Canada: Clause For Concern? Sandbagging Provisions In Canadian M&A

Sandbagging: To conceal or misrepresent one's true position, potential or intent, especially in order to take advantage of.

The use of express sandbagging language in M&A agreements (whether "pro" or "anti"), or the decision to remain silent, is commonly one of the most acrimonious issues faced by M&A practitioners in private acquisitions. The frequency of these provisions in Canadian M&A and the question of their enforceability are commonly discussed in light of evolving market practice and the historically limited guidance from Canadian courts.

HOW DOES SANDBAGGING WORK?

In the course of negotiating a definitive acquisition agreement, a buyer will typically extract detailed representations and warranties from the seller regarding the business to be acquired, along with an indemnity (subject to customary limitations) whereby the seller will agree to indemnify the buyer post-closing should any of the reps and warranties prove to be untrue.

The issue of "sandbagging" arises where an acquisition agreement has been signed and the deal subsequently closes, but there is an untrue seller rep and warranty in the agreement, and the buyer knows prior to closing that the rep and warranty is untrue but proceeds with the closing. In these circumstances, the question is whether the buyer should be able to sue for a breach of the untrue rep and warranty — can the buyer "sandbag" the seller? Sandbagging provisions are intended to expressly address the parties' negotiated agreement on this issue.

THE PROs AND CONs OF SANDBAGGING

Parties have three options available to address this question: pro-sandbagging language, anti-sandbagging language, or silence. For obvious reasons, a seller will generally try to negotiate anti-sandbagging language, while a buyer may push for pro-sandbagging.

PRO-SANDBAGGING

The following is one example of a typical pro-sandbagging clause, from the American Bar Association's (ABA) Model Asset Purchase Agreement: No Waiver. The right to indemnification, reimbursement or other remedy based on such representations, warranties, covenants and obligations shall not be affected by any investigation conducted with respect to, or any Knowledge acquired (or capable of being acquired) at any time. A buyer will often argue that this kind of pro-sandbagging provision encourages better disclosure and helps to protect the buyer from last-minute surprises, including issues uncovered during the interim period between signing and closing. A buyer will also want to ensure that its management does not have "knowledge" of a breach imputed to it where voluminous diligence materials have been made available and its review has been circumscribed.

ANTI-SANDBAGGING

By contrast, the following is an example of a typical anti-sandbagging clause, from the ABA's 2015 Canadian Private Target M&A Deal Points Study (ABA's 2015 Study):

Indemnity by the Seller. Notwithstanding the foregoing indemnities for breach of any representation or warranty, the Seller shall not be liable under this Indemnity provision for any damages based upon or arising out of any breach of any of the representations or warranties of the Seller contained in this Agreement if the Buyer had Knowledge of such breach prior to or at the Closing.

This form of anti-sandbagging provision may be coupled with an express representation and warranty by the buyer that it has no knowledge of any breach of a representation, warranty or covenant at either signing or closing.

A seller will often take the position that anti-sandbagging language encourages the buyer to bring forward any potential diligence issues before closing, and to avoid a "gotcha" scenario where the buyer seeks to use an indemnity claim to effectively reduce the purchase price.

Where a buyer makes a post-closing indemnity claim, this type of anti-sandbagging provision typically leads to disputes around what the purchaser "knew" pre-closing. Accordingly, parties should take care to specify what will constitute "knowledge of the buyer", including which individuals at the buyer's organization have knowledge that could preclude a claim.

The use of either a pro- or anti-sandbagging provision will always be highly fact-dependent and influenced by the tone and history of negotiations, the parties' relative bargaining power and nature of the diligence conducted.

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