Highlight: Understand how to spot a “sandbag clause” in your purchase and sale agreement and when to add specific anti-sandbag language to the agreement to make it more seller friendly.

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Hindsight is 20/20 but for the seller of a business it could be a very costly lesson learned. By the time a seller realizes the purchase and sale agreement has a flaw in it, the seller has already paid the price and it is likely too late. An example of a potential flaw in such an agreement that could cost a seller after closing is the inclusion of a “sandbag” clause. An experienced M&A lawyer will be able to spot specific sandbag language in your agreement and address it for you.

The negotiation of an agreement for the purchase and sale of a business is much more complicated than most business owners, and even some lawyers, believe it to be. Essential to every purchase and sale agreement is a section dealing with the representations and warranties of the seller, which is generally the longest section of the agreement. It is also the section where the seller’s exposure to liability is the greatest because if this section is not drafted or qualified properly, then the purchaser could use this as the basis of an indemnity claim against the seller.

Sellers sometimes take the drafting of their representations and warranties in an agreement lightly for a number of reasons, including:

• they are motivated to sell and are anxious to close;
• they may have already disclosed a number of risks to the purchaser throughout the course of negotiations; and
• they have assumed in good faith that if the purchaser has already been informed of the risks, then the seller doesn’t need to go through the efforts of qualifying their representations and warranties in the agreement to account for them.

This assumption is incorrect and could result in the seller being sandbagged by the purchaser after the deal has closed.

 What is Sandbagging?

Sandbagging is the act of understating one’s position or concealing the strength of one’s position to place one party in a better position than another. It can be applied in a number of ways in an M&A context but is predominantly applied where the purchaser is aware of inaccuracies or breaches of a seller’s representations, warranties or covenants prior to closing but goes ahead with the closing anyway. This is all done by the purchaser with the intention of using these inaccurate facts as the basis of an indemnity claim against the seller after closing.

Why Does Sandbagging Occur?

Different circumstances will lead to a seller getting sandbagged. It is typical in an M&A transaction for purchasers to conduct thorough due diligence and the seller to make comprehensive disclosures to the purchaser including uploading a tremendous amount of sensitive information and materials into a data room which is shared with the purchaser and its M&A advisors. We need to understand that sellers are often the shareholders of the company being sold and are not in every case the management of the day to day operations of the company – this results in the sellers not always knowing all of the issues pertaining to the business. Because of this, it is common for a purchaser through the course of its due diligence to uncover issues that the seller isn’t even aware of. This is the perfect opportunity to sandbag the seller!

In addition, the sale of a business is a complicated process for the seller for a number of reasons:

• the seller is expected to convey the business to the purchaser with the most accurate of information as possible – this is the information that is being relied upon by the purchaser in determining the purchase price of the business and often induces the purchaser into buying the business. This information is generally enumerated in the seller’s representations and warranties section of the purchase and sale agreement. If a seller makes an error or omission in this section, then the seller stands to be at the receiving end of an indemnity or breach of contract claim after the deal has closed; and
• in most jurisdictions, the purchaser’s lawyer prepares the first draft of the agreement. Assuming the purchaser’s lawyer is an experienced M&A lawyer, this agreement will always be drafted in favour of the purchaser, which by default puts the seller at a drafting disadvantage.

The above two factors amount to the perfect recipe for the insertion of what is commonly known as the “sandbag clause”, which is a clause inserted into an agreement by the purchaser’s lawyer. This clause gives the purchaser the right to make an indemnity claim after closing for an inaccurate fact that the purchaser knew was false when signing the agreement, despite not saying anything to the seller about it prior to closing.

 How can you reduce your risks of being sandbagged?

Your lawyer should be able to spot specific sandbag language in your agreement and address it for you. The final language settled upon between the purchaser and the seller is often the subject of great negotiation and it often comes down to a question of risk allocation between the two parties and who has more bargaining power.

If you are concerned about being sandbagged, your lawyer should insert specific “anti-sandbag” language in your agreement. An experienced M&A lawyer will therefore be able to advise you when the circumstances would be suitable for the inclusion of such “anti-sandbag” language.