Image a home buyer finally finds their dream house. There’s just one problem.
During their home inspection, they discover the foundation is cracked. But they buy the house anyway, fully aware of the issues with the foundation.
In the sale agreement, there’s a clause stating the house’s foundation is flawless.
Should the seller be liable to the buyer for breaching the sale agreement, even though the buyer knew the foundation was not flawless at the time they signed the agreement?
In other words, and to have some fun with legal terminology, should the buyer be able to “sandbag” the seller?
The unsatisfying answer is that it probably depends on if the sale agreement addresses sandbagging.
“Sandbagging” is the term used to refer to what happens when a buyer, who enters an agreement knowing that one or more of the seller’s representations or warranties are not true, brings a post-closing lawsuit against the seller regarding a breach of those same terms.
With sandbagging, it isn’t easy to determine who the bad actor is.
Is it the seller? They made an inaccurate representation which could have mislead the buyer.
Or is it the buyer? They knew the truth but decided to lie in wait for an opportune time to use it against the seller.
Like most legal disputes, sandbagging isn’t always black and white. That’s why different jurisdictions have differing views on the legality of it.
In this post, we’ll briefly explore how sandbagging is viewed in Delaware and Pennsylvania. The key takeaway is that any contract you sign should not be silent on sandbagging.
The “modern” and “traditional” sandbagging rules
In the mergers and acquisitions context, sandbagging provisions in a purchase agreement are often a source of contention between a buyer and seller.
The buyer will push for a “pro-sandbagging” provision, which would ensure the buyer would lose none of their remedies under the agreement, even if the buyer knew, either before or at the closing of the deal, about the facts or circumstances giving rise to their breach claim.
On the other hand, the seller will push for the agreement to include an “anti-sandbagging” provision, so that the buyer cannot turn around post-closing and seek indemnity for a breach of a representation or warranty that the buyer knew not to be true.
If the agreement is silent on the issue, then the sandbagger’s fate is at the mercy of the governing choice of law. Jurisdictions take one of two approaches toward sandbagging.
“Modern rule” jurisdictions are pro-buyer and pro-sandbagging. They believe a buyer has a right to rely on negotiated contractual obligations. In these jurisdictions, if a seller represents something is true, but it isn’t, a buyer should be able to hold the seller accountable for that misrepresentation—whether or not the buyer knew it wasn’t true when they entered the agreement.
“Traditional rule” jurisdictions are pro-seller and anti-sandbagging. In these jurisdictions, a buyer must show it relied on the allegedly breached representation or warranty of the seller. Reliance can be difficult to prove, if not impossible, when the buyer knew the representation or warranty was false before entering the agreement.
Delaware’s stance is clear: Pro-Sandbagging
A recent decision by the Delaware Court of Chancery, John D. Arwood et al. v. AW Site Services, LLC, C.A. No. 2019-0904-JRS (Del. Ch. March 24, 2022), made it clear that Delaware is a modern rule jurisdiction that is pro-buyer and pro-sandbagging. The case involved a buyer who, after purchasing the assets of a waste disposal business, discovered an alleged sham billing scheme, among other issues. The buyer then sought indemnification from the seller for breach of contract.
The seller argued the buyer’s reliance on the representations in the asset purchase agreement was not reasonable, but the court held it did not matter whether the buyer knew those representations were false prior to the closing because Delaware law allows a buyer to sandbag a seller. (The court made clear that sandbagging did not occur in this case.)
The court traced Delaware’s stance back to its “strong contractarian propensities.” Notably, this includes the rights of contracting parties to allocate the risk of sandbagging in the contract. As the court emphasized, anti-sandbagging clauses are “effective risk management tools that every transactional planner now has in her toolbox.”
In short, Delaware’s view is that sandbagging is fair and square, so long as the governing agreement does not expressly prohibit it.
Pennsylvania’s stance opens the door for sandbaggers
A recent Third Circuit decision, SodexoMAGIC, LLC v. Drexel Univ., 24 F.4th 183, 214 (3d Cir. 2022), sheds some light on how Pennsylvania courts would view sandbagging.
SodexoMAGIC provided on-campus dining services at Drexel University for nearly twenty years when their business relationship—but hopefully not the food the company provided—soured. In 2014, after receiving an unsolicited offer from a SodexoMAGIC rival, Drexel kicked off a heated bidding process for its on-campus dining contract, estimated to be worth up to $300 million over its full term.
SodexoMAGIC was one of several bidders for the contract. During the solicitation process, Drexel highlighted that its strategic plan called for a roughly 30% increase in its overall student population over the course of the next several years but noted that only first-year undergraduates were required to have all-inclusive meal plans. Drexel projected a first-year class size of 3,100 students for the then-upcoming 2014-2015 school year.
Internally, however, the school was singing a different tune. For internal budget purposes, Drexel estimated the size of that same class to be 2,800 students.
SodexoMAGIC ultimately won the contract, but the worst of the problems between SodexoMAGIC and Drexel was yet to come. As SodexoMAGIC continued to provide on-campus dining services for the 2014-2015 school year, it engaged in rocky negotiations with Drexel regarding the finalization of the new contract.
One obstacle centered on Drexel’s first-year student enrollment numbers. SodexoMAGIC wanted Drexel to guarantee annual enrollment increases. Instead, the parties ultimately agreed they would renegotiate in good faith if Drexel’s enrollment did not increase by at least two percent annually.
At last, both parties executed the new contract on May 28, 2015. That same day, The Philadelphia Inquirer reported that Drexel’s first-year class was down by nearly 200 students compared to the prior year. Shortly thereafter, Drexel’s president informed stakeholders, including SodexoMAGIC, that the university was focused on the quality, rather than quantity, of its students, and that class sizes would be smaller than in previous years.
SodexoMAGIC expressed shock over the shrinking enrollment. Through internal correspondence, a Drexel official shrugged it off, stating: “I guess they were going to find out sooner or later.” In the end, Drexel enrolled seven percent fewer first-year students for the 2015-2016 school year. This reduction had an immediate effect on SodexoMAGIC’s revenues.
The parties continued to battle over various aspects of the new contract, with each party trying to exercise the termination options it provided. Ultimately, Drexel replaced SodexoMAGIC with a new vendor effective after the Fall 2016 semester. In the meantime, SodexoMAGIC sued Drexel in federal court.
The parties brought a plethora of claims against each other. Of relevance to us here was SodexoMAGIC’s fraudulent inducement claim against Drexel. The claim alleged Drexel misrepresented and concealed its future student-enrollment projections, leading SodexoMAGIC to bid more favorably on the new contract than if Drexel’s projections were truthful.
The district court tossed out the claim, but, as discussed below, the Third Circuit appellate court put that claim back into play.
Drexel tried to defeat the claim by pointing to the new contract’s integration clause, which stated that the agreement contained all agreements between the parties on the subject matter of the agreement. Drexel argued that Pennsylvania’s “parol evidence” rule prohibits SodexoMAGIC from using any extrinsic evidence (i.e., evidence of prior discussions or agreements outside the parties’ written agreement that contradict or change any contractual terms) to prove that Drexel misrepresented or concealed any information concerning first-year student enrollment numbers.
The Third Circuit disagreed.
According to the court’s unanimous decision, the parol evidence rule prevents the use of extrinsic evidence to alter the terms of an integrated contract—which the one at issue in this case was because it included an integration clause. But the court explained extrinsic evidence that a party wants to bring in regarding fraudulent inducement claims is used for a different purpose: “to prove a precontractual misrepresentation or concealment.”
The court noted that when an integrated contract contains “fraud-insulating” clauses—referred to as an “integrated-plus” contract—the parol evidence rule would block the use of extrinsic evidence to vary the fraud-insulating term.
For illustration, the court mentioned several types of fraud-insulating clauses:
- No-Reliance Clauses. One party disclaims any reliance on the other party’s precontractual representations.
- Joint Responsibility Clauses. The parties assume joint responsibility for precontractual representations.
- Superseding Reps Clauses. The representations in the contract supersede all prior representations or are the only representations made.
These clauses effectively prevent sandbagging. That’s because under the parol evidence rule, a party to a contract can’t bring in outside evidence regarding earlier conversations to counter the language of these fraud-insulating clauses. These clauses state a party can’t rely on those prior conversations. As a result, a party will not be able to establish they relied on those prior conversations to prove their fraud claim.
Regarding the contract at issue in the case, the court held the parol evidence rule did not prevent the use of extrinsic evidence to prove Drexel’s alleged precontractual representations because the contract did not include a fraud-insulating provision. Here, SodexoMAGIC wasn’t using parol evidence to change contractual terms—it was using it to prove Drexel’s alleged fraud.
For that reason, by being allowed to bring in outside evidence about Drexel’s enrollment numbers, SodexoMAGIC could have sandbagged Drexel if SodexoMAGIC knew those enrollment numbers were untrue when it signed the new contract.
(As with the Delaware case we mentioned earlier, there doesn’t appear to have been any sandbagging here.)
The Third Circuit ultimately remanded SodexoMAGIC’s fraudulent inducement claim to the district court. More importantly for our purposes, the court’s decision indirectly gives sandbaggers the green light in Pennsylvania—unless an “integrated-plus” contract is involved.
It’s might always be sandbagging season in Pennsylvania and Delaware
Based on the two court decisions discussed above, both Pennsylvania and Delaware appear to allow sandbagging. However, both jurisdictions also allow contracting parties to include anti-sandbagging provisions in their governing agreements.
The Third Circuit’s holding arguably takes Pennsylvania law to the “we love sandbagging” level by holding that not even the parol evidence rule—a substantive rule of contract law which may vary from state to state—can prevent sandbaggers from succeeding on their legal claims.
(Of course, the Third Circuit doesn’t have final say over Pennsylvania law; the Pennsylvania Supreme Court does. The latter could decide a case with sandbagging implications differently than the Third Circuit did in the SodexoMAGIC case and create new law regarding the issue.)
For now, there are two takeaways about sandbagging that owners of closely held companies need to keep in mind.
First, choice of law matters. Before signing contracts, know how the jurisdictions governing those contracts view sandbaggers. Do they follow the modern rule or the traditional rule?
Second, do not stay silent. Address sandbagging in your contracts.
If you’re the buyer, push for pro-sandbagging provisions that would allow you to use what you learned before signing the agreement against the seller if there is a misrepresentation.
If you’re the seller, push for integration and anti-sandbagging provisions to create “integrated-plus” contracts that prevent a buyer from using what they learned against you.
Because, according to these two recent judicial opinions, it’s might always be sandbagging season in Pennsylvania and Delaware, the owners of closely held companies who enter into agreements covered by either state’s laws need to be aware of sandbagging and know how to avoid being the one left holding the bag.
