Catching the Sandbagger off the Green: Sandbagging in M&A

Torys Quarterly: Adapting to Change

What do golfers and sellers have in common? Both dislike sandbaggers.

You are preparing to close an acquisition. Your due diligence shows that one of the seller’s contractual representations about the target is untrue. If you decide to close the deal anyway, can you sue the seller after closing if you suffer a loss?

In M&A parlance, this is known as "sandbagging"—an issue that has now become a topic of open debate between buyers and sellers. The law on sandbagging is unsettled in Canada (and in other jurisdictions it will depend on their default rule under local law).

The issue is whether the buyer must prove it relied on the seller’s inaccurate representation (or “rep”) to enter into the deal. In practice, reliance may be difficult to establish: the buyer already knew the rep was untrue before signing. The buyer may also argue that the rep is a negotiated contractual term―not an inducement to enter into the contract―and therefore proof of reliance is irrelevant.

So how should parties address sandbagging in their contract?

If a buyer is concerned that there may be an issue with the accuracy of a seller’s rep, it may consider negotiating a pro-sandbagging clause in the purchase agreement. This clause will generally say that the buyer retains a right to indemnification regardless of its investigation or knowledge of any inaccuracy or non-compliance in respect of the seller’s rep prior to closing.

Conversely, an anti-sandbagging clause shifts the risk onto the buyer by restricting or eliminating its ability to bring a post-closing claim where the buyer had prior knowledge of the breach or inaccuracy. Defining the buyer’s “knowledge” in the agreement will be critical to negotiations.

Either way, while a pro- or anti-sandbagging clause may help allocate contractual risk between the parties, it will not necessarily determine the outcome if the matter is litigated in a Canadian court, given the lack of case law on the subject.

This is especially the case as Canadian contract law now recognizes a general organizing principle of good faith performance as well as a specific duty of honest performance—at the same time, the Supreme Court of Canada has also affirmed that freedom of contract should allow parties to contract for their own self interests.

How can rep and warranty insurance help?

Parties are increasingly turning their minds to rep and warranty insurance to protect against post-closing risks. However, this insurance usually does not cover known breaches like sandbagging. At best, the policy may be negotiated to limit the definition of “knowledge” to allow coverage in narrow circumstances.

Torys Quarterly Tips 2017

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