It’s a situation that, at least theoretically, could happen many times every business day, all across the country, given how often businesses choose to have Delaware law apply to their contracts. A party (the seller or transferor) to a transaction governed by that state’s laws makes representations and warranties about its business, and about the things of value being transferred under the contract, to its counter-party transferee. The transferee knows one or more of those representations and warranties to be materially false — but decides to complete the transaction anyway. Having decided to go forward with the deal, the transferee nevertheless later sues the transferor for breaches of the representations and warranties that it was already aware were false prior to closing the deal. What should a court applying Delaware law do? A recent Delaware Court of Chancery decision provides guidance. The court recognized this practice as “sandbagging,” but concluded that “Delaware is, or should be, a pro-sandbagging jurisdiction.” Even though that decision is generally in keeping with most prior Delaware cases involving this type of fact pattern, it raises new interesting policy questions about the advisability of being “pro-sandbagging.”
John D. Arwood et al. v. AW Site Services, LLC, C.A. No. 2019-0904-JRS (Del. Ch. March 9, 2022) is the case that provided this recent guidance. The buyer claimed that the seller committed fraud and breached an asset purchase agreement by concealing a sham billing scheme that caused a substantial overstatement of revenue. That alleged overstatement, according to the buyer, improperly inflated the purchase price it paid for the seller’s assets. The case proceeded to trial. The Delaware court determined that the buyer could not prevail on its fraud claim because it knew or should have known prior to closing the deal that the revenues were overstated. However, the court also recognized that the seller’s representations in the asset purchase agreement about its finances were untrue. The court asked the parties to submit post-trial briefs on Delaware law regarding “sandbagging.” Of particular interest to the court was the effect of a 2018 Delaware Supreme Court opinion, Eagle Force Holdings, LLC v. Campbell, on this issue.
Prior to Eagle Force, Delaware had permitted purchasers to “sandbag” by pursuing claims as to false representations and warranties even though the purchaser knew they were false and completed the transaction anyway. Eagle Force seemed to make the continued viability of this practice less clear. Even after considering the parties’ briefing, the Arwood court concluded that sandbagging is still permissible under Delaware law. One of several factors cited by the court in support of its conclusion was Delaware’s exclusion of reliance as an element required to establish a breach of contract claim. The court also noted that a pro-sandbagging approach to cases such as this one reinforces the notion that representations and warranties serve an important risk allocation function in transactions.
The court’s decision was clear. Less clear is whether the policy view articulated by the court really serves the best interests of parties to business transactions or, for that matter, Delaware courts. As a business matter, incentivizing (or at least excusing and validating) the completion of transactions known by the purchaser at the time of closing to be marred by material misrepresentations by the seller —- misstatements likely to cause damage to the purchaser — seems questionable. As a legal matter, it is generally understood that there needs to be some causal link between an alleged contractual breach and the damages that supposedly flowed from it. Was a misrepresentation truly the cause of a party’s damage in a transaction in which the party was already well aware of it, but decided to go forward with completing the transaction nonetheless? Perhaps the knowing acceptance of risks associated with what is “understood” to be a materially false representation or warranty, should be considered either a waiver, a superseding cause of any resulting injury, or both.
The issue of “sandbagging” presents a choice between what are, at least on the surface, unappealing alternatives. Courts doubtless do not wish to be seen as “rewarding” a party such as the defendant in this recent Delaware case, a party that it concluded had sought to conceal a fraudulent billing scheme. But sometimes, as in the case of the onslaught of business-to-business residential mortgage litigation that followed the 2007-08 financial crisis, the alleged “misrepresention” is the direct result of the purchaser requiring the seller to abandon traditional underwriting/diligence practices so as to promote greater speed and volume of sales, leaving the seller in a position in which it is asked to make representations as to subjects into which it was specifically instructed not to inquire. Moreover, it is troubling to, in essence, reward a company that evidently chooses to go forward with a transaction it knows is deeply flawed on the theory that it will, at worst, have no problem suing for going forward with the transaction. One hopes that Delaware courts are not inadvertently opening the floodgates to plaintiffs seeking to be compensated for signing contracts with parties that they had always known were making misrepresentations to them.