Is Knowledge a Defence To Breach in M&A Transactions?

AN INTRODUCTION TO SANDBAGGING PROTECTIONS

Sandbagging, a term borrowed from golf, is used in M&A parlance when a buyer seeks indemnity on a breach of a representation or warranty, in cases where the breach was known to the buyer, prior to closing the transaction. 

What happens when a buyer is aware of a breach of representation or warranty and chooses to stay silent, only to raise an indemnity claim post the closing? Would silence amount to waiver of the breach on the part of the buyer? 

On the contrary, if silence of the buyer is treated as a waiver of the breach, then can the seller take advantage of the buyer by dumping diligence documents, and later claim that the buyer had knowledge by means of discovery? 

It is not uncommon to see transaction counsels spending unusual amounts of time negotiating a sandbagging or an anti-sandbagging clause. 

A sandbagging clause is typically inserted to protect the buyer from any prior actions of the sellers or the target company, irrespective of any pre-existing knowledge of the buyer in relation to these actions. Conversely, an anti-sandbagging clause is considered necessary to avoid there being any undue advantage to the buyer, in cases where the buyer in fact, has the knowledge of the breach of the representation or warranty in question.

SANDBAGGING & ANTI-SANDBAGGING CLAUSES

Simply put, a sandbagging provision allows a buyer to seek indemnity from the seller, after the closing of a transaction, despite the buyer being aware or having knowledge of a breach. A typical sandbagging clause would read as follows:

“The right to indemnification, payment, reimbursement, or other remedy for breach of a representation or warranty will not be affected or diluted by any investigation conducted or knowledge acquired at any time, whether before or after execution and delivery of this agreement.”

An anti-sandbagging clause, on the other hand, would restrict indemnity claims on matters that the buyer had knowledge regarding, prior to signing or closing the transaction. Since it can be difficult to prove whether someone did or did not have knowledge, the term “knowledge” is defined to include both actual and constructive knowledge.  A typical anti-sandbagging clause would read as follows:

“The Seller shall not be liable for any losses arising from breach of any representation or warranty of the Seller if the Buyer had knowledge of such inaccuracy or breach prior to Closing.”

The M&A market in India has largely been a buyer’s market and therefore it is more common to see sandbagging protections – since these clauses allow the buyer to claim indemnity notwithstanding their prior knowledge of any breach – rather than seller friendly anti-sandbagging provisions. 

It is however not unusual to see anti-sandbagging provisions in agreements which are managed through a competitive bidding process, i.e. where the seller has considerable influence over negotiating the terms and conditions. 

COURTS ON SANDBAGGING

Jurisprudence on sandbagging clauses in M&A or investment transactions is few and far between, in the Indian context. 

The Bombay High Court has for example, in GWL Properties Ltd. vs. James Mackintosh and Company Private Limited[1], upheld the arbitral award against the seller-petitioner for misrepresentations made by them, in the share purchase agreement. The Court observed that reliance by the respondent-buyer on representations or warranties in a definitive agreement cannot be diluted by the fact that a diligence was conducted by them, prior to the agreement. The petitioner-seller in this case, contended that the respondent (buyer) had conducted a detailed due diligence and had enough evidence to discover the truth and existence of the claim before closing. 

In the US, a buyer would find it very difficult to claim a breach of representation and warranty where it had prior knowledge. It is common to see sandbagging clauses in US agreements to ensure that buyers have this protection. It is not so different in the UK. In the case of Infiniteland Ltd v Artisan Contracting Ltd[2], the Court of Appeals held that there was no breach of warranty in relation to faulty financial record-keeping, since the appellant’s accountant could have determined that the accounts were misleading and that such knowledge was actual knowledge (and not constructive knowledge). Here, the court ruled in favour of the seller-respondent, stating that that the disclosure schedule provided enough documents and material to the accountant engaged by the appellant to carry out due diligence in advance of the proposed purchase. 

CONCLUSION

The importance of drafting a well-negotiated sandbagging (or an anti-sandbagging) clause cannot be undermined. This is because the inclusion of this clause can often determine the outcome of a dispute relating to the breach of representations or warranties made, in relation to the transaction.

For any queries, please reach out to Praveen Raju

[1]MANU/MH/2781/2012

[2]Court of Appeal (Civil Division) – [2005] EWCA Civ 791 – 23 June 2005