How Does Sandbagging Work in M&A Deals?

This blog post was prepared with the assistance of summer student Jayelle Friesen.

Sandbagging and anti-sandbagging provisions are risk allocation tools primarily used in mergers and acquisitions transactions. These provisions allow for – or mitigate against – recovery relating to breaches of an agreement that the buyer knew about prior to closing the transaction.

Generally speaking, purchase agreements can contain provisions that are pro-sandbagging or anti-sandbagging, or they can remain silent on the subject of sandbagging altogether – although silence can be risky.

The decision to include these types of provisions in a purchase agreement will depend on several different factors, including the complexity of the transaction, the nature of the diligence conducted by the buyer, the level of access and disclosure provided by the seller, the history of the transaction negotiation, and the bargaining powers of each party. In many cases, pro- and anti-sandbagging provisions are used as one of many different risk allocation tools that are “traded” throughout the course of legal negotiation.

What Is Sandbagging?

The approach on sandbagging that is taken in a purchase agreement will inform whether a buyer who had knowledge of a breach of representation is able to proceed to close the transaction, and then subsequently bring an indemnity claim against the seller relating to that breach.

For example, in a purchase agreement, a seller may be asked to provide a representation that there are no pending claims against the business from current or former employees. But a buyer may learn, through its due diligence investigation of the business, of a pending claim from a former employee.

Despite having learned of the pending claim – and the seller’s breach of their representation that there were no such claims –  the buyer may nonetheless proceed to close the transaction. Following closing, if the employee claim manifests as a loss for the buyer, the buyer may still be able to bring an indemnity claim under the agreement relating to the seller’s breach of the relevant representation. This practice is known as sandbagging.

Where an indemnity claim is successful, the buyer may be compensated for the loss, damage or other liability caused by the breach, regardless of whether the buyer was aware of the breach before closing the transaction.

What Approaches Can Be Taken in Purchase Agreements?

A. Anti-Sandbagging

Anti-sandbagging provisions are seller-friendly, protecting the seller from claims arising from a breach known to the buyer before closing. Arguments for this approach frequently focus on the buyer’s ability to conduct their due diligence to determine whether to enter into an agreement.

The underlying theory is that a buyer who is provided with comprehensive disclosure by the seller, and given the opportunity to review that disclosure, should not be able to claim against the seller for a technical breach of a representation that they knew of. The buyer proceeded to close the transaction and complete their investment with knowledge of the breach, and therefore should not be able to be compensated for the risk they were aware of.

Key anti-sandbagging language in purchase agreements will disclaim a party’s liability for breaches that the other party had knowledge of prior to closing.

B. Pro-Sandbagging

Pro-sandbagging provisions entitle the buyer to pursue post-closing indemnification remedies for breaches, regardless of whether the buyer was aware of the breach prior to closing.

While pro-sandbagging may appear at first glance to be contrary to a basic concept of the assumption of investment risk, agreements with anti-sandbagging provisions have the potential for abuse by sellers, who may “bury the buyer with paper” by providing a large amount of disclosure immediately prior to a deal closing. The seller may then claim the buyer had knowledge of a breach and therefore cannot pursue indemnification, regardless of whether the buyer had a reasonable opportunity to digest the information.

A pro-sandbagging provision mitigates against this potential, and acts as a means to encourage transparency and careful consideration of the representations being given by the seller.

In a purchase agreement, tell-tale language of pro-sandbagging provisions will specify that a party’s right to indemnification is unaffected by their diligence or knowledge of a potential breach.

C. Silence

Agreements that are silent on sandbagging do not include express language that either allows or removes a party’s right to indemnification based upon a breach known post-closing. If a breach arises, the parties cannot look to the terms of a negotiated contract to allow or prevent recovery for the breach.

Since anti- and pro-sandbagging provisions benefit the seller and buyer, respectively, negotiations over whether to include such provisions will sometimes lead to the compromise of leaving sandbagging entirely unaddressed. While silence tends to be a common approach to sandbagging in purchase agreements, it is also the least likely to have a certain result if tested.

A court interpreting a purchase agreement may point to a sandbagging or anti-sandbagging clause as the negotiated position between the parties and choose to enforce the provisions of the agreement (although most of these cases are largely fact-dependent, making it challenging to ascertain a clear rule of interpretation). Currently, there is no clearly established rule as to how Canadian courts will treat an agreement that is silent on the effect of sandbagging.

Some decisions (see: Eagle Resources Ltd. v MacDonald, 2001 ABCA 264) have found a presumption of pro-sandbagging on the basis that a buyer should not be barred from enforcing a contract, even if they had reasons to be skeptical about the seller’s ability to perform. But in a subsequent decision (see: Transamerica Life Inc. v ING Canada Inc. 2003 CanLII 9923 (ON CA)), the duty of good faith in contract performance was pointed to, calling any firmly established presumption of pro-sandbagging into question.

The more recent Supreme Court of Canada decision in Bhasin v Hrynew (2014 SCC 71) focuses on the organizing principle of good faith. This may have implications for how Canadian courts treat sandbagging going forward, because the practice inherently brings up questions about good faith in contract performance. The impact of this decision on sandbagging specifically, however, remains untested.

The Importance of Knowledge

Definitions of “knowledge” in purchase agreements will frequently be negotiated with a view to their impact on the seller’s representations. If a seller makes a statement that is “to their knowledge” in a purchase agreement, determining exactly what constitutes a seller’s knowledge will be important in ascertaining whether there has been a breach of that representation.

However, if an agreement includes an anti-sandbagging provision, it is important to also consider the definition of “knowledge” in the context of sandbagging.

At a high level, “knowledge” can be construed narrowly (e.g. being confined to a party’s “actual knowledge” of an occurrence), broadly (e.g. implied knowledge, or what a party would know after having made certain inquiries and investigations), or at a negotiated midpoint.

Generally speaking, where a seller is providing representations that are qualified to be “to their knowledge,” they will prefer to keep the definition of knowledge narrow. They will limit their knowledge only to what they are actually aware of, and without deeming the seller to have made inquiry or investigation before providing the representation.

However, if a seller has secured an anti-sandbagging provision in the agreement, applying that same definition of “knowledge” in that context would work to the seller’s detriment. In these cases, if the same narrow construction of “knowledge” were applied, it would weaken the anti-sandbagging provision by allowing the buyer to rely only on their actual knowledge of a breach – and not an implied knowledge by virtue of the seller’s disclosure in due diligence – to support the bringing of a claim.

For these reasons, prudent sellers should consider the applications of “knowledge” as a concept, and the potential to negotiate a standard for the seller’s knowledge that is different from the buyer’s knowledge in the context of anti-sandbagging protection.

Conclusion

Since anti- and pro-sandbagging provisions are inherently in opposition to each other, their inclusion will frequently arise as part of the legal negotiation process. Even though it is common for agreements to remain silent on sandbagging (sometimes deliberately as part of the negotiation process), the uncertainty of how courts will treat the concept can make silence a risky decision.

Carefully considering the pros and cons of these provisions is important. Contact us to learn more if you’re planning to buy or sell a business.