M&A lawyers carefully negotiate representations (reps) and warranties in M&A agreements. In many agreements, if the reps and warranties are not materially accurate at closing, the buyer is not obliged to close the transaction. And, if a buyer in the private M&A context discovers after closing that a rep and warranty is inaccurate, the buyer can typically seek recourse against the seller by either making an indemnity claim (which often involves dipping into a holdback or escrow of the purchase price), or suing the seller for damages. But can a buyer who knows (or ought to know) before closing that a rep and warranty is inaccurate still close and then seek indemnification and/or sue for damages?
This article provides practical takeaways on so-called “sandbagging”, which has almost never been litigated in Canada.
Addressing sandbagging in the M&A agreement
An M&A agreement may be silent on the issue of sandbagging, or expressly provide for one of the following:
- Include a “pro-sandbagging” provision. This provision permits the buyer to seek indemnification and/or sue for misrepresentations it discovers before closing but nevertheless closes the deal. A typical pro-sandbagging clause might look something like this:
“The right to indemnification, payment, reimbursement or other remedy based upon any such representation, warranty, 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 the Agreement or the Closing Date, with respect to the accuracy or inaccuracy of, or compliance with, such representation, warranty, covenant or obligation”.
- Include an “anti-sandbagging” provision. This provision provides the seller with a defence against a claim that there was a misrepresentation, if the buyer closes the deal knowing the rep and warranty was false. A typical anti-sandbagging clause might look something like this:
“No party shall be liable under this article 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 terms of market practice, most Canadian M&A agreements are silent on the issue of sandbagging, and where an M&A agreement is not silent on the issue, pro-sandbagging provisions are more common than anti-sandbagging provisions.
Pro-sandbagging appears to be the default outcome if an agreement is silent
Although Canadian jurisprudence on sandbagging is sparse, we expect Canadian courts to favour contractual freedom and enforce express pro-sandbagging or anti-sandbagging provisions bargained for by the parties, subject to the duty of honest contractual performance. And where an M&A agreement is silent on the issue, we expect Canadian courts to favour the application of a pro-sandbagging approach.
For example, in Eagle Resources Ltd v. MacDonald, the Alberta Court of Appeal allowed a buyer to obtain the benefit of a warranty it knew to be false even though the purchase agreement was silent on sandbagging.[1]
In that case, the seller had given a rep and warranty stating that, to the best of its knowledge, there were no facts known to the seller that could adversely affect the business except as disclosed in the purchase and sale agreement.[2] During the sale process, the seller received reports showing a significant drop in oil reserves that it did not share with the buyer. However, the buyer independently knew about the reports pre-closing, closed the transaction, and sought post-closing recourse against the seller in the form of damages.[3] The Alberta Court of Appeal rejected the seller’s argument that the buyer could not enforce the rep and warranty because it knew about the misrepresentation before closing:
The argument of counsel for the respondent is that the purchaser knew the facts. But clause 3.3(g) does not speak of that. It warrants that all facts reports etc. are in the contract, not that the purchaser has been told about them. It is no bar to enforcing a contract that the buyer was skeptical as to whether the vendor would perform it, or could perform it, or that the buyer had reason to be skeptical.[4] [Emphasis added.]
In the United States, where sandbagging has been more extensively litigated, courts favour contractual freedom and enforce express pro-sandbagging or anti-sandbagging provisions bargained for by the parties.[5]
When the M&A agreement is silent, American courts have tended to adopt a pro-sandbagging approach. The Delaware Court of Chancery recently explained in Arwood v. AW Site Services, LLC[6] that a default “pro-sandbagging rule” is justified by two principles: (1) reps and warranties are important for risk allocation in an M&A transaction, and buyers should be able to rely on them, and (2) if the seller does not like sandbagging, they can contract around it:
While I acknowledge there is something unsettling about allowing a buyer to lay in wait on the other side of closing with a breach claim he knew before closing he would bring against the seller, the risk of such litigation, like any other risk, can be managed expressly in the bargain the parties strike. A pro-sandbagging rule supports the notion that “representations and warranties serve an important risk allocation function.” Indeed, as a general matter, Delaware’s “public policy favor[s] private ordering” and “respects the freedom of parties in commerce to strike bargains and honors and enforces those bargains.” I see no reason to alter that public policy here, especially since “anti-sandbagging clauses” have emerged as effective risk management tools that every transactional planner now has in her toolbox. [Emphasis added.]
Canadian courts have not yet addressed how sandbagging interacts with the duty of good faith in contractual performance endorsed by the Supreme Court of Canada in Bhasin v. Hrynew,[7] and C.M. Callow Inc. v. Zollinger.[8] We suppose it is possible that a pro-sandbagging approach, particularly when the M&A agreement is silent on the issue, could be interpreted as violating the duty of good faith performance, particularly since a buyer would have to close over a known breach and may, through its conduct, cause a seller to infer that there was no actionable breach.
However, the Supreme Court has emphasized that the purpose of the contractual duty of good faith is to secure the performance and enforcement of the contract made by the parties, and that the good faith principle cannot be used to create new, unbargained‑for rights and obligations, or to alter the express terms of the contract reached by the parties. Since parties cannot be held to a standard that is contrary to the plain wording of the contract, buyers and sellers should address the issue of sandbagging in their M&A agreements for greater certainty.
Takeaways
- Risk of pro-sandbagging where an M&A agreement is silent: If an M&A agreement is silent on the issue of sandbagging, there is a risk that a Canadian court will apply a pro-sandbagging approach, as in Eagle Resources and Delaware jurisprudence. Sellers who want a different outcome should bargain for an anti-sandbagging provision.
- Consider degree of knowledge required and scope of reps covered: If a buyer is willing to agree to an anti‑sandbagging provision, the buyer might try to narrow the knowledge standard to actual knowledge instead of a constructive or implied knowledge standard (e., “the buyer ought to have known”). If a broader standard is applied, the buyer might attempt to limit the application of the anti-sandbagging provision to specific reps of the buyer.
- Sandbagging may be easier if there is a materiality scrape: Certain reps and warranties may only be made subject to a specified level of materiality. If the M&A agreement contains a “scrape” that reads out a materiality qualifier to the reps and warranties in determining breach, a buyer may have an increased ability to sandbag the seller with reference to a rep and warranty that was accurate as given (e. with a materiality qualifier), but not accurate after the “scrape”.
- Reducing litigation cost or litigation risk: Pro-sandbagging rules arguably reduce litigation costs in the event of a dispute, by forcing courts to assess only whether the rep and warranty was false, not whether the buyer also knew or should have known the rep and warranty was false.[9] But pro-sandbagging arguably increases the risk of litigation by discouraging buyers from bringing a rep and warranty issue to the seller’s attention prior to closing, where the issue may be resolved through out of court negotiations in the context of the broader deal negotiations. Buyers and sellers should consider whether they value reduced litigation costs or litigation risk when deciding on an anti- or pro-sandbagging approach.
- Impact of rep and warranty insurance: Post-closing risks can be mitigated by appropriate rep and warranty insurance. These insurance policies typically have an anti-sandbagging clause in the form of an exclusion from coverage if the insured, typically the buyer, had knowledge of the applicable breach. The buyer is required pre-closing to execute a “no claims” declaration that, as of the time the policy is bound and at closing, it does not have such knowledge of a breach. These exclusions are typically narrowly defined by excluding coverage only when a buyer had actual knowledge of the breach and only with respect to a group of named deal team members.
- Damages: A breach of contract claim does not require a plaintiff to prove damages and, in exceptional cases, a plaintiff may be able to seek restitutionary damages (e., the gains/losses avoided) from the party that breached the contract. On the other hand, a seller could argue that the breach caused no material damage to the buyer. Moreover, if the dispute concerns a post-closing price-adjustment mechanism, the seller may argue that the buyer is not entitled to any adjustment because the buyer did not rely on the rep and warranty. Since these arguments are novel in Canada, parties should ensure the relevant provisions in the M&A agreement make clear the parties’ intentions regarding sandbagging.
