IN BRIEF
- Can a broad pro-sandbagging provision be applied to avoid the “reasonable reliance” element of a fraud claim?
- There are arguments on both the buyer’s and seller’s sides.
- If the buyer insists on such a provision, the seller should seek to draft the provision as narrowly as possible.
A “pro-sandbagging” clause is a provision in an acquisition agreement in which the seller of a company agrees that the buyer’s knowledge prior to the closing will not affect the buyer’s ability to bring a claim against the seller after the closing.[1] Typically, the pro-sandbagging clause is limited to the buyer’s potential indemnification claim if any of the contractual representations and warranties are inaccurate.[2] For example, a pro-sandbagging clause might read:
Buyer’s right to indemnification for any representations, warranties, or covenants within this acquisition agreement shall not be affected by any inspection, investigation, or knowledge acquired by Buyer (or that could have been acquired by Buyer).[3]
In cases where, prior to closing, the buyer has actual or constructive knowledge that a representation or warranty is inaccurate, this clause allows the buyer to complete the acquisition and then seek indemnification for the inaccurate representation or warranty after the closing (thereby “sandbagging” the seller).[4]
In some cases, however, the pro-sandbagging clause may be broader and not limited solely to an indemnification claim or the contractual representations and warranties. For example, the clause might read:
Buyer’s rights and remedies related to any representations, warranties, or covenants made by the Seller or the Acquisition Company shall not be affected by any inspection, investigation, or knowledge acquired by Buyer (or that could have been acquired by Buyer).
On its face, this provision includes all rights and remedies related to any representations made by the sellers or the acquisition company (including extra-contractual representations).[5] As a result, a buyer may attempt to apply this provision when bringing a fraud claim related to representations made by the seller or the acquisition company, including representations made outside of the contract. This article analyzes whether such a broad pro-sandbagging provision could allow a buyer to bring a post-closing fraud claim where, prior to the closing, the buyer had actual or constructive knowledge that the representation was actually or potentially false. In other words, can a pro-sandbagging clause negate an essential element of a fraud claim (i.e., reasonable reliance)?
I. Why Would a Buyer Want to Apply a Pro-Sandbagging Clause to a Fraud Claim?
The application of a pro-sandbagging clause typically arises in the context of a contractual indemnification claim. Still, there are two important situations where a buyer might attempt to apply a broad pro-sandbagging clause to a fraud claim. One situation is where a buyer is trying to avoid a contractual limitation on the amount of damages that it can recover for an indemnification claim. The other situation is where the buyer seeks damages based on extra-contractual representations by the seller.
First, many acquisition agreements include limitations on the sellers’ potential liability for indemnification claims. The seller will often agree to indemnify the buyer for losses caused by inaccurate representations and warranties, but only up to a certain capped amount.[6] In these situations, a buyer would not be able to recover damages greater than the capped amount under an indemnification claim. Notwithstanding these provisions, some states (including Delaware) hold that parties cannot contractually limit the seller’s liability for fraud.[7] These states reason that immunizing fraud is so against public policy that the court will ignore the parties’ contractual limitation on liability for a valid fraud claim.[8] Thus, a buyer may prefer to pursue a fraud claim over (or in addition to) an indemnification claim to avoid a contractual limitations cap on the damages that the buyer can recover. In such a situation, the buyer’s fraud claims would be significantly stronger if it could apply a pro-sandbagging clause to avoid any dispute about what, if any, knowledge the buyer acquired (or could have acquired) during the due diligence process.
Second, a buyer may want to pursue a fraud claim when the allegedly false statement is not included among the contractual representations and warranties in the acquisition agreement. Such extra-contractual statements may be actionable, provided that the acquisition agreement does not include an integration and/or a “nonreliance” provision.[9] Again, the buyer’s fraud claim is stronger if it can apply a pro-sandbagging clause to avoid any argument regarding the buyer’s actual or constructive knowledge regarding the accuracy of the seller’s extra-contractual representation.
II. The Common Law Regarding Sandbagging
Before considering the potential application of a pro-sandbagging provision to a fraud claim, it is important to understand different jurisdictions’ default law regarding “sandbagging” in contractual indemnification claims and the rationale for the common law.
A. The Modern Rule
Even absent an explicit pro-sandbagging provision, many jurisdictions follow the “modern rule,” which permits a buyer to bring an indemnification claim for inaccurate representations and warranties, regardless of the buyer’s knowledge of the inaccuracies prior to the closing. These courts hold that the representations and warranties are negotiated contractual obligations upon which the buyer had the right to rely.[11] The buyer is deemed to have purchased the seller’s promise that the company will meet the representations and warranties, and the seller may not avoid that promise just because the buyer has doubts (or even actual or constructive knowledge) regarding the accuracy or inaccuracy of the representations.[12] Indeed, where the buyer has reason to doubt the accuracy of the representation, the seller’s promise may be the most important.[13] The buyer wants to be certain that if the representation or warranty is not accurate, then the seller will bear any related losses, not the buyer. Among the states following the modern rule are Delaware, New York, Illinois, Florida, Connecticut, and Indiana.[14]
B. The Traditional Rule
Other states still follow the “traditional rule,” which is grounded in tort rather than contract law principles.[15] Under the traditional rule, a buyer must prove reliance on the representation or warranty as an element of the indemnification claim.[16] In these states, the contractual indemnification claims are similar to fraud claims, with reasonable reliance being a necessary element. The leading states that require a plaintiff prove reliance for a contractual indemnification claim include California, Kansas, Minnesota, and Texas.[17]
III. The Potential Application of a Pro-Sandbagging Provision on a Fraud Claim
In nearly every state, in order to prove a fraud claim, the buyer must show that it “reasonably relied” on the alleged fraudulent representation.[18] Under normal circumstances, a plaintiff cannot reasonably rely on a misstatement if the plaintiff knew that the statement was false.[19] Indeed, in some jurisdictions, a plaintiff cannot prove reasonable reliance if it merely had reason to doubt the representation.[20] Thus, the question will be whether a pro-sandbagging clause can negate the reasonable reliance element of a fraud claim.
A. The Seller’s Argument
A seller defending a fraud claim will likely argue that the buyer did not reasonably rely on the alleged representation because the buyer acquired knowledge during due diligence which caused (or should have caused) the buyer to doubt the alleged representation.[21] The seller will argue that a buyer cannot “reasonably rely” on a representation if the buyer discovered contradictory information during the due diligence process.[22] The seller will claim it would be “unreasonable” for the buyer to rely on a representation that the buyer’s own due diligence gave it reason to doubt. The seller also may argue that the buyer has no “right to rely” on information that it should have discovered as part of its due diligence.[24]
Where the acquisition agreement contains a broad pro-sandbagging clause, the seller may still argue that the buyer’s actions undermine any allegation that the buyer actually relied on the representation. The seller may argue that if the buyer were truly relying on a representation that the buyer had reason to question, the buyer would have negotiated an express representation or warranty into the contract.[25] The seller will likely argue that the buyer would not leave a representation on which it was truly relying outside of the contract, especially where the buyer had reason to believe that the representation might not be accurate.[26] If the buyer really were relying on the information—and not just trying to “trick” the seller—the buyer would have negotiated a contractual representation and warranty; it would not have risked the enforcement of the representation by relying solely on a broad pro-sandbagging clause.
B. The Buyer’s Argument
The buyer, on the other hand, will argue that its knowledge is not relevant to its fraud claim because of the broad pro-sandbagging clause. Indeed, the buyer may argue that the pro-sandbagging provision is exactly why it relied on the seller’s representations. In other words, notwithstanding the information it uncovered during due diligence, the buyer believed it could reasonably rely on the seller’s representations precisely because it had a broad pro-sandbagging provision in the acquisition agreement to protect it.
One case that the buyer may cite in support of its argument is Cobalt Operating, LLC v. James Crystal Enters.[27] In Cobalt, the buyer brought fraud and breach of contract claims against the seller for providing false financial information. The seller argued that the buyer could not prove that the buyer reasonably relied upon the false representations because the buyer’s due diligence uncovered the same information. The Cobalt court rejected the seller’s argument and held that the buyer satisfied its burden to show justifiable reliance for a fraud claim, in part, based on certain contractual provisions (including a pro-sandbagging clause) that promised the buyer could rely on the seller’s representations.[28]
First, the court held that the buyer could rely on the seller’s representations to support its fraud claim because the acquisition agreement contained an express and unqualified representation regarding the material accuracy of the acquisition company’s financial statements and its compliance with the law.[29] The court held that this contractual representation also supported the buyer’s justifiable reliance for its fraud claim.[30]
Second, Cobalt cited the contract’s pro-sandbagging provision, which stated, “no inspection or investigation made by or on behalf of [buyer] or [buyer’s] failure to make any inspection or investigation shall affect [the seller’s] representations, warranties, and covenants hereunder or be deemed to constitute a waiver of any of those representations, warranties, or covenants.”[31] Although, this pro-sandbagging provision covered only representations within the acquisition agreement, the court held that “[h]aving contractually promised [the buyer] that it could rely on certain representations, [the seller] is in no position to content that [the buyer] was unreasonable in relying on [the seller’s] own biding words.”[32]
Although the court did not explicitly address the effect of the pro-sandbagging clause on the buyer’s fraud claim, a buyer will likely cite Cobalt as holding that a contractual provision (i.e., the representation regarding material accuracy of the financial statement) can support the reasonable reliance element of a fraud claim. A buyer will similarly argue that it reasonably relied on the contractual pro-sandbagging provision when it accepted the seller’s extracontractual statements.[33]
In addition to Cobalt, a buyer may point to California law and the “traditional” common law rule as evidence that a broad pro-sandbagging provision can negate the “reasonable reliance” element of a fraud claim. As discussed above, a buyer cannot under California common law bring a claim for breach of an express warranty if the buyer had knowledge that the representation was false.[34] The buyer must show that it reasonably relied on the representation (even an express representation in contract).[35] In this way, an indemnification claim in California is the same as a fraud claim in other states; the buyer must prove reliance as an element of both claims.
Notwithstanding this general rule, California courts have held that a contractually negotiated pro-sandbagging provision can override the “reasonable reliance” element for an indemnification claim. In Telephia, Inc. v. Cuppy, the court cited the language of two pro-sandbagging provisions in an asset purchase agreement. [36] One of these provisions stated: “[n]o investigation made by or on behalf of the [buyer] with respect to the [acquisition company or its shareholders] shall be deemed to affect the [buyer’s] reliance on the representations, warranties, covenants, and agreements made by [the acquisition company].”[37] Telephia held that this provision was clear; the seller must be held accountable to the warranties in the acquisition agreement regardless of the buyer’s reliance on those warranties.[38] Based on Telephia, a buyer might argue that a similar pro-sandbagging provision also could override the “reasonable reliance” element for a fraud claim, just like it overrode California’s reliance requirement for an indemnification claim.
IV. Conclusion
As discussed herein, there are arguments on both the buyer’s and seller’s sides regarding whether a broad pro-sandbagging provision can be applied to avoid the “reasonable reliance” element of a fraud claim. Thus, to the extent that a buyer insists on negotiating a pro-sandbagging provision in an acquisition agreement, the seller should seek to draft the provision as narrowly as possible. To avoid these issues, a seller should include explicit language (i) limiting the pro-sandbagging clause solely to indemnification provisions and contractual representations and warranties, and (ii) excluding its application to any fraud claims and/or extracontractual representations.
[1] See Aleksandra Miziolek & Dimitrios Angelakos, SANDBAGGING, From Poker to the World of Mergers and Acquisitions, 92 Mich. B.J. 30 (June 2013).
[2] See id. (“A pro-sandbagging provision renders a buyer’s pre-closing knowledge of a breach of a seller’s warranty . . . irrelevant to its claims for indemnification for such breach.”).
[3] Other examples of such provisions include:
[N]o inspection or investigation made by or on behalf of [Buyer] or [Buyer’s] failure to make any inspection or investigation shall affect [Seller’s] representations, warranties, and covenants hereunder or be deemed to constitute a waiver of any of those representations, warranties, or covenants.
Cobalt Operating, LLC v. James Crystal Enters., 2007 WL 2142926, at *28 (Del. Ch. April 25, 2007) (citing section 9.2 of the relevant asset purchase agreement);
No information or knowledge obtained in any investigation . . . shall affect or be deemed to modify any representation or warranty contained in this Agreement. . . .
Telephia, Inc. v. Cuppy, 411 F. Supp. 2d 1178, 1188 (N.D. Ca. 2006) (citing section 6.1 of the relevant stock purchase agreement);
No investigation made by or on behalf of the [Buyer] with respect to the [Acquisition Company or its Shareholders] shall be deemed to affect the [Buyer’s] reliance on the representations, warranties, covenants, and agreements made by [the Acquisition Company].
Id. (citing section 10.1 of the relevant stock purchase agreement); and
Every . . . warranty . . . set forth in this Agreement and . . . the rights and remedies . . . for any one or more breaches of this Agreement by Sellers shall . . . not be deemed waived by the Closing and shall be effective regardless of any . . . prior knowledge by or on the part of the Purchaser.
Pegasus Mgmt. Co. v. Lyssa, Inc., 995 F. Supp. 29, 38 (D. Ma. 1998) (citing Section 9.1 of the relevant asset purchase agreement).
[4] See Miziolek & Angelakos, supra note 1, at 30 (“under certain circumstances, a buyer who has knowledge of the inaccuracy of a seller’s warranty may decide that it is more advantageous to sandbag the seller and try to recover on a breach of warranty claim after the closing of the transaction.”); Glenn D. West & Kim M. Shah, Debunking the Myth of the Sandbagging Buyer: When Sellers Ask Buyers to Agree to Anti-Sandbagging Clauses, Who Is Sandbagging Whom?, 11 The M&A Law. 3 (Jan. 2007) (“Rather than being forced to choose between negotiating a price concession or terminating or attempting to terminate the deal . . .the buyer may simply wish to enforce the benefit of the bargain it made by choosing to close the transaction and seek indemnification based upon the specific, contractual representations and warranties it negotiated with the sellers.”); see also Luke P. Iovine III, Sandbagging in M&A Deals: Silence May Not Be Golden, 16 The M&A Law. 10 (Nov/Dec 2012); Charles K. Whitehead, Sandbagging: Default Rules and Acquisition Agreements, 36 Del. J. Corp. L. 1081, 1082–83 (2011).
[5] Even the ABA’s model pro-sandbagging provision could be interpreted to include (i) fraud claims and (ii) extra-contractual representations, and may not be limited solely to contractual indemnification claims. The ABA’s model provision provides:
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 (including any environmental investigation or assessment) 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.
See Whitehead, supra note 4, at 1087, n.19 (citing ABA Mergers & Acquisitions Comm., Model Stock Purchase Agreement with Commentary 299 (2d ed. 2010) (emphasis added); see also Miziolek & Angelakos, supra note 1, at 30 (citing same).
[6] West & Shah, supra note 4, at 3.
[7] See, e.g., Abry Partners V, L.P. v. F&W Acquisition LLC, 891 A.2d 1032, 1064 (Ch. Del. 2006) (holding that exclusive remedy and limitation-on-liability provisions in a stock purchase agreement could not limit the seller’s exposure for claims of fraud under Delaware public policy).
[9] See, e.g., id. at 1059 (holding that in order to bar a fraud claim for extra-contractual statement, an integration clause must contain language that shows a clear anti-reliance clause by which the plaintiff has contractually promised that it did not rely upon statements outside of the contract’s four corners in deciding to sign the contract); IAC Search, LLC v. Conversant LLC, 2016 WL 6995363, at *6 (Del. Ch. Nov. 30, 2016) (holding that there are no magic words to disclaim reliance, but that an anti-reliance clause must come from the point of view of the buyer asserting fraud and cannot be simply an assentation by the seller of what it was and was not representing and warranting); West & Shah, supra note 4, at 3–4.
[10] See, e.g., Charles K. Whitehead, Sandbagging: Default Rules and Acquisition Agreements, 36 Del. J. Corp. L. 1081, 1084–85, Appendix A, 1108–14 (2011); Brandon Cole, 42 J. Corp. L. 445, 448–49.
[11] See CBS, Inc. v. Ziff-Davis Publ’g Co., 553 N.E.2d 997, 1000–01 (N.Y. 1990) (“The critical question is not whether the buyer believed the truth of the warranted information . . . but whether it believed it was purchasing the seller’s promise as to the truth.”).
[12] Id. at 1001 (“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.”).
[13] See Universal Enterprise Group, L.P. et al. v. Duncan Petroleum Corp. et al., 2013 WL 3353743, at *15 (Del. Ch. July 1, 2013) (noting that after the buyer discovered evidence that caused it to question some of the seller’s representations, the buyer renegotiated the acquisition agreement to expressly allocate the risk to the seller).
[14] See Whitehead, supra note 10, at 1108–14, Appendix A, 1108–14; Cole, supra note 10, at 449.
[15] See Whitehead, supra note 10, at 1084, Appendix A, 1114–15.
[18] See, e.g., 37 Am. Jur. 2d Fraud & Deceit § 231 (2d ed. Nov. 2017); Law of Fraudulent Transactions § 2:3 (Aug. 2017).
[19] 37 Am. Jur. 2d Fraud & Deceit § 231.
[21] The strength of the seller’s defense also may turn on what information the buyer allegedly discovered during due diligence and exactly how it relates to the alleged fraudulent representation. See Ainger v. Michigan Gen. Corp., 476 F. Supp. 1209, 1229 (S.D.N.Y. 1979) (holding that the buyer could bring a fraud claim against the seller, even though the buyer was informed prior to closing that the acquisition company did not did not have a contract vesting it with ownership in a book series, because the seller actively prevented the buyer from discovering that the author had affirmatively asserted a claim to book series).
[22] See Universal Enterprise Group, 2013 WL 3353743, at *15 (dismissing a buyer’s fraud claim because the buyer discovered evidence during due diligence that called into question the allegedly fraudulent representation); see also 37 Am. Jur. 2d Fraud & Deceit § 231 (“Reliance cannot be deemed reasonable for purposes of a claim for fraud . . . when minimal investigation would have revealed the truth, or when the plaintiff closes its eyes and passively accepts the contradictions that exist in the information available to it.”).
[23] Id. at 14 (“a party who gains actual knowledge of the falsity of a representation, structures a contract to address the risk of loss associated with the false representation, and proceeds to closing cannot claim justifiable reliance.”); see also 37 Am. Jur. 2d Fraud & Deceit § 231 (“In some jurisdictions, if a fraud plaintiff even has reasons to doubt the truth of a representation, reliance is not reasonable.”).
[24] See Doral Money, Inc. v. HNC Prop., LLC, 2014 WL 5791574, at *7 (D. Or. Nov. 6, 2014) (holding that the buyer failed to prove the “right-to-rely” element of a fraud counterclaim because the buyer “cannot fail to conduct due diligence before entering into an arm’s-length business transaction and then bring a claim for fraud against the other party to the transaction for allegedly misrepresenting facts that the sophisticated business could and should have discovered on its own.”); MAFG Art Fund, LLC v. Gagosian, 123 A.D.3d 458, 459 (N.Y. App. Div. 2014) (holding that, as a matter of law, a sophisticated buyer cannot demonstrate reasonable reliance when they conduct no due diligence); see also 37 Am. Jur. 2d Fraud & Deceit § 231 (“Reliance cannot be deemed reasonable for purposes of a claim for fraud . . . when minimal investigation would have revealed the truth . . . .”).
[25] See Universal Enterprise Group, 2013 WL 3353743, at *15 (recognizing that the buyer treated the seller’s alleged fraudulent representation with “healthy skepticism” and went forward with the acquisition only after renegotiating the contract to expressly allocate the risk to the seller that the representation was false).
[26] For contractual representations and warranties, the seller may argue that a fraud claim cannot be based entirely on a breach of the terms of a contract. In re Bracket Holding Corp. Lit., 2017 WL 3283169, at *8 (Del. Super. Ct. July 31, 2017) (“Under Delaware law, a plaintiff may claim fraud ‘based on representations found in a contract,’ but ‘where an action is based entirely on a breach of the terms of a contract between the parties, and not on a violation of an independent duty imposed by law, a plaintiff must sue in contract and not in tort.’” (quoting ITW Glob. Invs. Inc. v. Am. Indus. P’rs Capital Fund IV, L.P., 2015 WL 390908, at *6 (Del. Super. Ct. June 24, 2015).).
[30] Id. The court distinguished Homan v. Turoczy, 2005 WL 2000756 (Del. Ch. 2005), which held that a buyer could not establish justifiable reliance necessary to recover for fraud or equitable fraud where the buyer proceeded to closing in a commercially unreasonable manner, failed to conduct any meaningful due diligence, and signed an express anti-reliance clause stating that he was not relying on the statements that he later claimed to be false.
[33] The seller may argue that Cobalt is distinguishable because the allegedly fraudulent representation was an express and unqualified representation within the acquisition agreement (i.e., the representation regarding the material accuracy of the acquisition company’s financial statements and its compliance with the law) and not an extracontractual statement.
[34] See, e.g., Kazerouni v. De Satnick, 228 Cal. App. 871, 872–73 (Cal. App. 1991).
[36] See Telephia, Inc. v. Cuppy, 411 F. Supp. 2d at 1188 (holding that the buyer was not required to prove reliance on written warranties based on the pro-sandbagging provision in the parties’ acquisition agreement).
[37] Id. (citing section 10.2 of the stock purchase agreement).
[38] Id. (“Although the defendants argue that it would be ‘condoning a fraud’ to allow [the buyer] to enforce warranties that it knew to be false, the Court finds it no stranger a result than to interpret the [acquisition agreement] in a manner that results in [the buyer] having insisted on a toothless provision.”)