Legal Matters: ‘Sandbagging’ provisions in M&A transactions governed by Delaware law: The risk of remaining silent

Thomas R. Taylor 

Delaware has long been the preferred state in which to organize companies doing business in the United States. The preference for Delaware law relates primarily to its corporate law statute, the Delaware General Corporation Law (the Delaware act), and the existence of the Delaware Court of Chancery (the Chancery Court), which was established solely to hear and decide business and corporate matters.

While the corresponding Utah statutes are{mprestriction ids="1,3"} also modern and progressive, there are many situations and transactions that lend themselves to having Delaware law govern. It’s common in M&A transactions for the buyer to require that Delaware law govern the transaction, particularly when the counterparty is not a Utah company or is not being advised by Utah counsel. Requiring that Delaware law apply alleviates the need for the counterparty and its counsel to engage a Utah lawyer to advise on Utah law issues. Most private equity firms are organized in Delaware and will often prefer — and in many instances, insist — that Delaware law govern their transactions and that jurisdiction and venue be exclusively in the Chancery Court in the event a dispute ever arises.

As a result, many Utah companies entering into M&A transactions will be required to have Delaware law govern. As a result, it’s imperative for Utah companies and their legal counsel to understand Delaware law and Delaware case authority governing M&A transactions so they will be aware of and appreciate the impact Delaware law and case authority will have on a transaction.

Background

One general principle that must be understood and considered in the context of any M&A transaction that will be governed by Delaware law is “sandbagging.”

In the context of an M&A transaction, the term “sandbagging” has a very specific meaning. In an M&A transaction, “sandbagging” refers to a scenario where a buyer closes a transaction based on the representations and warranties (collectively, “Representations”) made by the seller in the transaction agreement, some of which are discovered by the buyer before the closing to be false, and then, postclosing, the buyer sues the seller based on the breach of those Representations. Delaware has long been considered by practitioners, judges and commentators to be a “prosandbagging” jurisdiction. That is, under Delaware law, a buyer in an M&A transaction can close a transaction having actual knowledge that certain of the seller’s Representations are false, and then, after closing, sue the seller for damages based on the breach of those Representations — a socalled “prosandbagging” position.

No case law or statutory authority exists in Utah that addresses the “sandbagging” issue or whether Utah is a socalled “prosandbagging” state or an “antisandbagging” state. In states where the treatment of sandbagging is unsettled or not been addressed (such as Utah), the seller is welladvised to attempt to negotiate an express “antisandbagging” provision in the transaction agreement.

Arwood v. AW Site Services LLC

The most recent Delaware case addressing the “sandbagging” issue, Arwood v. AW Site Services LLC, decided by the Chancery Court on March 9, 2022, clarified and confirmed that Delaware is in fact a “prosandbagging” jurisdiction. Thus, under Delaware’s” prosandbagging” default rule, a buyer in an M&A transaction can close a transaction and then sue the seller for its breach of a Representation that the buyer had actual knowledge of its breach before the closing.

That default rule can only be overridden if the transaction agreement contains explicit language addressing the “sandbagging” issue and clearly and unambiguously overrides Delaware’s “prosandbagging” default rule. Experienced and sophisticated M&A counsel to buyers will often suggest that the parties simply remain silent on the “sandbagging” issue in the transaction agreement. However, remaining silent is very dangerous for sellers because of the “prosandbagging” default rule that was confirmed by the Chancery Court in Arwood. The risk of remaining silent in a purchase agreement governed by Delaware law on the “sandbagging” issue is that Delaware’s default “prosandbagging” rule will apply, allowing a buyer to sue the seller for a breach of a Representation that the seller knew was false before closing.

After Arwood, unless the definitive transaction agreement contains an express “antisandbagging” provision, a buyer can close an M&A transaction with actual knowledge that one or more of the seller’s Representations are false, and then, after the closing, sue the seller for its breach of those Representations.

Discussion

In the last few years it has become increasingly more difficult for sellers to successfully include an “antisandbagging” provision in the transaction agreement. Moreover, when a seller requests an “antisandbagging” provision, buyers will often ask for a “prosandbagging” provision, and because there really is no “middle ground” or compromise position on this issue — either “sandbagging” will be allowed or it won’t —the parties will find themselves at an impasse. As a result, most experienced and sophisticated buyer M&A counsel will then suggest that the parties simply remain silent on the “sandbagging” issue. However, remaining silent is very dangerous for sellers because of the Delaware “prosandbagging” default rule, which was confirmed by the Chancery Court in Arwood. The risk of remaining silent in a transaction agreement governed by Delaware law is that Delaware’s default “prosandbagging” rule will apply, thus allowing a buyer to “sandbag” the seller and then sue the seller for a breach of a Representation that the seller knew was false or inaccurate before closing. Unless seller’s counsel understands and appreciates the consequences of remaining silent in an M&A transaction agreement governed by Delaware law, the seller will unwittingly submit itself to Delaware’s default “prosandbagging” rule.

ABA Studies and Seller Considerations

The M&A Market Trends Subcommittee of the American Bar Association’s Mergers & Acquisitions Committee publishes a Private Target Company Survey every other year. Those Studies provide a comprehensive summary of all private target company M&A transactions that closed in the two preceding years. The most recent ABA Study covered transaction that closed in 2020 and 1Q 2021 (the “2021 ABA Study”). The 2021 ABA Study reported that the existence of “antisandbagging” provisions in transaction documents dropped from 6% in 201617, to 4% in 201819 and to 2% in the 2021 ABA Study. Prior to 2016, “antisandbagging” provisions existed in about 8%10% of private target company M&A transaction agreements. Because there is no “middle ground” or compromise position on the “sandbagging” issue, buyers often convince sellers to remain silent on the issue, and the 2021 ABA Study confirms the same and reports that in 202021 fully 68% of the M&A transaction agreements were silent on the issue (an increase from only 41% of the transactions closed in 2016). While in the last several years it’s become very difficult for sellers to prevail on the “antisandbagging” issue, there are nevertheless certain concepts that can be, and often are, incorporated in M&A transaction agreements to mitigate the risk and potential liability that remaining silent may present for a seller. Accordingly, sellers in M&A transactions and their legal counsel must approach the sandbagging issue strategically and take appropriate steps to limit the seller’s exposure.

Among the concepts that sellers should consider including in a transaction agreement are a fraud exception limiting the buyer’s right to indemnification for breaches or inaccuracies in the Representations to only apply to fraud. The 2021 ABA Study shows that over the last 17 years the vast majority of M&A transaction agreements contained a fraud exception. However, care must be exercised in properly defining what “fraud” means and what types of fraud will be covered. Furthermore, it’s generally advisable to provide an “exclusive remedy” clause providing that indemnification will be the buyer’s only remedy for a breach not involving fraud. The 2021 ABA Study reported that 92% of the transaction agreements reviewed contained an exclusive remedy provision.

Seller’s should also consider including a comprehensive and properly drafted “nonreliance” representation from the buyer providing that the buyer has not relied on any seller representations or warranties other than those set forth in the Representations section of the transaction agreement. Any such “nonreliance” representation should cover information set forth in the Confidential Information Memorandum and Data Room. A properly drafted fraud carveout to a nonreliance representation will preserve fraud claims against the seller, but protect the seller from negligent misrepresentation and promissory estoppel claims. In addition, a ‘no other representations” clause should be considered. Both of those provisions have become common over the last several years. Nonreliance representations, which cover seller’s extracontractual misstatements and omissions made during the sales process, have been held to be enforceable by Delaware courts, but they must be carefully drafted so as to meet the judiciallyestablished requirements.

Finally, sellers should also consider including a socalled “nonrecourse” provision in the transaction agreement. The purpose of such a provision is to limit contractual liability to only the individuals and/or entities that are actually parties to the transaction agreement, and prevent nonparties (such as directors, officers, equityholders, advisors, etc.) from being held liable for fraud claims made by the buyer against the seller/the actual parties to the agreement. Sellers should be aware that this area of the law is currently developing and evolving rapidly, including two Delaware cases that address the issue that were handed down in late 2022 and address when nonparties may be held liable under Delaware law.

Thomas R. Taylor is a corporate and M&A lawyer and shareholder in the international law firm of Dentons Durham Jones Pinegar P.C. in Salt Lake City. He is listed as one of the leading M&A lawyers in the United States by both Chambers & Partners and Super Lawyer.{/mprestriction}