Arwood v. AW Site Services: Delaware Chancery Court declares Delaware ‘pro sandbagging’

Corporate / M&A Decisions update series

In Arwood v. AW Site Services LLC, C.A. No. 2019-0904-JRS (Del. Ch. March 9, 2022), the Delaware Court of Chancery held that “Delaware is a ‘pro-sandbagging jurisdiction,’” meaning that, absent a provision to the contrary, an M&A buyer is entitled to seek indemnification for breaches of contractual representations even if it knew or should have known of the breaches at the time of contract. The court further stated that, even where available, sandbagging could not arise as a defense unless the buyer had actual knowledge that a representation was false at the time it was made, and that even reckless disregard for the truth was insufficient. The case clarifies that, under Delaware law, a buyer’s pre-closing knowledge will not bar its ability to bring claims for breached representations and warranties, unless the agreement contains anti-sandbagging provisions. The court also clarified the standards for showing justifiable reliance in connection with fraud claims.

At issue in Arwood v. AW Site Services LLC were claims by the sellers of a waste management business that they should not be responsible for breaches of financial and other contractual representations concerning their former business because the buyer was, or should have been, aware that the representations were false at signing.

The transaction involved somewhat unusual facts. The plaintiff had founded the business at issue but had not marketed it for sale. The court found that he “did not know how to package a business to be sold”; “had not valued his businesses”; “did not maintain any financial records”; and “did not know how to prepare them.” After expressing an interest in acquiring the business, the seller granted the buyer “extraordinary” access to the business so that the buyer could perform valuation and prepare a “detailed set of financials.” The parties negotiated a price and the transaction closed.

Following the closing, the buyer discovered what it alleged was a fraudulent overbilling scheme. The buyer refused to release US$1.41 million in escrowed funds, claimed fraud, and demanded indemnification for breaches of the seller’s representations and warranties concerning the company’s financial statements, its compliance with laws, and other matters. The seller demanded the release of the escrowed funds and sued when the buyer refused. Among other things, the seller argued that the buyer could not recover for breaches of contractual representations that it knew were false at the time of contract – a sandbagging defense.

The Court of Chancery rejected the sellers’ argument following a bench trial, despite finding that the buyer “knew as much about the businesses” as the sellers, holding that “[t]he sandbagging defense is inconsistent with our profoundly contractarian predisposition.” The court held that “[v]iewed through the lens of contract, not tort, the question is simple: was the warranty in question breached? If it was, then the buyer may recover – regardless of whether she relied on the warranty or believed it to be true when made.”

The court also held that a sandbagging defense – if it were even available – could only be viable if the buyer had actual knowledge of the falsity of a representation, and that even reckless indifference to the falsity of a representation would be insufficient.

Finally, the court rejected the sellers’ fraud claims, finding no evidence of intent to defraud by the seller, whom the court found was “unsophisticated”, and who had granted the buyer “unfettered access” to the business to permit the buyer to conduct its diligence review. The court found that a buyer claiming fraud could show reasonable reliance on false information by showing that it did not have or recklessly disregard knowledge of the falsity of the information, but held that the buyer had not met that showing.

The court further allowed the buyer to recover up to the contractual cap but rejected the buyer’s claims for losses in excess of the cap because the buyer failed to show fraud.

 

 

Authored by Ryan Philp and David Michaeli.

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Ryan Philp
Partner
New York
David Michaeli
Counsel
New York
Allison Wuertz
Senior Associate
New York
Jon Talotta
Global Co-Lead
Northern Virginia
Michael Hefter
Partner
New York
William Regan
Partner
New York

 

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