In an opinion of significance to M&A Practitioners, the Delaware Court of Chancery recently made it clear that Delaware law allows a buyer in an acquisition to “sandbag” a seller if the acquisition agreement allows for sandbagging or if the acquisition agreement is silent on the subject.  “Sandbagging” only applies when a buyer knows that a representation and warranty in an acquisition agreement is false prior to the closing the transaction, closes the transaction despite this knowledge, and then seeks indemnification for breach of the representation and warranty after closing.

Background

In John D. Arwood et al. v. AW Site Services, LLC, C.A. No. 2019-0904-JRS (Del. Ch. March 24, 2022), AW Site Services, LLC (“AWS”) acquired John D. Arwood’s waste disposal businesses for $16 million, including an escrow of $1.26 million for plaintiff’s indemnification obligations and $150,000 for working capital adjustments. The Court’s summary states that:

• Defendants were highly sophisticated and knew that Arwood was a decidedly unsophisticated seller;
• Defendants knew that Arwood had opened the doors of his businesses to them so that they could determine how the businesses were run, what they were worth and whether to buy them;
• Defendants conducted extensive due diligence on the target businesses; and
• There were no financials for the target business, and Arwood had not made presentations to defendants regarding the financial fitness of his businesses before their extensive review.

The Asset Purchase Agreement (APA) expressly allowed for sandbagging and provided that an “Indemnified Party ’shall be entitled to indemnification . . . notwithstanding whether an employee, representative or agent of the Indemnified Party [in this case AWS] seeking to enforce a remedy knew or had reason to know of such breach and regardless of any investigation by such Indemnified Party.’”

The APA included representations and warranties by the sellers that (i) their financial statements of the acquired business were accurate, (ii) its accounts receivable less than 120 days outstanding were valid and enforceable claims, (iii) the sellers had materially complied with the law and (iv) all employees of the acquired business were disclosed.  The APA also provided for indemnification of AWS against losses due to inaccuracy or breach of a representation and warranty in the APA.

After closing, defendants discovered an alleged sham billing scheme and additional information that had been concealed from them concerning employee costs, all of which caused a substantial overstatement of the acquired company’s revenue. Litigation ensued, and among other things, defendants alleged fraud, fraudulent inducement and breach of contract.

Breach of Contract Claim

The Court found that the customer billing scheme rendered certain of the sellers’ representations in the APA false. That in turn constituted a breach of contract and triggered the indemnification obligations to AWS set forth in the APA. Of significance, the Court found that the reasonableness or not of AWS’s reliance on the sellers’ representations and warranties was not a relevant consideration in assessing AWS’ indemnification claim.

The Court rejected the plaintiff’s claim that the buyers cannot rely upon representations in the APA to sue for breach of contract because they either knew pre-closing that the representations were false or were recklessly indifferent to their truth.  Instead, the Court found that “Delaware is, or should be, a pro-sandbagging jurisdiction” and “even if Delaware were an anti-sandbagging jurisdiction, I am not satisfied that a buyer’s reckless, as opposed to knowing, state of mind would trigger the doctrine in any event.”

The above resulted in AWS being entitled to retain the funds held in escrow and an award of damages up to the cap set forth in the APA.

Fraud and Fraudulent Inducement

The Court found that defendants’ fraud and fraudulent inducement claims failed for two reasons. First, AWS did not justifiably rely on Arwood’s misstatements or omissions in deciding to close the transaction, and justifiable reliance is a required element of fraud.  The Court found that the defendants could not prevail on their fraud claim because the extensive due diligence conducted on the acquired business prior to closing indicated that the defendants knew or should have known of the overstatement of revenue. Second, the Court found that the preponderance of the evidence revealed that Arwood did not intentionally or recklessly induce AWS to buy his businesses, which is another element of a fraud claim.

Key Takeaways

M&A Practitioners representing a seller should consider if the intent is for a buyer not to be entitled to indemnification if the buyer knew or should have known about the falsity of a representation and warranty prior to closing. If the goal is not to provide indemnification in that circumstance, and the agreement is governed by Delaware law, then the acquisition agreement should expressly set forth anti-sandbagging language in order to avoid unwanted results. A buyer, on the other hand, should still consider adding pro-sandbagging language to avoid any potential conflicts on the issue in various other provisions of an acquisition agreement.

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