Sandbagging in merger and acquisition transactions in India: uncovering the legal landscape

Gaurav G Arora
JSA, Gurugram
gaurav.arora@jsalaw.com

Aditi Richa Tiwary
JSA, Gurugram
 

Diksha Grover
JSA, Gurugram
 

This article explores the relevance of sandbagging in merger and acquisition transactions, highlighting the implications for buyers and sellers when adopting a pro-sandbagging or anti-sandbagging approach. It examines the significance of buyer knowledge, the doctrine of caveat emptor and Indian judicial precedents, while framing the sandbagging clause. Additionally, this article advocates for clearly defined sandbagging provisions in contracts to mitigate potential disputes and ensure fair negotiations between the relevant parties.

Introduction

In the 19th century, street gangs used the tactic of sandbagging, which involved filling socks with sand and using them as weapons. In the context of today’s ever-expanding world, the term ‘sandbagging’ has a different connotation. Typically, representation, warranties, covenants and indemnity clauses incorporated into a contract tend to cover the risks associated with the seller’s business that have been identified by the buyer during the due diligence process.

In certain scenarios, post-closing the merger and acquisition (M&A) deal, a buyer may discover misrepresentations in the warranties and representations furnished by the seller. In such a case, the buyer can claim recourse through an indemnity claim. However, what happens when a buyer is aware of a breach before the closing of the agreement and, yet, concludes the agreement to later claim indemnity against the seller? In such situations, sandbagging becomes relevant. Sandbagging is a word frequently used in golf to refer to a player who pretentiously conceals their ability and strength to gain an edge over unaware competitors. Similarly, in M&A, sandbagging transactions refers to a situation where the buyer becomes aware of inaccurate representations or warranties of the seller, but still closes the deal, only to claim indemnity against the seller post-closing. Typically, a contract contains either a pro-sandbagging clause or an anti-sandbagging clause. But, more often than not, most contracts are silent regarding the sandbagging issue.

Pro-sandbagging clauses

From the buyer’s perspective, it is favourable to incorporate a pro-sandbagging clause in a contract, as it allows the buyer to claim indemnity against the seller for any misrepresentations irrespective of the buyer’s knowledge of the breach pre-closing. Buyers argue that the exclusion of a pro-sandbagging clause discourages thorough disclosures by the seller and results in the seller intentionally withholding due diligence documents until the last minute. Further, excluding pro-sandbagging clauses gives sellers the chance to avail themselves of the benefits of an anti-sandbagging clause by arguing that the buyer possessed the knowledge of the breach pre-closing, barring the buyer’s right to an indemnity claim. The inclusion of a pro-sandbagging clause, on the other hand, removes the burden of proof on the buyer to furnish evidence against the seller’s assertion that the buyer possessed prior knowledge regarding the breach.

Anti-sandbagging clauses

An anti-sandbagging clause is a seller friendly clause, as it restricts the buyer’s ability to bring an indemnity claim against the seller for misrepresentation.

If a dispute arises post-closing, the buyer will be required to establish misrepresentations on the part of the seller, in addition to establishing the buyer’s knowledge of such misrepresentation. In such cases, the major point of contention and negotiation is the interpretation and scope of such ‘knowledge’ - for instance, whether such knowledge would be construed as actual knowledge or constructive knowledge. A well-constructed contract, therefore, will lay down the parameters for interpreting ‘knowledge’. While a seller may seek to negotiate the inclusion of a broader construction of ‘knowledge’, which would include constructive, actual or implied knowledge, a buyer, on the other hand, would probably argue for a narrower interpretation of ‘knowledge’, which would be limited to actual knowledge. The definition of knowledge should include the standard of proof and the source as integral components to establish the evidence of such ‘knowledge’. Anti-sandbagging clauses provide a shield for sellers against buyers who intend to utilise the indemnity clause to gain a post-closing advantage, thereby promoting fair and equitable negotiation rounds between the parties.

Caveat emptor: the significance of the buyer’s knowledge

The buyer’s knowledge is an integral factor when interpreting the sandbagging provisions in an M&A transaction. Knowledge can be divided into two categories: actual knowledge and constructive knowledge. Actual knowledge refers to a scenario where the buyer is aware of the misrepresentation, whereas constructive knowledge is a scenario where the buyer ought to have known about the breach. The ‘knowledge of the buyer’ underscores the ‘doctrine of caveat emptor’, a Latin maxim that translates as ‘let the buyer beware’. During an M&A transaction, the buyer must conduct due diligence in regard to the relevant product or service.

In the context of M&A, the doctrine of caveat emptor places the burden on the buyer to conduct proper due diligence before closing the deal. However, express terms are an exception to the doctrine of caveat emptor as found under section 16(4) of the Sale of Goods Act, 1930. The Delhi High Court, in the case of Rajesh Gupta v Ram Avtar (2022 SCC OnLine Del 1482) ruled that the doctrine of caveat emptor is not applicable in scenarios where the seller has given express representation and warranties, which are relied upon by the buyer. Furthermore, in the case of K.C. Ninan v Kerala State Electricity Board and Others ((2023) 14 SCC 431), the Supreme Court of India held that unless the contract states otherwise, a seller should reveal only significant facts that are not obvious to and are not easily discoverable by the buyer through ordinary care. The Supreme Court stated that buyers are responsible for undertaking due diligence. In the case of Commissioner of Customs (Preventive) v M/S Aafloat Textiles (I) P Ltd & Ors ((2009) 11 SCC 18), the Supreme Court of India held that the buyer has no remedy against the seller for defective goods if the transaction is not covered by conditions or warranties, either express or implied. While the doctrine requires the buyer to exercise due care while conducting due diligence, the enforcement of the doctrine will differ in the cases where representations or warranties by the seller have been made.

The absence of a sandbagging clause: a glaring concern

As per a 2023 survey[1] on private target transactions, 24 per cent of agreements were found to contain pro-sandbagging clauses, six per cent of agreements were found to contain an anti-sandbagging clause and 70 per cent of agreements were silent on the sandbagging issue. When agreements are silent on sandbagging, if a dispute arises, it is governed by the law of the jurisdiction that governs the contractual relationship between the parties. Parties who are not able to agree on the terms of a sandbagging clause, usually take the approach of remaining silent on the sandbagging issue and moving ahead with closing the deal. However, this approach has risks associated with it, subject to the jurisprudence around sandbagging under the common law principles and law governing the particular jurisdiction.

The Indian legal landscape in respect of sandbagging

While Indian judicial decisions have not explicitly dealt with the issue of sandbagging, Indian courts have issued tangential rulings that govern the concepts integral to sandbagging, such as knowledge, fraud and misrepresentation. Section 17 of the Indian Contract Act, 1872 (ICA), sets out the definition of fraud. Section 18 of the ICA defines misrepresentation and section 19 of the ICA sets out the exceptions to fraud and misrepresentation. In the case of Kapparthi Venkataratnam v Palleti Sivaramudu (AIR 1940 Mad 560), the Madras High Court held that an agreement is voidable by the party deceived if the contract has been obtained through fraud (section 17), irrespective of whether the fraud could have been discovered through ordinary due diligence by the deceived party. However, the High Court noted that if the case concerns a misrepresentation within the meaning of section 18 of the ICA, then the exception and explanation embedded in section 19 of the ICA will apply and the deceived party must prove that the truth was not discoverable through ordinary due diligence. A similar stance was taken by the Delhi High Court and the Allahabad High Court in the case of Sangam (India) Ltd v The National Highway Authority of India (2024 SCC OnLine Del 3667) and Niaz Ahmad Khan and another v Parsottam Chandra and another (AIR 1931 All 154), respectively.

Furthermore, in the case of GWL Properties v James Mackintosh & Company Private Limited (2012 SCC OnLine Bom 404), the seller contended that since the buyer had performed due diligence on the seller’s business, the buyer could not claim indemnity for concealment of the material facts. The Bombay High Court upheld the arbitral award, noting that the buyer is entitled to rely on the representations and warranties provided by the seller irrespective of the due diligence conducted by the buyer. The High Court opined that due diligence performed by the buyer cannot be a sufficient reason to overlook the contractual relationship between the parties. Therefore, silence on the aspect of sandbagging could potentially trigger litigation and it is relevant for the parties to consider the Indian legal framework, which provides a robust foundation to resolve disputes involving fraud, misrepresentation and knowledge.

The way forward for sandbagging clauses

While drafting and negotiating a sandbagging clause in an agreement, it is pertinent for the parties to measure and evaluate the associated risks and advantages. Crafting a well-defined and balanced sandbagging clause in an agreement is crucial to ensure fair and transparent dealing among the parties. An effective approach is to tailor the application of the anti-sandbagging clause only to the direct claims of the buyer, thereby excluding third-party claims. This can protect sellers from indemnity claims by the buyer for misrepresentations known before closing, while protecting buyers from unknown liabilities arising from third-party claims. In essence, it is essential for the parties to negotiate and incorporate a sandbagging provision in an agreement to prevent uncertainty and address any disputes that may arise post-closing.

The views expressed in this article are the personal views of the authors.