The Delaware Court of Chancery has ruled that, absent an agreement between an acquiror and seller to the contrary, Delaware law permits the practice of contractual "sandbagging"—i.e., an acquiror may close a transaction while actually knowing that a representation made by the seller in the acquisition agreement is false, and still seek damages for breach of that representation post-closing.
On March 9, 2022, the Delaware Court of Chancery issued a post-trial decision in Arwood v. AW Site Services, LLC, subsequently amended on March 24, 2022. The plaintiff, John Arwood, had spent decades building a waste management business, which he agreed to sell in 2018. Arwood did not use an "official accounting system" or produce formal financial statements. Therefore, he agreed to give the buyer complete access to the company's records so the buyer could build its own financials before deciding whether to proceed with the transaction.
After the closing, the buyer discovered that Arwood regularly overbilled customers, and refused to release the purchase funds in escrow. Arwood sued to obtain the escrow money. The buyer countersued, claiming that Arwood had fraudulently induced it to buy the business and that he had breached certain representations in the purchase agreement, including those relating to the company's financial statements and legal compliance.
The court rejected the buyer's claim that Arwood had fraudulently induced it to buy the business. But the court upheld the claim that Arwood had violated the representations and warranties in the purchase agreement. Arwood, by overbilling his customers, had not conducted his business "in compliance with … Laws."
The court considered the possibility that the buyer had "sandbagged" Arwood—because it had complete access to the company's pre-sale records, it may have known of the issues before closing, closed anyway, then turned around and sued for breach of representations it knew were false. Having weighed the evidence, the court held that the evidence was more consistent with the buyer's reckless indifference to the truth or falsity of the representations, and not actual knowledge. Even so, the court held that had the buyer actually known about the breach of representations, it still would have been able to recover for that breach. "Delaware," the court noted, is "what is affectionately known as a 'sandbagging' state."
Subsequently, in an amended opinion, the court sua sponte identified a provision in the purchase agreement that the parties had not identified that stated expressly that an indemnified party would "be entitled to indemnification" even if it "knew or had reason to know of [the] breach." The judge noted that since the parties contracted for sandbagging, he would uphold their agreement. But he reiterated that, barring an agreement to the contrary, Delaware law by default permits sandbagging.
The Delaware Supreme Court has not yet definitively ruled whether Delaware common law permits sandbagging absent an agreement by the parties on the subject. But the Court of Chancery's decision in Arwood confirms that, at least for the moment, sandbagging is the default in Delaware. Parties drafting purchase agreements governed by Delaware law should keep the Arwood decision in mind.
