Mergers and acquisitions are delicate processes that require careful planning and mutual courtesy between both sides. Many of these transactions are between parties with an unbalanced relationship – sometimes a company agrees to be acquired as a last resort, or two companies who may be struggling financially agree to merge to pool their resources, leads, and assets. Sometimes in these scenarios, both parties engage in one-upmanship in order to have the ’upper hand’ within the new company. In situations like this, one roadblock that the transaction may encounter is ‘sandbagging’. Our Partner David Rodriguez explains this issue and what can be done to resolve it below.
Sandbagging and Pro-Sandbagging Provisions
Generally speaking, sandbagging is when a buyer files a suit or brings an indemnity claim against a seller for breaches that the buyer discovered before closing, usually during the buyer’s due diligence. M&A definitive agreements can potentially contain sandbagging or anti-sandbagging provisions, in order to avoid arguments over possible sandbagging bogging down the M&A process. These are fairly common. A recent study showed that nearly half of all M&A agreements contained either a pro or anti-sandbagging provision.
A pro-sandbagging provision – which is what many buyers argue for in M&A agreements – generally states that the buyer’s claims against the seller will not be affected by whether or not the buyer had full knowledge of the facts or circumstances giving rise to those claims, prior to closing. An example of this could be where the parties are almost finished with due diligence and are actually preparing for closing, and the seller decides to provide a significant amount of information in the due diligence room. The buyer, who is eager to close, discovers material information that can prove the seller has made false or inaccurate statements in the definitive agreement.
The buyer may decide that they don’t have enough concrete information to make an informed decision at that time, or perhaps they aren’t sure whether the breach rises to the level of creating damages, so they decide to close. Under a pro-sandbagging provision, the buyer retains their right to bring a claim after closing if, in fact, their losses turn out to be material. The buyer would not be prohibited from bringing an indemnification claim or breach of a representation after closing, even though they knew or discovered the information prior to closing. Essentially, this type of provision places the burden on the party (in this case, the seller) making the representation to ensure that all information in the agreement is accurate.
Sellers Strike Back with Anti-Sandbagging Provisions
On the other hand, an anti-sandbagging provision would prohibit the buyer from bringing the claim by limiting the buyer’s ability to seek recourse on those matters that the buyer knew about before closing. This type of provision basically shifts the burden to the party (in this case, the buyer) who had the knowledge. Oftentimes, definitive agreements are silent on this issue because this is usually one of the last issues that the parties negotiate. Rather than debate the issue within the confines of an agreement, the parties rely on the law chosen to govern the definitive agreement.
Although we learned above that slightly over half of M&A agreements do not contain sandbagging language, leaving it out could be risky, depending upon which state law is chosen to govern the agreement. Deciding whether a party is liable for damages could revolve around whether the state law in question requires reliance on the truth of the representation in order for the buyer to recover materially under the breach claim, which may be difficult to prove.
How Does Texas Handle Sandbagging?
In Texas, buyers are likely to be required to prove they relied on the representation or warranty in order to bring a claim for breach of an express warranty. Texas courts have found that buyers cannot reasonably rely on misstatements that they knew were false. Therefore, precedent exists in the Lone Star State for buyers to argue for sandbagging provisions, as ‘he said, she said’ sandbagging situations do not tend to go the buyer’s way in Texas courts without solid evidence to back their claims.
Indemnification provisions are often the most heavily negotiated provisions and definitive agreements in M&A transactions. On the other hand, disputes concerning sandbagging issues can often be the most contentious and costly to resolve. Rather than rely on state law to govern the rights of the parties, parties should take the time to perform detailed due diligence and fully negotiate any possible sandbagging issues prior to closing, in order to avoid the costly disputes following the closing of a deal.
If you’re a business owner planning to merge, acquire, or be acquired by another company, it goes without saying that there is a lot of work in store for you. If you need trusted and experienced counsel to assist you during this sensitive and complex process, Richards Rodriguez & Skeith may be able to help! Contact us today to schedule a consultation with one of our business attorneys.