How to Sandbag Your Opponent in the Unsuspecting World of High Stakes Acquisitions

• Publication year: 2022

47 Creighton L. Rev. 459. HOW TO SANDBAG YOUR OPPONENT IN THE UNSUSPECTING WORLD OF HIGH STAKES ACQUISITIONS

HOW TO SANDBAG YOUR OPPONENT IN THE UNSUSPECTING WORLD OF HIGH STAKES ACQUISITIONS

STACEY A. SHADDEN

I. INTRODUCTION

The term "sandbagging" originates from the 19th century where gang members would fill socks full of sand to use as weapons against unsuspecting opponents.(fn1) While at first glance, the socks were seemingly harmless, when used to their full potential they became very effective and would inflict substantial damage on a "sandbagged" victim.(fn2) Over time, the term "sandbag" has taken meaning in many facets of daily life, but equally in each, the term has developed a negative connotation. As a verb, the term is defined broadly to mean to misrepresent or conceal one's true intent, position, or potential in order to take advantage of an opponent.(fn3) The term has taken significance as a modern sporting term, specifically, in golf signifying a golfer who pretends to play worse than he or she actually is to gain advantage and sympathy over an unsuspecting opponent.(fn4) The term has also developed in the context of a business deal. A "sandbagging" buyer refers to the situation where a buyer is or becomes aware that a specific representation and warranty made by the seller is false, yet instead of alerting the seller to this fact, the buyer consummates the transaction, despite its knowledge of the breach, and seeks post-closing damages against the seller for the breach.(fn5)

The phrase "sandbag" evokes an inference of wrongful intent and malfeasance, yet the reasons a modern buyer might sandbag its seller vary and do not always involve morally questionable intentions.(fn6) The initiation of negotiations by either party over a sandbagging provision can instantly cause wary behavior, but as the parties properly allocate risks associated with the deal, scholars have begun to question who really sandbags whom?(fn7) Whether sandbagging really is an issue of fundamental fairness that imputes bad motives to buyers?(fn8) Or whether the buyer is in as much need of protection as the seller?(fn9)

This paper will analyze the real meaning and effect behind the use of a sandbagging provision in deal transactions. First, this paper will introduce how pro-sandbagging and anti-sandbagging provisions operate in the deal setting. Then, this paper will analyze the motives behind each party in negotiating for or against a sandbagging right, in determining who really "sandbags" who in this high-stakes game of allocating risk. Next, this paper will examine the trends in sandbagging. And finally, this paper will conclude by scrutinizing the ethical and moral implications faced by both sides in the "sandbagging" battle.

II. HOW TO SANDBAG YOUR OPPONENT

A provision creating or restricting a party's ability to sandbag may appear innocuous or boilerplate, yet understanding the potential effect and carefully crafting the provision to prevent unwanted risks is critical to both a buyer and seller. One consideration to note prior to delving into the full discussion of sandbagging is that in the United States, the current trend remains in favor of pro-sandbagging rights. The following provides an example of a common scenario where a sandbagging provision (or lack thereof) may come into play and control the actions taken by both buyer and seller.

In a typical scenario where a sandbagging provision (or lack thereof) may come into play, before the purchase agreement is signed, buyer is informed of a potential material liability uncovered during its teams due diligence investigation. Buyer immediately faces a choice: bring this liability to the attention of seller and attempt to negotiate around it or back out of the deal itself.(fn10) The risk of re-negotiating the deal could easily lead a seller to back out, or scare the buyer's own lenders based on new liabilities now surfacing.(fn11) As buyer becomes cautious of its options, its lawyer informs it that the liability would constitute a breach of seller's representations and warranties. Buyer starts to wonder if it has a third option: may buyer proceed to closing without raising the issue and seek a post-closing claim for seller's breach? An acquisition agreement between buyer and seller may deal with this issue in three ways: (i) expressly permitting buyer to engage in sandbagging even if buyer has previous knowledge of the falsity of seller's representations and warranties; (ii) expressly preventing buyer the right to indemnification for a breach of seller's representations or warranties if buyer had prior knowledge of its inaccuracy; (iii) or remaining silent on the issue.(fn12)

A. PRO-SANDBAGGING PROVISIONS

1. The Pro-Sandbagging Right and Seller's Attack Against Its Use.

A pro-sandbagging right, or "knowledge savings" clause, is a specific provision within the purchase agreement reinforcing the benefit to a buyer of the representations and warranties it bargained-for from seller notwithstanding any knowledge or awareness buyer may have of their truth when made by seller.(fn13) A sandbagging right may be included as a representation, covenant, drafted as part of the indemnity provision or placed separately in the miscellaneous section of the agreement. A common example of such a provision is as follows:

Seller has agreed that Buyer's rights to indemnification for the express representations and warranties set forth herein are part of the basis of the bargain contemplated by this Agreement; and Buyer's rights to indemnification shall not be affected or waived by virtue of (and Buyer shall be deemed to have relied upon the express representations and warranties set forth herein notwithstanding) any knowledge on the part of Buyer of any untruth of any such representation or warranty of Seller expressly set forth in this Agreement, regardless of whether such knowledge was obtained through Buyer's own investigation or through disclosure by Seller or another person, and regardless of whether such knowledge was obtained before or after the execution and delivery of this Agreement.(fn14)

If a seller is forced to accept a pro-sandbagging provision, there are numerous negotiating tactics it may employ to limit the buyer's ability to sandbag it after closing. First, the seller should negotiate the ability to update its disclosure schedules, setting forth exceptions to its representations and warranties, between signing and closing.(fn15) With this right, if a material adverse change does occur, affecting the truth of the seller's representations and warranties, buyer will be barred post-closing for indemnification for the disclosed issue.(fn16) Further, when approached by a buyer requesting a pro-sandbagging right, a seller should review its indemnification obligations, and the scope of damages such obligations cover, to narrow their post-closing application to breaches of seller's representations and warranties.(fn17) When reviewing buyer's indemnification rights, seller can narrow the damages by expressly excluding consequential or punitive damages; or by obligating buyer to "act in good faith and in a commercially reasonable manner to mitigate damages."(fn18) However, no matter what compromises each of the buyer and seller are able to settle on, there are costs to each party associated with including a pro-sandbagging right.

2. The Costs of A Pro-Sandbagging Rule

The purpose of a written agreement fully negotiated between sophisticated parties is to specifically allocate risks between buyer and seller.(fn19) If the default standard is in favor of pro-sandbagging, then even buyers who do not value the right and choose silence over negotiating for the express right to sandbag, will be subjected to a pro-sandbagging standard.(fn20) With this default standard all sellers treat each buyer as a potential sandbagger.(fn21) This in turn transfers at the forefront of the negotiations to all buyers the incremental costs of the risks of sandbagging that are faced by each seller, creating an uphill battle for buyer.(fn22) These incremental costs may be created through fewer or more limited representations and warranties provided by seller.(fn23) The costs may also be seen through strict restrictions placed on seller's obligations to indemnify buyer, either through more narrowly drafted obligations, higher deductibles, lower caps, or shorter survival periods.(fn24) Therefore, rather than a buyer purchasing the right to sandbag,(fn25) as is commonly argued, each buyer, even those who remain silent, bear a higher proportional total cost in acquiring seller from the start.(fn26)

Additionally, if a seller is unable to differentiate between buyers, the seller itself may fail to allocate its resources properly when diligently stipulating its representations and warranties to buyers who are feared to be potential sandbaggers.(fn27) A seller uses its representations and warranties as insurance to a buyer that what it is purchasing has value and is not a lemon. Communicating the value through representations and warranties is usually a cost-effective substitute to buyer over a costly due diligence period. Providing sound representations and warranties thus indirectly increases the purchase price and reduces buyer's pre-closing costs.(fn28) Without a pro-sandbagging default, sellers will place more emphasis on their representations and warranties to safeguard the...