M&A Deal Points | Rest Easy with the Water at Bay

Last week, I had a great conversion with Rosa Romaine from acquire.com on sandbagging provisions in M&A agreements.

In the world of middle-market M&A, few technicalities spark as much debate during SPA negotiations as sandbagging provisions. These clauses determine whether a buyer retains the right to bring a post-closing indemnity claim for a breach of representation even if they had prior knowledge of that breach before the deal closed.

While the concept may seem like a legal nuance, it fundamentally dictates the allocation of risk and the finality of the transaction.

The Two Primary Approaches

There are two distinct ways to draft these provisions, each favoring a different side of the table:

Pro-Sandbagging Clause: Expressly allows the buyer to seek recovery for a breach of representations regardless of whether they discovered the issue during due diligence.

Anti-Sandbagging Clause: Explicitly prohibits the buyer from bringing a claim if it can be proven they had knowledge of the inaccuracy prior to closing.

Why Sellers Fight (And Often Lose) the Argument

Sellers frequently argue that pro-sandbagging language is inherently unfair. Their logic is straightforward: if a buyer knows about a problem before they sign or close, they should raise it then or waive it.

However, from a deal-structuring perspective, pro-sandbagging language often prevails for several practical reasons:

Eliminating Factual Disputes: Anti-sandbagging clauses invite "litigation within litigation." Before even addressing the breach itself, parties must argue over exactly what the buyer knew and when they knew it. This creates uncertainty and increases legal costs.

Incentivizing Diligence: If a buyer knows that discovering an issue might bar them from future recovery, it can create a perverse incentive to be less than thorough during the due diligence phase.

R&W Insurance Alignment: Most Representation and Warranty Insurance (RWI) policies are structured to allow buyers to bring claims despite knowledge (subject to specific exclusions), making pro-sandbagging language a necessity for policy alignment.

Market Trends and the Power of Silence

Despite the friction these clauses cause, anti-sandbagging provisions remain an extreme minority, appearing in only approximately 2% of lower middle-market (LMM) deals according to recent studies. Roughly half of modern deals include pro-sandbagging language, while the remainder stay silent on the matter.

However, "silence" is not a neutral position. It is critical to understand the governing law of the purchase agreement:

Delaware Law: Recent judicial decisions suggest that if a contract is silent, the court will default to a pro-sandbagging position (protecting the buyer).

California and Other Jurisdictions: In states with strict "reliance" requirements, silence may be interpreted as anti-sandbagging. In these jurisdictions, if the buyer cannot prove they relied on the truth of the representation, they may be barred from recovery.

When is an Anti-Sandbagging Provision Warranted?

While rare, there are specific scenarios where an anti-sandbagging provision is appropriate. The most common example is a Management Buyout (MBO). In these transactions, the buyers (the executive team) often possess significantly more granular information about the target company than the sellers (the investors or founders). In such a lopsided information environment, protecting the seller from "sandbagging" by the more informed management team is a logical and often necessary concession.

For most standard private equity or strategic acquisitions, maintaining a pro-sandbagging stance, or at least ensuring the governing law aligns with the buyer’s expectations, remains the standard for ensuring a predictable post-closing indemnity process.