Delaware is a “Pro-Sandbagging” State

While M&A practitioners have long taken the view that Delaware is a “pro-sandbagging” state, a recent case in the Delaware Court of Chancery has added concrete authority to that position. In Arwood v. AW Site Services (March 9, 2022), the Court found that a buyer was entitled to indemnification stemming from the breaches of certain representations, despite that buyer having effectively prepared the financials and other information that were covered by the reps.

“Sandbagging” is the buyer-favorable concept that preserves a buyer’s rights to indemnification based on breaches of a seller’s representations, irrespective of whether the buyer had knowledge, prior to closing the deal, of facts and circumstances giving rise to an indemnification claim.

The case at issue related to a transaction where a private equity firm sought to acquire a waste disposal business from an “alarmingly unsophisticated businessman”. To properly value the business, the firm sent one of its principals to the company to perform extensive due diligence. The principal was given ‘extraordinary” access to the business, including administrative access to the company’s billing system and even the founder’s personal bank accounts. Ultimately, the principal prepared a set of financials that the buyer used to further negotiate the deal terms, and the parties eventually closed the sale.

Following the closing, the seller made a claim against the buyer for wrongfully refusing to release escrowed deal consideration. The buyer countered with a claim that the seller defrauded them by concealing a fraudulent billing scheme and further claimed that the seller’s financial representations (based upon the financials the buyer’s principal prepared) were inaccurate, resulting in an indemnification claim. The seller raised a sandbagging defense to the indemnity claim, saying that a buyer cannot rely upon representations to sue for breach of contract when they either knew pre-closing that the representations were false or were recklessly indifferent to their truth.

While disregarding the buyer’s fraud claims, Vice Chancellor Slights also rejected the seller’s sandbagging defense, noting “In my view, Delaware is, or should be, a pro-sandbagging jurisdiction. The sandbagging defense is inconsistent with our profoundly contractarian predisposition. Even if Delaware were an anti-sandbagging jurisdiction, I am not satisfied that a buyer’s reckless, as opposed to knowing, state of mind would trigger the doctrine in any event.”

The Vice Chancellor even went further to indicate that the concept of sandbagging could only apply when a buyer affirmatively knows a representation to be false pre-closing but seeks post-closing indemnification anyway. As a result, his view is that the question of sandbagging is not implicated when a buyer is unaware of the lack of truthfulness, even if they should have known of the falsehoods after exercising reasonable care, and even if they were recklessly indifferent to that truth.

Going forward, sellers seeking to avoid being sandbagged by buyers should be particularly cautious to include explicit anti-sandbagging language. Future buyer’s may wish to include pro-sandbagging provisions, though given this Arwood ruling, such language may not be necessary in agreements governed by Delaware law.

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