Knowledge is not necessarily power: sandbagging in New York M&A transactions.

AuthorCole, Brandon
PositionMergers and acquisitions
  1. INTRODUCTION II. BACKGROUND A. Sandbagging Explained B. The Foundation of the Current Rule C. The CBS Rule Gets Clarified D. Putting It All Together: New York Sandbagging Law Today III. ANALYSIS A. The Arguments for Incorporating a Sandbagging Provision B. The Arguments for Incorporating an Anti-Sandbagging Provision C. When the Acquisition Agreement is Silent on Sandbagging or Anti-Sandbagging IV. RECOMMENDATION A. Recommendation for a Buyer B. Recommendation for a Seller C. Recommendation for New York Courts When the Acquisition Agreement is Silent on Sandbagging or Anti-Sandbagging 1. When Someone in the Buyer's Due Diligence Team Receives Actual Knowledge But Does Not Pass it Along 2. When Someone in the Buyer's Due Diligence Team Receives (Potentially) Constructive Knowledge But Does Not Realize the Misrepresentation and Thus Does Not Pass it Along V. CONCLUSION I. INTRODUCTION

    Sandbagging is a practice in the mergers and acquisitions (M&A) (1) context that involves "one party to an acquisition agreement (most often a buyer) seeking post-closing indemnification for breaches of representations and warranties, which breaches that party was aware of prior to signing the acquisition agreement or, in some cases, closing the transaction." (2) Buyers and sellers of businesses should be aware of this practice as it has implications for both of them. For buyers, it is a potential avenue for indemnification, and for sellers, it means a potential lawsuit. (3) Parties can directly approach this issue by incorporating sandbagging or anti-sandbagging provisions into the acquisition agreement. (4)

    However, if either party does not do so and the acquisition agreement is silent on sandbagging, the state law governing the acquisition agreement will determine the appropriate outcome. (5) The focus of this Note, the State of New York, has ambiguous sandbagging case law that has made it difficult to predict what the appropriate outcome would be for buyers and sellers of businesses. (6) Despite that ambiguity, this Note argues that the New York approach is preferable to other approaches--such as those seen in California and Delaware--because it is the most equitable to all parties.

    This Note will proceed as follows. Part II will begin with a background on sandbagging that includes a detailed discussion of what sandbagging is, sandbagging trends in the M&A community, and how various courts, with an emphasis on New York courts, approach sandbagging when an acquisition agreement is silent on the matter. Part III will give arguments on the reasons for incorporating a sandbagging or anti-sandbagging provision and it will discuss the various ambiguities under New York sandbagging law. Part IV will include sandbagging related recommendations for buyers and sellers in a transaction. It will also give recommendations for how New York courts, when the acquisition agreement is silent on sandbagging, can solve some of the current ambiguities that have arisen due to the relevant case law. Finally, the Note will conclude with Part V, which will give a brief summary of this Note.

  2. BACKGROUND

    This Part will first begin with a more detailed discussion of what sandbagging is--including examples of sandbagging provisions and anti-sandbagging provisions. This Part will then provide a brief discussion of sandbagging trends within the M&A community. It will then discuss how various jurisdictions approach sandbagging when the acquisition agreement is silent on the matter, with an emphasis on New York state law.

    1. Sandbagging Explained

      Sandbagging is a practice in the M&A context that involves "one party to an acquisition agreement (most often a buyer) seeking post-closing indemnification for breaches of representations and warranties, which breaches that party was aware of prior to signing the acquisition agreement or, in some cases, closing the transaction." (7) An example of a breach of representation and warranty could include an instance where a seller of a business does not accurately depict the profitability of its business to the buyer. (8) Sandbagging can include instances where the seller had knowledge of the breach and instances in which the seller had no knowledge of the breach prior to closing. (9) Parties can directly approach this issue by incorporating sandbagging or anti-sandbagging provisions into the acquisition agreement. (10) An example sandbagging provision may provide:

      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 this Agreement or the Closing Date, with respect to the accuracy or inaccuracy of, or compliance with, such representation warranty, covenant, or obligation. (11) On the other hand, an anti-sandbagging provision may provide: "[n]o 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." (12)

      However, trends suggest that acquisition agreements have become increasingly silent on the issue of sandbagging. (13) The most recent data released by the American Bar Association indicates that 56% of acquisition agreements are silent on the matter. (14) Because sandbagging provisions favor the buyer, while anti-sandbagging provisions benefit the seller, (15) one possible reason for this trend is that buyers and sellers agree to be silent as a compromise. (16) Figure 1 illustrates these trends from 2010 to 2014.

      (17)

      In situations where the acquisition agreement is silent on sandbagging, the state law governing the acquisition agreement will determine the appropriate outcome. (18) For instance, Delaware does not require a buyer to prove reliance on the truth of the representation in order to assert a breach of warranty claim (19) (thus the buyer can have knowledge of a breach of warranty prior to closing and still successfully sandbag the seller). In contrast, California requires "a buyer to demonstrate that it relied on the truth of the representation in order for it to bring a successful breach of warranty claim" (20) (thus if the buyer has knowledge of a breach of warranty prior to closing, they cannot successfully sandbag the seller).

      New York, which is often the governing law in acquisition agreements, takes an approach that is in between Delaware and California. (21) This has resulted in a more ambiguous rule as it relates to pre-closing knowledge and asserting a breach of warranty claim. This Note will focus specifically on New York sandbagging law. The next Section will discuss the line of cases that have led to how sandbagging is handled in the State of New York when an acquisition agreement is silent on the matter.

    2. The Foundation of the Current Rule

      CBS Inc. v. Ziff-Davis Publishing Co. (23) is responsible for establishing the general rule in New York, which requires a buyer to believe it is "'purchasing the promise as to the truth' of the relevant warranties." (24) In CBS, a buyer agreed to acquire a business based on the profitability information that the seller provided in addition to express warranties regarding the information's truthfulness. (25) The buyer, through its own research, came to believe the profitability information was not accurate. (26) The buyer and seller, despite the buyer bringing this discovery to the attention of the seller, agreed to continue with the deal and ultimately closed it ("with the mutual understanding that it would not in any way affect the previously asserted position of either party"). (27) The buyer subsequently brought suit for breach of warranty. (28)

      The court stated that the appropriate standard is whether the buyer believed it was purchasing the truthfulness of the seller's promise. (29) Thus, the court held the buyer could sue for breach of warranty. (30) They reasoned this by stating "the fact that the buyer has questioned the seller's ability to perform as promised should not relieve the seller of his obligations under the express warranties when he thereafter undertakes to render the promised performance." (31)

    3. The CBS Rule Gets Clarified

      The holding in CBS was clarified further by two additional cases. In Galli v. Metz, (32) the court stated that when the buyer and seller agree that certain warranties are inaccurate, the buyer is foreclosed from a breach of warranty claim. (33) The court noted that when a party knows that there is a breach of warranty, the source of that knowledge is relevant. (34)

      For instance, if a third party disclosed the breach of warranty, the buyer in Galli would have a strong argument under the CBS rule. (35) This distinction was later illustrated in Rogath v. Siebenmann. (36) Rogath stated that if the source of buyer knowledge is common knowledge or a third party disclosed the information to them--and the source is not the seller--the buyer may prevail in a breach of warranty claim. (37)

    4. Putting It All Together: New York Sandbagging Law Today

      Taking all of these cases together, a succinct reading of the New York sandbagging rule could state:

      [U]nless there is an effective pro-sandbagging clause in the M&A agreement, a purchaser's knowledge prior to closing of a breach of a representation, warranty or covenant contained in a M&A agreement will prevent that purchaser from seeking damages or indemnification post-closing IF the purchaser is aware of such breach as a result of the vendor's disclosure. (38) Like California, the New York approach requires a form of reliance as part of a breach of warranty claim. (39) However, this reliance is limited to the buyer believing "it was purchasing the truth of the warranty" and not actually believing in the warranty itself. (40) The...

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