Buyers and Sellers of Businesses Beware: Due Diligence, Sandbagging and the Destruction of Warranties and Representations
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10.01.06
I. INTRODUCTION
While ever y purchase or sale of a business comes with its own unique set of facts and circumstances that must be factored into the advice given to the client, it is also true that each deal shares essentially the same timeline:
- First, there is a willing Buyer and a willing Seller.
- Second, the Buyer and the Seller agree—even if roughly—to a valuation of the company.
- Third, the Buyer and the Seller sign a letter of intent or equivalent document. The letter of intent will provide that the Seller will take its company off the market for a certain period of time to allow the Buyer to evaluate the proposed transaction. The letter of intent will also contain appropriate mutual confidentiality provisions to foster the exchange of information between the Buyer and the Seller without prejudice to either should the deal fall through.
- Fourth, and most importantly, the Buyer will engage in due diligence. Due diligence, which can last over a period of weeks or even months, allows the Buyer to scrutinize all aspects of the business and the proposed transaction to ensure that, if the transaction does close, the Buyer will "get what it is paying for." In many transactions—and certainly in larger transactions—it is not uncommon for a Buyer to retain accountants, environmental consultants, appraisers and other professionals to assist in the more technical aspects of due diligence.
- Fifth, an agreement of sale is negotiated. Aside from describing exactly what is being bought and sold, and setting forth the purchase price and how it will be paid, the agreement of sale will contain the representations and warranties made by the Buyer and the Seller. Typically, so long as the Buyer pays the agreed-upon purchase price, the Buyer’s representations and warranties will never become an issue. It is the Seller’s representations and warranties that most often form the subject matter of litigation over the deal. Most litigation boils down to one essential issue: the company is not as profitable post-closing as the Buyer expected and, consequently, the Buyer believes it paid too much for the company. The Buyer will blame this on the Seller’s outright misrepresentations or concealment regarding the company (i.e., fraud) or on the Seller’s non-fraudulent breaches of the representations and warranties in the agreement of sale (i.e., breach of contract).
The balance of this article deals with the following question:
If, during due diligence, the Buyer learns adverse facts about the company it is purchasing, and those adverse facts could give rise to a post-closing claim for breach of the Seller’s representations and warranties, can the Buyer proceed forward with the closing, purchase the company, and later sue the Seller for a breach of the representations and warranties?
At first blush, it would seem that the answer would be "No," because the Buyer became aware of the adverse facts and proceeded forward with the transaction at its own risk. However, all in the law is not as it first seems. The actual answer depends on how the contract is drafted, more specifically, upon whether the contract contains what is known as a "sandbagging" or "anti-sandbagging" clause.
Buyers and Sellers (and their legal counsel) who enter into transactions without familiarity with the mechanics of these provisions do so at their own peril.
II. AN EXAMPLE OF SANDBAGGING
Before proceeding further, the concept of sandbagging must be described and understood. The easiest way to do this is through the following example:
A Buyer enters into a letter of intent to purchase a manufacturing plant in a rural area. The Buyer hires numerous consultants to assist it in evaluating the transaction during due diligence. Before the agreement of sale is executed between the Buyer and the Seller, the Buyer’s environmental consultant discovers that there is an old underground storage tank on the property which, at one time, may have leaked unknown substances into the surrounding soil.
The Seller did not disclose the presence of the underground storage tank during due diligence. Indeed, in the agreement of sale, the Seller will absolutely represent and warrant to the Buyer that there are no such underground storage tanks on the property.
The Buyer consults with his lawyer, who gives the following opinion: (i) if the Buyer proceeds forward with the transaction, the Buyer will be exposed to potential liability arising out of the presence of the underground storage tank on the property; and (ii) to the extent that this occurs, it would constitute a material breach of the Seller’s representations and warranties in the agreement of sale and, consequently, the Seller would be required to indemnify the Buyer.
Armed with this knowledge, the Buyer is now faced with two options.
Option 1. The Buyer can disclose to the Seller that, during due diligence, the Buyer’s environmental consultant discovered the underground storage tank and, in the opinion of the Buyer’s lawyer, this exposes the Buyer to an unknown contingent liability. The Buyer would then attempt to negotiate a purchase price reduction on account of this contingent liability or, alternatively, a special indemnification provision from the Seller relating to the underground storage tank. The Buyer may be reluctant to do this for several reasons. For example, negotiations may be contentious. The Buyer may not want to "rock the boat" to the point that the Seller will walk away from the deal. Further, if the deal is leveraged, the Buyer’s lenders could be scared off by disclosure of the potential environmental liability, and may attempt to renegotiate the terms of their loans.
Option 2. The Buyer can remain silent, proceed forward with the transaction and, if any issues relating to the underground storage tank crop up after the sale, seek indemnity from the Seller for the Seller’s breaches of the representations and warranties in the agreement of sale. Under Option 2, the Buyer is hoping that it will be able to seek indemnification from the Seller despite the Buyer’s knowledge that there was an underground storage tank on the property.
If the Buyer chooses Option 2, the Buyer has engaged in "sandbagging." Whether the Option 2 Buyer will be able to bring a post-closing action against the Seller for breach of the Seller’s warranties and representations will be determined by the relevant provisions of the agreement of sale and governing case law.
III. AN EXAMPLE OF ANTI-SANDBAGGING
While the concept of sandbagging is best understood from the Buyer’s perspective, the concept of anti-sandbagging is best understood from the Seller’s perspective. Expanding on the preceding example:
The Seller is a family-owned business. While the Seller is highly knowledgeable with respect to its industry, it is not knowledgeable in the complexities of mergers and acquisitions.
Thus, the Seller decides to allow the more experienced Buyer to drive due diligence. The Seller allows the Buyer and the Buyer’s consultants full access to the company’s records and facilities. The Seller, through its legal counsel, officers and employees, does its best to respond to the Buyer’s requests for information during due diligence.
At the end of due diligence, feeling that the Buyer was provided ample opportunity to conduct due diligence, the Seller insists on a provision in the agreement of sale stating to the effect that the Buyer will not be entitled to indemnity for any breach of the Seller’s representations and warranties if the Buyer was aware of such breach before the closing. In other words, if the Buyer discovered a potential problem during due diligence, remained silent and proceeded forward with the closing, the Buyer does so at its own risk and cannot later seek indemnification from the Seller.
This is known as an "anti-sandbagging provision." Inclusion of an anti-sandbagging provision will deter the Buyer from choosing Option 2, discussed above. It may also have the benefit of bringing problems discovered by the Buyer during due diligence out into the open before the closing, thereby encouraging the negotiation and resolution of these problems, or even prompting a "walk away" from the transaction if the problem is judged insurmountable. While drastic, this result may be preferable to the expense of subsequent litigation.
IV. PROTECTION OF THE PARTIES’ EXPECTATIONS VIA CONTRACTUAL PROVISIONS
The best way to deal with sandbagging is for the parties to draft an appropriate provision into their agreement of sale. Unfortunately, this is easier said than done. There are only two kinds of effective sandbagging-related provisions: those favoring the Buyer and those favoring the Seller. Negotiating the inclusion of one-sided provisions into an agreement of sale is difficult under cordial circumstances and often impossible if negotiations are contentious.
A. A Model "Buyer-Friendly" Provision
A simple "Buyer-friendly" sandbagging provision which can be included in the agreement of sale is as follows:
The representations and warranties of the Seller shall not be affected or deemed waived by reason of any investigation made (or not made) by or on behalf of the Buyer including, but not limited to, any investigations made (or not made) by any of the Buyer’s advisors, agents, consultants or representatives, or by reason of the fact that the Buyer or any of such advisors, agents, consultants or representatives knew or should have known that any such representation or warranty is or might be inaccurate or untrue. The Seller hereby acknowledges that, regardless of any investigation made (or not made) by or on behalf of the Buyer, and regardless of the results of any such investigation, the Buyer has entered into this transaction in express reliance upon the representations and warranties of the Seller made herein. The Seller further acknowledges that, in connection with this transaction, the Buyer has furnished to the Seller good and sufficient consideration in exchange for the Seller’s representations and warranties made herein.
This "Model Sandbagging Provision" is informed by case law dealing with sandbagging where the agreement of sale is silent on the issue.
First, courts have held that the Seller’s representations and warranties are intertwined with the Buyer’s due diligence (or lack thereof). The Model Sandbagging Provision breaks that connection by stating that the Seller’s representations and warranties are independent of, and cannot be adversely affected by, the Buyer’s due diligence (or lack thereof). In other words, the Model Sandbagging Provision makes the Seller’s representations and warranties absolute and unqualified.
Second, courts have held that to the extent the Buyer discovers a problem in due diligence and, therefore, has actual knowledge that a representation and warranty may be inaccurate or untrue, the Buyer cannot reasonably rely upon that representation and warranty in entering into the transaction. Consequently, the Buyer cannot maintain a post-closing action against the Seller for breach of the representation and warranty. The Model Sandbagging Provision acknowledges that the parties have agreed that the Buyer’s knowledge of any inaccuracy or untruth of a representation and warranty does not adversely affect the Buyer’s ability to subsequently bring suit for breach.
Third, courts have held that the Buyer’s due diligence should be less likely to affect the Buyer’s ability to bring a subsequent suit for breach of a representation and warranty where there is evidence that the Buyer specifically paid for the Seller’s representations and warranties in connection with the transaction. While this would seem to be assumed or implied in the transaction, the safer course is to expressly acknowledge that such payment has been furnished to the Seller by the Buyer. The Model Sandbagging Provision makes it clear that the Buyer is paying for the Seller’s representations and warranties as part of the transaction.
By including the Model Sandbagging Provision, the Buyer and Seller have expressly agreed that the Buyer can sandbag. There is nothing in the case law indicating that this is offensive to public policy such that the parties’ express agreement should be modified or limited in scope. Considering that even simple mergers and acquisitions are commercial transactions between relatively sophisticated parties represented by counsel and other advisors, a court will likely enforce this Model Sandbagging Provision as written.
If it is the Buyer’s intent to have the benefit of the full protection of the Seller’s representations and warranties irrespective of the scope of the Buyer’s due diligence, then the Buyer (and its legal counsel) should not stray too far from the Model Sandbagging Provision set forth above.
B. A Model “Seller-Friendly” Provision
Conversely, a "Seller-friendly" provision is known as an anti-sandbagging provision. A simple Seller-friendly provision which can be included in the agreement of sale is as follows:
The Buyer acknowledges that it has had the opportunity to conduct due diligence and investigation with respect to this transaction. The Buyer further acknowledges that, to the extent the Buyer, or any of the Buyer’s advisors, agents, consultants or representatives, by reason of such due diligence and investigation, whether or not undertaken, knew or should have known that any representation and warranty made herein by the Seller is or might be inaccurate or untrue, this constitutes a release and waiver of any and all actions, claims, suits, damages or rights to indemnity, at law or in equity, against the Seller by the Buyer arising out of breach of that representation and warranty. Nothing herein shall be deemed to limit or waive the Buyer’s rights against the Seller arising out of any other representation and warranty made herein by the Seller.
By including this "Model Anti-Sandbagging Provision," the Buyer and the Seller have expressly agreed that the Buyer has no claim for breach of a representation and warranty to the extent that: (i) the Buyer conducted due diligence and, as a result of that due diligence, knew or should have known that the representation and warranty might be inaccurate or untrue; or (ii) the Buyer failed to conduct due diligence and due diligence would have disclosed that the representation and warranty might be inaccurate or untrue. In other words, the Model Anti-Sandbagging Provision memorializes the theory of caveat emptor.[1] The concept of caveat emptor runs throughout the law of commercial transactions. As such, it is highly unlikely that a court would refuse to strictly enforce the Model Anti-Sandbagging Provision as written.
C. Negotiated Changes To The Model Provisions
Each of the Model Provisions discussed above are drafted starkly in favor of the Buyer or the Seller. Certain changes can be made to mitigate these Model Provisions without destroying the fundamental protections they provide.
For example, the parties can agree that a representation and warranty will be affected only if the Buyer has actual knowledge that the representation and warranty is inaccurate or untrue.[2] Further, the parties can contractually allocate the burden of proof with respect to actual knowledge. Either the Seller will have the burden to demonstrate that the Buyer had actual knowledge or the Buyer will have the burden to demonstrate that it did not have actual knowledge.
The parties can also agree that, to the extent the Buyer can show that the Seller deliberately misrepresented or concealed material facts, i.e., to the extent the Buyer can prove the Seller committed fraud, the representation and warranty at issue remains unaffected, irrespective of the Buyer’s due diligence or lack thereof. This recognizes that even extensive due diligence will not always uncover fraud. Nor should a Buyer be burdened to uncover a Seller’s fraud, because the Seller should not be committing fraud in the first place.
Again, while changes to the Model Provisions are limited only by the creativity of the drafter, it is recommended that the drafter not stray too far from the language of the Model Provisions. One of the goals in drafting the agreement of sale is to ensure that the expected protection comports with the actual protection afforded in subsequent litigation over the transaction. A "watering down" of the language of the Model Provisions will not advance this goal.
D. Management, Employee Or Insider Buy-Outs
One final issue needs to be addressed before the relevant case law is discussed. From time to time, the company’s current management, employees or other insiders, such as directors or shareholders, may be part of the Buyer’s group. In such cases, it is recommended that a broad anti-sandbagging provision be included in the agreement of sale to protect the Seller. By virtue of their relationship with the company, management, employees and insiders are often aware of problems which tend to make a warranty or representation inaccurate or untrue. Indeed, the "insider" Buyer may actually have caused or contributed to these problems. Under such circumstances, there is no reason to allow the "insider" Buyer to sandbag.
V. IN THE ABSENCE OF CLEARLY DRAFTED CONTRACTUAL PROVISIONS, BUYERS AND SELLERS ARE AT THE MERCY OF SANDBAGGING CASE LAW
Decisions in cases where the parties have failed to expressly address the issue of sandbagging with an appropriate contractual provision are somewhat muddied. While a full analysis of the case law in this area is beyond the scope of this article, representative cases are discussed below.
Delaware courts have taken the approach that, where the agreement of sale is silent, the Seller’s representations and warranties are unaffected by the Buyer’s due diligence. In an action by the Buyer against the Seller for breach of the representations and warranties in the agreement of sale, the Delaware Superior Court held:
[t]o the extent [the Seller] warranted a fact or circumstance to be true in the Agreement, [the Buyers] were entitled to rely upon the accuracy of the representation irregardless of what their due diligence may have or should have revealed. In this regard, [the Seller] accepted the risk of loss to the full extent of its indemnification commitments in the event the covenants were breached.
Interim Healthcare, Inc. v. Spherion Corp., 884 A.2d 513, 548 (Del. Super. Ct. 2005).
Interim Healthcare, Inc. stands for the proposition that, under Delaware law, a Buyer can sandbag the Seller unless the parties include an anti-sandbagging provision in their agreement of sale. This rule appears to be unique to Delaware. As discussed below, the law of other states takes a more nuanced approach to the problem.
The leading sandbagging case is CBS Inc. v. Ziff-Davis Publishing Co., 553 N.E.2d 997 (N.Y. 1990). This New York Court of Appeals case has been widely cited (and followed) by courts in other states.[3] In CBS, Inc., the Buyer alleged that the Seller breached its representations and warranties. The Seller, in turn, argued that the Buyer suspected that the representations and warranties were inaccurate or untrue, but decided to close on the transaction anyway. The Seller further argued that, under these circumstances, the Buyer had waived its right to sue the Seller for breach of the representations and warranties.
The court found in favor of the Buyer, holding:
- The critical question is not whether the Buyer believed the truth of the warranted information, but whether the Buyer believed that it was purchasing the Seller’s promise that the information was true.
- Once the Buyer demonstrates that, as part of the transaction, it purchased the Seller’s promise that the warranted information was true, the Seller cannot be relieved of the obligation to stand behind its promises merely because the Buyer formed doubts, prior to the closing, as to the truth of the information.
- Relieving the Seller of its obligations merely because the Buyer questioned the truth of certain warranted facts prior to the closing would deprive the Buyer of the value of the Seller’s express warranties as continuing promises by the Seller to indemnify the Buyer if the warranted facts later proved to be untrue.
See CBS Inc., 553 N.E.2d at 1000-02.
Thus, the Buyer’s belief as to whether or not a particular representation and warranty was true or false is not even a relevant factor. Rather, the single relevant factor is whether or not the Buyer believed that it was purchasing the Seller’s promise to indemnify the Buyer should a particular representation and warranty turn out to be untrue. The logic in this rule is apparent.
First, the Seller, having owned and operated the business prior to deciding to sell, is in a better position than the Buyer to know about critical facts relating to the business. Second, the period to conduct due diligence is often limited in duration by the terms of the parties’ letter of intent or by outside factors. Third, in the limited amount of time available for due diligence, there are numerous factors that the Buyer must investigate and verify. Fourth, as a consequence, it is not unusual for the Buyer to miss something or, more likely, to fail to fully appreciate the significance of the facts uncovered during due diligence.
Essentially, a Buyer purchases the Seller’s representations and warranties to provide an extra layer of protection in the transaction, in addition to the layer of protection provided by the Buyer’s own due diligence. As explained by another court immediately subsequent to CBS, Inc., "a warranty is intended precisely to relieve the [Buyer] of any duty to ascertain the fact for himself." Metromedia Co. v. Fugazy, 753 F. Supp. 93, 99 (S.D.N.Y. 1990).
Finally, in CBS, Inc. the court held that the representations and warranties paid for by the Buyer should not be discarded merely because the Buyer’s due diligence may have caused the Buyer to doubt the veracity of the Seller’s representations and warranties. It is here that a clear distinction must be drawn in the case law. CBS, Inc. and its progeny do not stand for the proposition that a Buyer can proceed to closing with actual knowledge that a representation and warranty is untrue or inaccurate in the hope that, should adverse consequences occur after the closing, the Buyer will be able to seek indemnification from the Seller for breach of that representation and warranty. Rather:
[w]here a Buyer closes on a contract in the full knowledge and acceptance of facts disclosed by the Seller, which would constitute a breach of warranty under the terms of the contract, the Buyer should be foreclosed from later asserting the breach. In that situation, unless the Buyer expressly preserves his rights under the warranties…we think the Buyer has waived the breach.
Galli v. Metz, 973 F.2d 145, 151 (2d Cir. 1992) (emphasis added).
In summary then, if the agreement of sale is silent on the sandbagging issue, the following two rules will be dispositive: (i) if the Buyer only suspected that the representation and warranty was untrue or inaccurate, the Buyer will likely be able to maintain an action for breach against the Seller; or (ii) if, on the other hand, the Buyer had actual knowledge that the representation and warranty was untrue or inaccurate, the Buyer will likely not be able to maintain an action for breach against the Seller.[4]
VI. CONCLUSION
Buyers and Sellers of businesses, and their legal counsel, should be aware of sandbagging issues during due diligence and in connection with the negotiation and drafting of the agreement of sale. Finding out about these issues for the first time in subsequent litigation arising out of the transaction can lead to unexpected and detrimental results.
As the noted Philadelphian Ben Franklin said, "An ounce of prevention is worth a pound of cure." A precisely drafted sandbagging or anti-sandbagging provision in the agreement of sale may be worth tens of thousands of dollars in legal fees during subsequent litigation.
By: William J. Clements
sclements@klehr.com
ENDNOTES
[1] "Let the buyer beware. This maxim summarizes the rule that a purchaser must examine, judge and test for himself." Black’s Law Dictionary, 6th Ed.
[2] "Actual knowledge" differs substantially from "constructive knowledge." To demonstrate constructive knowledge, it is sufficient to show that a party, had it conducted an appropriate investigation, would reasonably have discovered that a representation and warranty was inaccurate or untrue. The burden to show constructive knowledge is, thus, lower than the burden to show actual knowledge.
[3] The Court of Appeals is the highest court in the State of New York.
[4] The author has deliberately drafted these rules to be "fuzzy," because that is how they will be applied in subsequent litigation arising out of the transaction. Such a case will probably go to trial because there will be too many facts at issue to allow for disposal of the case via a motion to dismiss or summary judgment. The distinction between "only suspected" and "had actual knowledge" is a fine one, being what lawyers and courts refer to as a "jury question"—i.e., a question that can be answered only after a jury has heard all the evidence at trial. Of course, the expense of a trial may be avoided by including a clearly drafted sandbagging or anti-sandbagging provision in the agreement of sale.