Private Equity

Earlier this year, in Eagle Force Holdings LLC v. Campbell,^[1] the Delaware Supreme Court created a stir in some parts of the deal lawyer community as the result of a footnote that was otherwise irrelevant to its holding.  That footnote suggested that Delaware law was not as clear as many previously believed with respect to the question of whether a buyer must prove it relied upon a contractual warranty in order to recover for its breach.^[2]  Given Delaware’s strong contractarian bent, most deal lawyers tended to believe that Delaware would follow what is viewed as the majority rule and enforce contractual warranties without requiring proof of reliance.^[3]  But instead of confirming that view, the footnote simply “acknowledge[d] the debate,” recognized that the majority view “holds that traditional reliance is not required to recover for breach of an express warranty,” and concluded that Delaware “had not yet resolved this interesting question.”

Prior to the Eagle Force footnote, most acquisition agreements governed by Delaware law were silent on the issue of whether knowledge acquired by a buyer during the course of its due diligence could impact its ability to enforce the specific representations and warranties made by the seller.^[4]  Indeed, the selection of Delaware law was viewed by many buyers as avoiding the need for the inclusion of any specific clause addressing this issue.  This was so because Delaware’s claimed contractarianism was viewed as precluding any required tort-based reliance element in order to enforce an express, contractual representation and warranty.  In words that critics of this contractarian approach would use, Delaware was viewed as a “pro-sandbagging” state.^[5]  And, for the most part the debates about whether the acquisition agreement was to contain a so-called “pro-sandbagging” clause that would preclude the seller from avoiding the enforcement of an express warranty, by claiming that the buyer knew the warranty had been breached before signing or closing, were avoided.  But from time to time there were always a few sellers who would try and expressly make buyer’s purported prior knowledge of a breach a disqualifying event, which precluded the buyer’s ability to enforce its bargained-for representations and warranties from the seller, by including a so-called “anti-sandbagging” clause.

Following the Eagle Force footnote, there are now those that believe that by failing to include an express “pro-sandbagging,” or as proponents of the contractarian approach would say, “benefit of the bargain,” clause in your Delaware law governed acquisition agreements, buyers may well find themselves having to dispute what they knew and when in order to enforce the seller’s express contractual warranties; i.e., Delaware may well turn out to  be an “anti-sandbagging,” or a “non-benefit of the bargain,” state when it comes to enforcing contractual representations and warranties.  Because most Delaware law governed private equity acquisition agreements already include an express statement by the seller that acknowledges and agrees contractually that the buyer is in fact relying on the express, contractual representations and warranties made by the seller, and Delaware’s contractarianism has heretofore been generally reliable, the stated need to reignite the pro-versus anti-sandbagging clause debate may be overstated.  Nonetheless, understanding that debate and weighing the need for more express provisions may well be warranted.

Negotiating so-called “pro-sandbagging” clauses before silence became the preferred approach could many times involve protests of unfairness, if not outrage, by sellers; i.e., the same kind of protests and outrage by buyers that sometimes (unfairly) accompany the negotiations over non-reliance clauses and defined fraud carve-outs required by private equity sellers.^[6]  After all, “sandbagging” is a term used to describe a situation in which a person misrepresents their skills in order to take advantage of an unsuspecting opponent.  In golf, “[a] sandbagger will misrepresent his playing ability (claiming to be worse than he really is) in order to get more strokes than he deserves.”^[7]  Sandbagging in golf is also known as cheating and a sandbagger is considered a fraudster.  No one wants to be known as a sandbagger or be sandbagged.  Indeed, the term appears to have originally derived from a nineteenth century practice whereby street thugs would fill a sock with sand and then use the resulting sandbag as a weapon.  The sock may have looked innocuous, but it could cause substantial damage nonetheless.^[8]

In the context of private equity acquisition transactions, however, the term “sandbagging” has been used by some to refer to any situation in which a buyer bargains for a specific set of representations and warranties from the seller in the acquisition agreement, subject to the agreed-upon caps and baskets, and thereafter seeks to enforce that bargain notwithstanding that the seller claims that the buyer knew, at the time the acquisition agreement was signed (or at the time of closing), that one or more of  the seller’s representations and warranties were untrue.  In other words, sandbagging in the M&A world is the claimed existence of knowledge on the part of the buyer of an existing breach by the seller of one or more of the bargained for representations and warranties, prior to date the buyer completes its purchase.

But does a buyer with such purported knowledge in such a context really deserve to be assigned such a harsh moniker as “sandbagger?”  In most cases the answer is decidedly no.  In a 2007 article, aptly titled Debunking the Myth of the Sandbagging Buyer: When Sellers Ask Buyers to Agree to Anti-Sandbagging Clauses, Who Is Sandbagging Whom?, it was noted that:

While the phrase “to sandbag” evokes connotations of malfeasance and wrongful intent, the actual reasons the buyer decides to sign and/or close in these situations vary and do not always involve morally questionable behavior on the part of the buyer. Indeed, the discovered facts may be unclear as to whether a breach has really occurred, or even if the breach is clear, its materiality and the right of the buyer to treat the breach as an unfulfilled condition to closing may be unclear (e.g., if buyer must close unless an “Material Adverse Effect” occurred between signing and closing). The seller may in fact be or become aware of the same facts as the buyer prior to signing and/or closing. The seller may be indirectly “dumping” the “newly” discovered information on the buyer at a late date in an effort to avoid its bargained-for representations and warranties.  The seller may have previously indicated an unwillingness to agree to a purchase price adjustment, provide an express indemnification or concede that the buyer has the right to terminate the transaction for other similar purported breaches. Rather than being forced to choose between negotiating a price concession or terminating or attempting to terminate the deal in such circumstances, 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 seller.^[9]

It is undoubtedly true that a buyer cannot assert a tort-based claim of common law fraud (or negligent misrepresentation) against a seller based upon a representation that was made by the seller but which the buyer knew to be untrue at the time of the acquisition, because the prior knowledge of the buyer defeats any claimed reliance by the buyer upon the truth of the seller’s representation.  Reliance is a critical element of any claim based upon common law fraud (or negligent misrepresentation).  And that is why a well crafted disclaimer of reliance clause can be effective in defeating fraud claims based upon purported extra-contractual representations.^[10]  But does a buyer really have to prove that it specifically relied upon a bargained-for set of representations and warranties set forth in a fully negotiated acquisition agreement in order to enforce the seller’s agreed upon indemnification obligations?

In most states, which follow the modern rule that elevates contract obligations over tort-based theories regarding express contractual warranties, the answer is decidedly no.  Indeed, as a matter of general contract law, “[t]here is no requirement that a claimant prove that it specifically relied upon a specific promise made by the other party in entering into the contract; rather a claimant is entitled to enforce all of the promises made in the contract independently of any specific reliance on each particular promise made by the other party.”^[11]  But in some states, which follow a rule that developed before express warranties were a matter of contract law rather than a tort concept outside of contract principles, reliance is as much a required element for a contract claim based upon an express warranty as it is for a tort claim based upon a fraudulent or negligent misrepresentation.^[12]

Despite the Eagle Force footnote, it is hoped that Delaware has not become a state that conflates tort-based concepts with contract-based concepts, and thereby fails to follow its stated contractarian principles.  But for those concerned that the Eagle Force footnote has introduced some confusion, the following clause is reoffered, from the previously noted 2007 article, as an express contractual clause to remedy any contorted principles that otherwise may have crept into the otherwise solid contractarian principles that formed the reliable basis for Delaware jurisprudence:

No Waiver of Contractual Representations and Warranties.  Seller has agreed that Buyer’s rights to indemnification for the express representations and warranties set forth herein are part of the basis of the bargain contemplated by this Agreement; and Buyer’s rights to indemnification shall not be affected or waived by virtue of (and Buyer shall be deemed to have relied upon the express representations and warranties set forth herein notwithstanding) any knowledge on the part of Buyer of any untruth of any such representation or warranty of Seller expressly set forth in this Agreement, regardless of whether such knowledge was obtained through Buyer’s own investigation or through disclosure by Seller or another person, and regardless of whether such knowledge was obtained before or after the execution and delivery of this Agreement.^[13]

And the buyer’s request for such an express provision is perfectly justified, notwithstanding the typical protests by the seller.  To again quote from the previously noted 2007 article:

After all, the seller has bargained-for indemnification, with a generous deductible, a limited cap, and time limitations on survival, as the sole and exclusive remedy for any breach of representations or warranties made by the seller. The seller has further disclaimed, through an extensive “disclaimer of reliance” clause, any obligation with respect to any other representation or warranties, other than those specifically set forth in the agreement. The buyer, as a matter of contract, has accepted those limitations on its rights of recovery against the seller if there is a breach of any of the bargained-for representations and warranties set forth in the agreement and priced those bargained-for representations and warranties (as so limited) into the consideration it agreed to pay. If the seller does not wish to expose itself to the vagaries of extra-contractual claims based on what the seller might have known or might have told the buyer outside the four corners of the agreement, why should the buyer? Why does the buyer’s purported knowledge of the breach of any of the seller’s express, contractual representations and warranties eliminate even the limited remedies against the seller that were bargained for by the buyer?^[14]

And please don’t assume that your concerns about Delaware can be solved by choosing New York law instead.  New York has its own confusing cases regarding the effect of a buyer’s knowledge of prior breach on the enforceability of express contractual representations.^[15]