Selling a Business? Don’t Get ‘Sandbagged’!

anti-sandbagging provisionIn the context of selling or buying a business, the term “sandbagging” refers to when the buyer in an acquisition agreement (asset purchase agreement or purchase and sale  agreement)  seeks post-closing indemnification for breaches of representations and warranties that the buyer was aware of prior to signing the acquisition agreement, or in some cases, closing the transaction.

Sandbagging most often occurs when a buyer has already signed the agreement but finds a breach before the closing of the transaction. The buyer then elects to close the transaction, even though the buyer has knowledge of a breach, because the buyer intends to exercise its rights against the seller for the breach. This can take the form of suing for breach, withholding holdback funds, or some other method to extract a greater benefit from the seller.

Generally, a buyer is not even required to establish that it relied on a seller’s warranty or representation in order to recover post-closing damages as a result of a breach. The buyer’s pre-signing or pre-closing knowledge of the breach is not, in many cases, a defense for the seller. However, if there are sandbagging provisions in the agreement, it can have a serious impact on the buyer’s claim for breach or indemnification.

There are three different routes to take when dealing with the issue of sandbagging in an acquisition agreement, purchase and sale agreement or asset purchase agreement. From the seller’s perspective, an anti-sandbagging provision is a must-have, and from the buyer’s perspective, a pro-sandbagging provision is favored. Although many agreements are silent on this issue, silence is too risky for either side to accept given that different jurisdictions treat ‘silence’ on sandbagging differently:

  1. Pro-Sandbagging Provision: provides that a party’s right to indemnification based on the inaccuracy or breach of any representation or warranty “shall not be affected by any investigation conducted or knowledge acquired at any time”, whether before or after the signing of the acquisition agreement or the closing of the transaction.
  2. Anti-Sandbagging Provision: provides that “no party shall be liable for any losses resulting from or relating to any inaccuracy in or breach of any representation or warranty in the acquisition agreement if the party seeking indemnification for such losses had knowledge of such breach before closing.”
  3. Silence: if the acquisition agreement is silent on the issue of sandbagging, the governing law of the agreement will determine a party’s right to bring a post-closing indemnification claim regarding a matter that it knew prior to closing.

State law varies absent a provision regarding the issue of sandbagging. For instance, Texas law requires a buyer to have relied on the seller’s representation or warranty to maintain an indemnification claim or claims for breach. New York law looks to the source of the information; if the seller notifies the buyer of the breach then typically a buyer cannot seek indemnification. However, if the buyer obtains knowledge from a 3rd party then a buyer will likely prevail in bringing an indemnification claim. Delaware law does not require reliance or look to the source of information, rather they advise to include pro-sandbagging provisions if the buyer has pre-closing knowledge of a misrepresentation or breach.

If you are selling a business or buying a business, and require assistance with an acquisition agreement, purchase and sale agreement or asset agreement, the attorneys at The Jacobs Law LLC can help. Contact our Business Lawyers at Business@TheJacobsLaw.com or 1-800-652-4783.