendors.
Purchasers will typically seek the inclusion of a pro-sandbagging provision. Among other advantages of taking this approach is the fact that a pro-sandbagging provision reduces the practical difficulties of disproving the existence of prior knowledge regarding any indemnification claim that can be created by an anti-sandbagging clause (especially where a public or large private equity purchaser is involved). This is particularly true where an anti-sandbagging clause includes constructed, imputed or implied knowledge. The inclusion of a pro-sandbagging provision also incentivizes the vendor to diligently prepare its disclosure schedules to the acquisition agreement (disclosure schedules that adequately describe any exceptions to the representations, warranties and covenants would generally bar a purchaser recourse with respect to such matters) in order to provide the purchaser with accurate disclosure. The inclusion of an anti-sandbagging provision could arguably tempt the purchaser to avoid thorough due diligence with respect to risk-prone areas on the theory that the less it knows before closing the better (because less knowledge on the purchaser’s part may reduce the ability of a vendor to argue that a purchaser had prior knowledge of a breach – which, under the anti-sandbagging provision, would disqualify it from indemnification post-closing).
As a compromise, purchasers may agree to the inclusion of an anti-sandbagging provision that includes a narrow definition of “Knowledge” or simply agree to remain silent on the issue of sandbagging.
Purchasers who successfully negotiate the inclusion of a pro-sandbagging clause should be careful to consider how such a provision may interact with other clauses of the acquisition agreement. For example, a broad damages mitigation clause may have the potential to “gut” a hard-won pro-sandbagging clause.
The inclusion of anti-sandbagging clauses may be particularly sensitive to public company and private equity acquirors, especially where the applicable provision defines “Knowledge” so as to include constructive, implied or imputed knowledge. Such purchasers typically involve large deal teams on transactions and, as such, it can often be difficult for a purchaser of this type to disprove prior knowledge, given the complex reporting lines within their organizations and the numerous individuals who may have examined due diligence materials.
Vendors will generally seek the inclusion of an anti-sandbagging provision with a broad definition of “Knowledge”. Such a provision arguably encourages both parties to inform themselves as fully as possible prior to closing, giving them an incentive to collaborate and negotiate openly and honestly, which is in the interest of both parties. This also avoids the situation, which some parties consider to be unfair, of the vendor providing full disclosure while the purchaser fails to disclose the breach.
As a compromise, vendors may agree to a narrower definition of “Knowledge” or decide to remain silent on the issue of sandbagging.
Both purchasers and vendors should consider the uncertainty that accompanies silence on the issue of sandbagging in M&A agreements as evidenced by the case law (or the lack thereof) in Canada and elsewhere.
M&A agreements are meant to allocate and account for risk between purchasers and vendors. Given the impact that pro-sandbagging and anti-sandbagging provisions can have on risk allocation, sophisticated parties would be wise to put their minds to the issue of sandbagging when negotiating and drafting agreements.
The author would like to thank Chad Bass-Meldrum for his valuable assistance in writing this article.
Please note that the author and Stikeman Elliott practice Canadian law, and that references to U.S. and U.K. laws herein are not intended to imply qualification to practice in any U.S. or U.K. jurisdictions.
1 Transamerica Life Canada Inc. v. ING Canada Inc.,  68 O.R. (3d) 457 (C.A.).
2 CBS Inc. v. Ziff-Davis Publishing Co. et al., 553 N.E.2d 997 (N.Y.C.A. 1990).
3 See e.g., Galli v. Metz, 973 F.2d 145 (2d Cir. 1992); Rogath v. Siebenmann, 129 F.3d 261 (2d Cir. 1997); Coastal Power International Ltd. v. Transcontinental Capital Corp., 10 F.Supp. 2d 345 (S.D.N.Y. 1998); and Gusmao v. GMT Group, Inc., 2008 WL 2980039 (S.D.N.Y. 2008).
4 See for example: Interim Healthcare, Inc. v. Spherion Corp., 884 A.2d 513 (Del. Super. Ct. 2005); ABRY Partners V LP v. F&W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006); and Cobalt Operating LLC v. James Crystal Enterprises LLC, 2007 WL 2142926 (Del. Ch. 2007).
5 Infiniteland Ltd. v. Artisan Contracting Ltd.,  EWCA Civ 758. See also Eurocopy plc v. Teesdale,  BCLC 1067 and Lonedale Ltd. & Ors v. Scottish Motor Auctions (Holdings) Ltd.,  CSOH 04 (Scot. Ct. of Sessions), para. 14.

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