The law regarding sandbagging (which refers to a buyer that brings a claim for misrepresentation post-closing even though the buyer knew the representation was false before closing)[1] in Delaware seemed clear to many practitioners. Vice Chancellor Laster stated in a 2015 oral ruling that “Delaware is what is affectionately known as a ‘sandbagging’ state.”[2] In addition, then-Vice Chancellor Strine held that a buyer need not establish justifiable reliance in order to bring a breach of contract claim arising out of an acquisition agreement,[3] and given that the reliance element is what creates a problem for a buyer attempting to sandbag, this decision is often interpreted as a pro-sandbagging holding. Additionally, the 2017 ABA Deal Point study seems to confirm that practitioners have this view by finding that 51 percent of deals were silent on the point.[4] After all, many buyers reason that if Delaware is a pro-sandbagging state, why use negotiating capital to get a clause that is unnecessary?
However, this approach is dangerous after the May 24, 2018 Delaware Supreme Court’s decision in Eagle Force Holdings, LLC v. Stanley Campbell.[5] In a footnote, the majority opinion explained that there is a debate about whether a buyer can recover for a breach-of-warranty claim when the buyer knew at signing that the representation was not true. Although the majority observed that most states follow New York’s CBS Inc. v. Ziff-Davis Publishing Co.[6] (which held that traditional reliance is not required, and that the only “reliance” required is that the express warranty is part of the bargain of the parties), the majority did not decide this “interesting issue” because the claims were not before the court. Similarly, the dissent did not determine how this issue should be decided but emphasized Delaware’s anti-sandbagging jurisprudence.[7]
How Did Delaware Law Get Here?
To understand why the law is unclear on the sandbagging issue, it is helpful to discuss the path of the law. Early on, courts did not consider mere representations to be promises. Consequently, a buyer could not sue a seller for a breach of representation in a contract dispute because the representation was effectively not part of the contract. [8] To provide a buyer relief for being lied to, however, courts allowed the buyer to make a tort claim for misrepresentation, and one element of such a claim is reliance. Thus, under the traditional tort-based framework, a buyer must prove that it relied on the misrepresentation. Under the modern view, however, representations are actionable under contract law, and given that reliance is not part of contract law, the buyer need not show reliance.[9] It is this history of the importation of tort law to fill a gap in contract law (which gap, by the way, no longer exists) that has created uncertainty.
As a side note, this history of tort law and contract law is part of the reason acquisition agreements refer to “representations and warranties.” The representation refers to a tort concept and the warranty to a contract concept. As the debate about these near synonyms has been discussed in prior years in this publication, we will not relitigate the issue.[10]
Returning back to Delaware sandbagging case law, in the 1910s the Delaware Superior Court held that reliance was a necessary requirement of a breach-of-warranty claim.[11] This was reaffirmed in 2002.[12] However, in 2005, the Superior Court shifted and held that reliance was not an element of a claim for breach.[13] Shortly thereafter, the Chancery Court came out in favor of sandbagging in the often-cited Cobalt Operating, LLC v. James Crystal Enterprises case.[14] This is one of the cases mentioned in the introduction, but the Cobalt case might not be as strong as it first appears because the contract in Cobalt contained a clause that representations would not be affected by due diligence, and the court found that the Cobalt defendant intentionally obscured its fraud and gave misleading explanations when the plaintiff inquired about inconsistencies that arose in due diligence. These two facts can make it easy for a court to distinguish the case, and in fact, Delaware courts continued to have decisions that were inconsistent regarding sandbagging. The Delaware Supreme Court had not ruled on this issue[15]—that is, until the dicta comments in Eagle Force.
Conclusion
Although the majority and dissent in Eagle Force leave some clues as to how they might rule on the sandbagging issue, it is not productive to speculate about the outcome. Instead, buyers are best advised to include a pro-sandbagging clause (which is commonly referred to as a knowledge savings clause) in the purchase agreement. The following is an example of such a clause:
The post-Closing indemnification rights of the parties pursuant to Article [●] (Indemnification) shall not be affected by any waiver of condition set forth in Article [●] (Conditions to Closing) or any knowledge, obtained from any source at or before the execution hereof or at or before the Closing, of any breach of representation, warranty, covenant or agreement, and the parties shall be deemed to have reasonably relied upon the representation, warranty, covenant and agreement notwithstanding such knowledge.
Eagle Force has put buyers on notice that they might need to update their approach to sandbagging. To be silent is to leave the matter ambiguous.
This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content herein does not reflect the views of Sidley Austin LLP.
[1] The term “sandbagging” dates back to the 19th century when street gangs would craft a homemade weapon by pouring sand into socks. Although the sock looked innocuous enough, when swung at an enemy, the concealed lump of sand could inflict substantial damage. The term has evolved to represent concealing or misrepresenting with the purpose of deceiving another. See Glenn West & Kim Shah, Debunking the Myth of the Sandbagging Buyer, M&A Lawyer, Jan. 2007, at 3.
[2] See NASDI Holdings v. North Am. Leasing, No. 10540-VCL, slip op. at 57 (Del. Ch. Oct. 23, 2015).
[3] See Cobalt Operating, LLC v. James Crystal Enters., LLC, 2007 WL 2142926, at *28 (Del. Ch. July 20, 2007), aff'd without op., 945 A.2d 594 (Del. 2008).
[4] See ABA M&A Mkt. Trends Subcomm., Private Target Mergers & Acquisitions Deal Points Study 66 (Jessica C. Pearlman ed., 2017).
[5] See Eagle Force Holdings, LLC v. Campbell, C.A. No. 10803-VCMR at 47, n.185 (Del. May 24, 2018).
[6] See CBS Inc. v. Ziff-Davis Publ’g Co., 553 N.E.2d 997 (N.Y. 1990). It is interesting that the majority opinion did not did not discuss the subsequent case law that has significantly narrowed Ziff-Davis’s impact.
[7] See Eagle Force, No. 10803-VCMR at 10 (Strine, J. & Vaughn, J., dissenting) (“[T]o the extent Kay is seeking damages because Campbell supposedly made promises that were false, there is doubt that he can turn around and sue because what he knew to be false remained so. Venerable Delaware law casts doubt on Kay’s ability to do so . . . .”).
[8] See West & Shah, supra note 2, at 4–5.
[9] See Charles K. Whitehead, Sandbagging: Default Rules and Acquisition Agreements, Del. J. Corp. L. 1081, 1084–86.
[10] See Kenneth A. Adams, A lesson in drafting contracts: What’s up with “representations and warranties”?, Bus. L. Today, Nov.-Dec. 2005; Tina L. Stark, Nonbinding Opinion: Another view on reps and warranties, Bus. L. Today, Jan.–Feb. 2006. Interestingly, the footnote in the majority opinion in Eagle Force cites to Professor Stark’s article (but for a different proposition).
[11] See Clough v. Cook, 87 A. 1017, 1018 (Del. Ch. 1913); Loper v. Lingo, 97 A. 585, 586 (Del. Super. Ct. 1916). The dissent in Eagle Force cited the Clough case for the proposition that a party who signs a contract with knowledge that a representation is false may not later claim reliance on it. See Eagle Force, No. 10803-VCMR at 10 n.39 (Strine, J. & Vaughn, J., dissenting).
[12] See Kelly v. McKesson HBOC, Inc., 2002 WL 88939, at *8 (Del. Super. Ct. Jan. 17, 2002) (“According to sound Delaware law, a plaintiff must establish reliance as a prerequisite for a breach of warranty claim.”).
[13] See Interim Healthcare, Inc. v. Spherion Corp., 884 A.2d 513, 548 (Del. Super. Ct. 2005). The court also noted that “the extent or quality of plaintiffs’ due diligence is not relevant to the determination of whether [defendant] breached its representations and warranties in the Agreement. . . . [P]laintiffs were entitled to rely upon the accuracy of the representation irregardless [sic] of what their due diligence may have or should have revealed.” Id.
[14] See Cobalt Operating, LLC v. James Crystal Enters., LLC, 2007 WL 2142926, at *28 (Del. Ch. July 20, 2007), aff'd without op., 945 A.2d 594 (Del. 2008).
[15] The Delaware Supreme Court did affirm Cobalt, but it did so without a written opinion. James Crystal Enters. v. Cobalt Operating, LLC, 945 A.2d 594 (Del. 2008).