Knowledge Is Power … or Is It? Knowledge’s Impact on ‘Sandbagging’ in Canadian M&A Transactions
“Knowledge is power.” A well-known quote often associated with Francis Bacon, Thomas Hobbes and Thomas Jefferson is typically thought to mean that the possession of knowledge makes you influential or provides you with an advantage over others. One instance where the concept of knowledge arises in mergers and acquisitions (“M&A”) transactions is when one party (typically the purchaser) knows that the other party (typically the vendor) has breached, or has the potential to breach, one or more representations and warranties in the applicable purchase agreement at the time of closing. This practice is commonly referred to as “sandbagging.”
Like many other aspects of M&A practice, the concept of sandbagging in Canada, the United States and other international jurisdictions is similar, and is typically addressed in the applicable purchase agreement with either “pro” or “anti” sandbagging provisions, or silence on the point. For Canadian purchasers and vendors of Canadian businesses in Canadian transactions, this article sets out some of the key concepts applicable to sandbagging. For U.S. and international purchasers and their advisors, this article sets out some of the key Canadian-specific practices they need to be aware of when it comes to sandbagging in the context of private M&A transactions involving Canadian businesses.
Pro-Sandbagging – ‘Purchaser-Friendly’
If the applicable purchase agreement allows for sandbagging (i.e., is “pro-sandbagging”), that means that the purchaser can still bring claims against the vendor for breaches of representations and warranties despite the purchaser’s prior knowledge of the breach, or potential for a breach, before closing. An example of a pro-sandbagging provision in a purchase agreement might look like this:
The rights of the Purchaser to indemnification or any other remedy under this Agreement shall not be impacted or limited by any knowledge that the Purchaser may have acquired, or could have acquired, whether before or after the Closing Date, nor by any investigation or diligence by the Purchaser. The Vendor hereby acknowledges that, regardless of any investigation made (or not made) by or on behalf of the Purchaser, and regardless of the results of any such investigation, the Purchaser has entered into this transaction in express reliance upon the representations and warranties of the Vendor made in this Agreement.
The arguments typically raised by purchasers in favour of the inclusion of a pro-sandbagging provision are common in Canadian M&A transactions and M&A transactions that include a U.S. or international party, and often include some variation of one or more of the following:
- Deterrent to Fulsome Diligence Process – not permitting the purchaser to rely on knowledge of a breach of a representation and warranty identified before closing is a deterrent to the purchaser to conducting a fulsome due diligence process to avoid obtaining knowledge of a breach (i.e., “don’t know of breach, so not limited from claiming a breach”).
- Disclosure Schedules to Disclose Issues – disclosure schedules are the means by which vendors can inform the purchaser of any exclusions to representations and warranties in the applicable purchase agreement since, generally speaking, purchasers will not have recourse against vendors for matters disclosed in the disclosure schedules.
- Post-Closing Dispute About Whether Knowledge Exists – not permitting the purchaser to rely on knowledge of a breach of a representation and warranty identified before closing could unnecessarily complicate an indemnity claim by making the purchaser’s knowledge (or not) of elements of the claim an issue, rather than focusing on the particulars of the claim itself.
- Post-Closing Disputes About Who Has Knowledge – the issue of which of the purchaser’s executives, employees or advisors has knowledge (or not) of one or more facts pertinent to any claim could unnecessarily complicate an indemnity claim by having the “who has knowledge of the claim?” become an issue, rather than focusing on the particulars of the claim itself.
- Buying an Indemnity Claim – the purchaser is not interested in closing and making an indemnity claim for a known issue with a representation and warranty, and would rather identify and resolve outstanding issues prior to closing, but the purchaser does not want to be prohibited from alleging a breach of a representation and warranty post-closing.
Anti-Sandbagging – ‘Vendor-Friendly’
“Anti-sandbagging” provisions, on the other hand, are provisions in a purchase agreement that prevent a purchaser from bringing an indemnification claim against a vendor for inaccuracy or breaches of representations and warranties that the purchaser was aware of before closing. An example of an anti-sandbagging provision in a purchase agreement might look like this:
The Purchaser acknowledges that it has had the opportunity to conduct due diligence and investigation with respect to the Company, and in no event shall the Vendor have any liability to the Purchaser with respect to a breach of representation, warranty or covenant under this Agreement to the extent that the Purchaser knew of such breach as of the Closing Date.
The arguments typically raised by vendors in favour of the inclusion of an anti-sandbagging provision are common in Canadian M&A transactions and M&A transactions that include a U.S. or international party, and often include some variation of one or more of the following:
- Fairness – a purchaser is permitted to review all aspects of the vendor’s business and it would be “unfair” for the purchaser not to advise the vendor of any issues uncovered about the business prior to closing only to have the purchaser then bring an indemnity claim against the vendor following closing.
- Encourages a Collaborative Process – including an anti-sandbagging provision requires a collaborative process in that if the purchaser discovers an issue (or potential issue) with a representation and warranty prior to closing, then the purchaser and the vendor will be required to work collaboratively to address those issues (or potential issues) prior to closing rather than in an adversarial manner post-closing through an indemnity claim.
Silence – Neutral … or Is It?
Purchasers and vendors can also choose to be silent in the purchase agreement on the issue of sandbagging. Purchase agreements that are silent on sandbagging do not include express language that allows or removes the right to indemnification based upon a known breach of a representation and warranty after closing. If a breach arises, the parties cannot look to the terms of the purchase agreement to permit or prevent recovery for the breach, leaving the issue to be determined in accordance with applicable law.
Statistics on Sandbagging in the U.S. and Canada
As statistics in both the U.S. and Canada reveal, silence is common but the result may be unpredictable, as courts must interpret each situation, including the applicable law of the purchase agreement.
The American Bar Association, which periodically publishes data on private M&A deals, reported in 2021 that 68% of M&A deals were silent on sandbagging. The balance of the reported deals did have inclusion of sandbagging language with pro-sandbagging provisions being 29% and anti-sandbagging provisions being 2% of the deals. Silence, however, appears to be trending upwards. In a comparative 2005 study, 39% of deals were silent on sandbagging which is almost a full flip from the 68% reported in 2021. In our experience, the position among the laws of various U.S. states differs on the treatment of sandbagging in applicable purchase agreements.
According to the 2023 M&A Deal Terms Study by SRS Acquiom, pro-sandbagging clauses were found in approximately 50% of the deals, with the other 50% being silent. Less than 1% of the deals, according to this study, included anti-sandbagging provisions.
Impact on Sandbagging by the Concept of ‘Good Faith’
Prior to the express recognition of the concept of a principle of “good faith” and a duty of honest performance in Canadian contract law in the Supreme Court of Canada’s decision Bhasin v. Hrynew (“Bhasin”), Canadian courts that considered sandbagging generally favoured a pro-sandbagging position when an agreement was silent on the issue. In Bhasin, the duty of honest performance, which means not lying or misleading the other contracting party about one’s contractual performance, is a general doctrine of contract law and now applies to all contracts governed under Canadian law.
The Bhasin decision did not expressly deal with sandbagging provisions in any type of contract, including purchase agreements in M&A transactions. In our view, it is not settled law in Canada that the inclusion of a pro-sandbagging provision would be enforceable in light of Bhasin; rather, it would be the case that for a purchaser to attempt to rely on knowledge of a breach of a representation and warranty known to the purchaser prior to the closing of a transaction, that the applicable purchase agreement would need to have a pro-sandbagging provision. Further, in our view, if the purchase agreement is silent on sandbagging, the default position of a Canadian court would be that the purchaser could rely on the representations and warranties as written with the important proviso that the buyer must be acting in good faith. Again, where the purchase agreement is silent on sandbagging, a buyer who knows of a breach and then sues on the representation and warranty would probably not be acting in good faith, with the result being that they could not rely on that known breach in making an indemnity claim. These interpretations, while not definitively settled, likely hinge on various factors including the specific language and nature of the provisions in the applicable purchase agreement, the nature and extent of the purchaser’s knowledge, and other fact-driven circumstances.
The arguments in favour of and against sandbagging provisions are relevant in both Canadian domestic and cross-border M&A transactions, though there are peculiarities to the application and availability of sandbagging that are Canada-centric. The interplay between sandbagging and the principle of “good faith” in Canada will likely continue to further influence the complex issue of sandbagging in Canadian M&A. This evolving landscape warrants close attention from purchasers, vendors and advisors alike and should be thoughtfully considered in each M&A transaction.
The Capital Markets Group at Aird & Berlis will continue to monitor developments in cross-border and domestic Canadian M&A transactions, including developments related to sandbagging. Please contact a member of the group if you have questions or require assistance with any matter related to sandbagging or any of your cross-border or domestic M&A needs.
 For a closer look at other important Canadian M&A legal considerations and market practices, see our previous article: Important Canadian Legal Considerations and Market Practices for U.S. and International Purchasers in Cross-Border Private M&A Transactions (airdberlis.com).