Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The M&A Anti-Sandbagging Trap That Cost a Buyer $15 Million
Transcript
- Lucas: You're doing your due diligence on a target company. You find something — maybe a regulatory violation, a customer concentration risk, a tax exposure. You know the seller hasn't disclosed it in the reps. You flag it internally, but you decide to close the deal anyway because the price is right, and you figure you'll have recourse post-close under the indemnification clause. Luna: Right, that's a classic buyer move — close first, sue later. Lucas: Except there's a clause buried in the purchase agreement that can completely shut that down. It's called the anti-sandbagging provision. And if you're the buyer and you had actual knowledge of a breach before closing, that clause can bar you from recovering anything on that claim. In a 2022 Delaware case involving an industrial manufacturer, a buyer learned about a $15 million environmental compliance gap during due diligence, closed the deal anyway, and then tried to sue for indemnification. The court held that the anti-sandbagging clause in the agreement meant the buyer had waived its right to recover because it knew about the problem before signing. Luna: So the buyer essentially walked into the trap with eyes wide open. What state law applies usually determines whether sandbagging is even allowed? Lucas: Exactly. Under traditional common law in most states, a buyer can't recover for a breach of representation if they had actual knowledge of the breach at closing — that's the default anti-sandbagging rule. But Delaware, where most big M&A deals are governed, has a more nuanced approach. In Delaware, the default rule is actually pro-sandbagging — meaning a buyer generally can recover even if they knew about the breach, unless the contract explicitly says otherwise. So the anti-sandbagging clause is a contractual override that shifts the risk back to the buyer. The clause typically says something like: 'No representation or warranty of Seller shall be deemed untrue or inaccurate, and Seller shall not be liable for any breach, to the extent that Buyer had actual knowledge of such breach prior to Closing.' Luna: That's a massive shift. So if you're a buyer, you want to either avoid that clause entirely, or carve out your knowledge — like only exclude claims if you had explicit written knowledge, not just someone in the deal team had a hunch. Lucas: Right — and that's where the negotiation gets subtle. Buyers will try to limit the knowledge qualifier to only what's in the data room or the management presentation. Sellers will want it to cover anything any officer or director knew, or even any employee involved in due diligence. The worst-case for a buyer is a broad anti-sandbagging clause that imputes knowledge across the entire organization. In that industrial case I mentioned, the buyer had a single environmental consultant who flagged the issue in a draft report. The court imputed that knowledge to the buyer entity itself, because the consultant was acting as the buyer's agent. So the buyer couldn't claim it didn't know. Luna: So the lesson is: if you find something during due diligence, don't just close and assume you'll litigate later. You need to either renegotiate the price, get a specific indemnity, or insist on amending the reps. Otherwise you're gambling on whether the anti-sandbagging clause will bite you. Lucas: Exactly. And for sellers, this clause is a powerful shield. If you're selling a business and you know there are skeletons in the closet — but you've disclosed them in the reps or the buyer discovers them — you want anti-sandbagging language to lock in that the buyer can't come back later. It's a clean-break tool. But sellers need to be careful too: if the buyer has no knowledge, they can still sue for breaches they didn't know about. So the clause only protects the seller from known at closing issues. Luna: But isn't there a tension here with the buyer's duty to conduct due diligence? I mean, if a buyer does a sloppy job, they might miss something. Shouldn't they bear that risk? Lucas: That's the policy debate. Pro-sandbagging advocates say: the seller made a representation, they should stand behind it regardless of what the buyer knew. Anti-sandbagging advocates say: the buyer should not be able to close with knowledge of a problem and then use the court system as a backup warranty. The market has settled on a middle ground: most large deals today have some form of anti-sandbagging clause, but with negotiated carve-outs. For example, a buyer might agree to anti-sandbagging only for 'willful' breaches — meaning if the seller intentionally misrepresented something, the buyer can still sue even if they knew. Or they'll negotiate a knowledge threshold: the buyer is only barred if it had 'actual knowledge' — not constructive knowledge. Luna: That last point is crucial. 'Actual knowledge' versus 'should have known' is a huge difference. If you can keep the bar at actual knowledge, as a buyer you have a lot more room to argue you didn't 'know' something even if a junior analyst had a concern. Lucas: Right. And the case law on what constitutes 'actual knowledge' varies. Some courts say it requires subjective awareness — someone in the buyer's organization actually understood the fact and its significance. Others say it's enough that the information was in the buyer's possession, even if no one read it. That's why the drafting is so important. A well-drafted clause will define knowledge explicitly: 'Knowledge of Buyer means the actual knowledge, after reasonable inquiry, of the individuals listed on Schedule X.' That gives both sides clarity. Luna: So for a buyer, you want a schedule that lists only the CEO and the general counsel, not the entire due diligence team. For the seller, you want to list everyone who touched the deal. Lucas: Exactly. And then there's the interplay with reps and warranties insurance. If you have RWI, the insurer will generally require that the buyer has no actual knowledge of any breach at closing. If they find out later that the buyer knew something, the policy could be voided. So the anti-sandbagging clause in the purchase agreement can also affect whether the insurance pays out. In the industrial case, the buyer also had RWI, but because of the anti-sandbagging clause, the insurer denied coverage, arguing that the buyer's knowledge precluded coverage under the policy's knowledge exclusion. Luna: That's a double whammy: no recovery from the seller, and no insurance. So the buyer ate the full $15 million. Lucas: They did. And that's the kind of outcome that keeps M&A lawyers up at night. So let's talk about practical takeaways. If you're a buyer, first: negotiate the anti-sandbagging clause out entirely if you can. If you can't, narrow the knowledge qualifier to a specific list of people, and define 'actual knowledge' narrowly. Second: during due diligence, don't just flag issues — escalate them. If you find a material problem, document that you are not accepting it, and negotiate a specific indemnity or price adjustment before signing. Third: consider a 'bring-down' condition that requires the reps to be true at closing, which gives you a walk-away right if something turns out to be wrong. Luna: And for sellers? What's your advice? Lucas: For sellers, push for a broad anti-sandbagging clause that covers all knowledge within the buyer's organization, not just named individuals. And make sure the definition of knowledge includes information in the data room and any written communications. Also, consider adding a provision that the buyer's sole remedy for known breaches is to terminate the deal before closing — no post-closing claims. That gives you a clean exit. Luna: It's interesting how this clause essentially forces the buyer to make a decision at closing: either walk away or accept the risk. You can't have it both ways. Lucas: Exactly. And that's the beauty of the anti-sandbagging clause: it eliminates moral hazard. The buyer can't sit on a known problem and then use it as a bargaining chip later. It aligns incentives — both parties have to be transparent during due diligence. But it's also a trap if you're not paying attention. I've seen experienced private equity funds miss this clause because it's buried in a 200-page purchase agreement, and they assume they have full indemnification rights post-close. Luna: That's a sobering thought. And it's the kind of thing that makes this show valuable — these hidden clauses can cost millions. Speaking of value, a quick thought: if you're getting something out of these deep dives, consider supporting the show. It's listener-supported, ad-free, and a couple of dollars a month genuinely helps keep it going. You can find that at buy me a coffee dot com slash fexingo. We don't have a big marketing budget, so it's really the community that keeps this going. Lucas: Absolutely. And we appreciate every bit of support — it lets us keep digging into these niche topics that most business shows skip. So back to the anti-sandbagging clause: let's talk about how it interacts with the 'material adverse change' clause, because there's an interesting overlap. If a buyer discovers a material issue during due diligence and doesn't walk, can they later claim a MAC occurred after closing based on the same issue? Luna: That seems like a stretch — the MAC clause usually requires a change that occurs after signing. If the issue existed before, it's not a MAC, it's a breach of reps. Lucas: Right. And courts have generally held that a known pre-existing condition cannot be repackaged as a MAC. So the anti-sandbagging clause effectively closes that escape hatch too. In the industrial case, the buyer also tried to argue that the environmental issue triggered a MAC, but the court said: you knew about it before closing, so it's not a 'change' — it's a known condition. So the anti-sandbagging clause also reinforces the temporal boundary of MAC clauses. Luna: So the anti-sandbagging clause is really a risk-allocation tool that forces the buyer to make a clean decision at closing. If you know something, you either adjust the deal or you accept it. Lucas: Exactly. And that's why I think every operator should understand this clause, whether you're buying or selling. It's not just lawyer jargon — it's a multi million dollar decision point. If you're a seller, you want it to protect your clean exit. If you're a buyer, you want to preserve your right to sue. But the key is: know what you're signing, and never assume you can fix it in court later. Because if you knew about it at closing, you might be out of luck. Luna: Great episode. One last thing: for listeners who want to see the actual clause language, we'll put a sample anti-sandbagging clause in the show notes, along with a checklist for both buyers and sellers. Lucas: Thanks, Luna. And thanks to our listeners. We'll be back next week with another trap that could cost you millions.