In the complex landscape of mergers and acquisitions (M&A) transactions, the interplay between a buyer[1] and a seller[2], before a transaction closes, shapes the negotiation of the underlying transaction documents.

Sandbagging (or Pro-Sandbagging) occurs when a buyer in an acquisition/ investment knows about a breach of the seller’s/ founders’ representations or warranties before the closing of the transaction but proceeds with the same anyway without raising any concerns or objections.  After the transaction is completed, the buyer/ investor might “sandbag” the seller/ founder by using the known breach as a basis for claiming a breach of warranty or representation and corresponding remedies.

On the other hand, anti-sandbagging provisions are contractual clauses designed to prevent the practice of sandbagging. They might take various forms, but generally, anti-sandbagging provisions stipulate that the buyer cannot raise claims for breaches of representations or warranties if the buyer was aware of such breaches prior to the deal’s closure.  The purpose of anti-sandbagging provisions is to ensure that the buyer conducts thorough due diligence and addresses any issues or concerns before finalizing the deal, rather than waiting and then using them as leverage post-closing.

An example of a typical sandbagging clause found in transaction documents is: “None of the Company Warranties[3] shall be treated as qualified by any actual or constructive knowledge on the part of the Buyer or any of its agents, representatives, officers, employees or advisers. The Company and the Seller shall not invoke Buyer’s knowledge (whether actual, constructive or imputed) of any matter or thing as a defence to a claim made by the Buyer against the Company[4] in terms of the Transaction Documents.”

An example of a typical anti-sandbagging clause found in transaction documents is: “The Buyer fully acknowledges that it has exercised due diligence and proper investigation with respect to the Company and that the Seller will not be liable to the Buyer with respect to any breach of any representation or inaccuracy or warranty in this Agreement if the Buyer had knowledge of such breach before Closing (including by virtue of the matters disclosed in the Disclosure Letter).”

Buyers will argue for the inclusion of a sandbagging provision in the transaction documents, whereas sellers will want to include an anti‑sandbagging provision. Whether the underlying transaction documents will have a sandbagging provision or an anti-sandbagging provision, will depend on the relative position of the buyer and seller vis-à-vis each other in the overall scheme of things as regards the proposed transaction.

Knowledge of the buyer

The knowledge of the buyer plays an important role in M&A transactions. Such knowledge can be divided into the following two categories – actual knowledge and constructive knowledge. Actual knowledge pertains to situations where the buyer was aware of the breach, while constructive knowledge involves scenarios where the buyer ought to have been aware of the breach.

The Bombay High Court, in GWL Properties Ltd. vs. James Mackintosh and Company Private Limited[5], emphasized the buyer’s entitlement to rely on the representations and warranties outlined in the agreement, maintaining that the effectiveness of such reliance could not be diminished by the prior diligence conducted on the seller. The seller’s contention that the buyer had conducted a thorough due diligence and possessed adequate documents to uncover the truth before the transaction’s completion, was dismissed by the court.

Further, in the case of Niaz Ahmad Khan and Ors. v Parsottam Chandra and Ors.[6], the court held that in case of active misrepresentation (where the party knew the fact to be false), it is not required that the defrauded party prove that it had no means of discovering the truth with ordinary diligence.

The pertinent issue revolves around the fact that whether a buyer’s awareness of the warranty’s falseness, provided by the seller, should hinder their ability to pursue a warranty claim. When a buyer willingly accepts the incorporation of anti-sandbagging provisions into the agreement, they can mitigate their risk by specifying that the standard of knowledge is limited to their actual awareness.

However, in the case of K.C. Ninan v. Kerala State Electricity Board and Others[7], the Supreme Court stated that as per the doctrine of caveat emptor, the buyer is responsible for conducting a due diligence. The seller is not mandated to reveal obvious facts but only significant facts that are known to them, but not easily discoverable by the buyer through ordinary care, unless a contract states otherwise.

Adding to the discourse on buyer responsibility, the Delhi High Court, in the case of Mr. Rajesh Gupta v. Ram Avtar[8], observed that the principle of ‘caveat emptor’ does not apply where an express representation is made by the seller and is relied upon by the purchaser. While the principle of caveat emptor imposes a general responsibility on buyers to exercise prudence and care, the inclusion of express representations can alter how this principle is enforced.

It is pertinent to mention that implementing an anti-sandbagging clause could trigger potential litigation. For instance, a clause preventing sandbagging by relying on the buyer’s pre-closing knowledge may give rise to ambiguity regarding the definition of “knowledge”, providing sellers with the opportunity to obstruct valid post-closing indemnity claims. Furthermore, such a clause might discourage sellers from fully disclosing information, as they could reveal issues in a manner designed to escape the buyer’s notice. This underscores the delicate balance between preventing sandbagging and ensuring transparent transactions. The challenge lies in formulating rules that discourage deceptive practices without inadvertently fostering legal complexities or hindering genuine disclosure.

What does being silent imply?

Parties involved in M&A transactions are frequently seen omitting explicit provisions regarding sandbagging, wherein the agreement neither explicitly permits nor prohibits sandbagging. In such cases, the legal jurisdiction overseeing the agreement will determine whether the absence of specific clauses allows or prohibits sandbagging. Under certain circumstances, remaining silent on the matter may be construed as consenting to a broader anti-sandbagging provision than what could have been negotiated as part of a specific provision.

Practical Application of Sandbagging related provisions in Transaction Documents

As a matter of prevalent practice in M&A transactions in India, transaction documents contain sandbagging provisions which are, however, limited to the extent of matters disclosed specifically by the seller by way of a disclosure letter.  In effect, the sandbagging provision protects the buyer despite its actual or constructive knowledge of any findings from its due diligence. However, such protection is limited if the same findings are also disclosed by the seller in a disclosure letter.  Furthermore, there are certain matters/ findings which are identified by the buyer as ‘critical’ and are bucketed in the category of ‘specific indemnity matters’. These are matters where the parties acknowledge the existence of such findings in the transaction documents itself, and the seller upfront agrees to indemnify the buyer for any loss that the buyer may incur on account of such identified findings, notwithstanding the knowledge of the buyer of such matters prior to closing of the transaction.

Conclusion

In essence, navigating the complexities of sandbagging and anti-sandbagging provisions requires a nuanced understanding of the risks and benefits associated with each approach. Crafting well-defined and mutually agreed-upon clauses in M&A agreements is essential to fostering transparent, efficient, and fair transactions while minimizing the potential for post-closing disputes.

Written By Nidhi Arora (Partner) and Manan Kapoor (Associate)

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[1] Includes reference to an investor

[2] Includes reference to a founder of the company receiving investment

[3] Includes reference to a seller/ founder warranties

[4] Includes reference to a seller/ founder

[5] 2012 SCC OnLine Bom 404

[6] AIR 1931 All 154

[7] 2023 9 SCR 637

[8] 2022/DHC/1914