Canadian M&A Perspectives Private and Public Mergers & Acquisitions | Private Equity

Sandbagging in Good Faith: How Bhasin v Hrynew Can Impact Indemnification for Known Breaches

Posted in Contractual Matters, Strategy
Geoff R. HallMatthew HarrisJeremy Busch-HowellBenjamin Layton

In the context of a merger or acquisition, a vendor may unknowingly make untrue representations about the target business. “Sandbagging” occurs when a buyer discovers such misrepresentations prior to closing and seeks to enforce indemnity provisions after closing.  The success of such claims will depend on the following:

  • The Terms of the M&A Agreement. If the parties expressly agree that the buyer’s knowledge will (or will not) bar post-closing indemnification, Canadian courts will consider, and likely respect, the parties’ intentions.
  • The Common Law. In Bhasin v Hrynew (“Bhasin”), the Supreme Court of Canada articulated a general duty of good faith that applies to the performance of all legal contracts.1 If the M&A agreement is silent on sandbagging, Canadian courts will be asked to consider whether the buyer’s indemnity claim is compatible with the general duty of good faith expressed in Bhasin.

Canadian courts have not yet offered specific guidance on whether it is possible to sandbag in good faith. Pending further judicial instruction, the discussion below offers tips on how to minimize uncertainty by including clear and comprehensive pro- or anti-sandbagging provisions in M&A agreements.

Sandbagging: Background and Purposes

M&A agreements may expressly allow, prohibit or be silent about whether a buyer can pursue indemnification after the transaction has closed for misrepresentations of a vendor of which the buyer was aware before closing. Here is a typical example of a pro-sandbagging clause:

“The right to indemnification based upon any breach of any representation or warranty will not be affected by any investigation conducted, or any knowledge acquired at any time, with respect to the accuracy or inaccuracy of such representation or warranty.”

Here is a typical example of an anti-sandbagging clause:

“No party will be liable for any breach or inaccuracy of any representation or warranty if the party seeking indemnification for such losses had knowledge of such breach before closing.”

Vendors are opposed to sandbagging. Anti-sandbagging provisions give vendors an extra defence against claims for indemnification, namely, that the buyer had prior knowledge of the breach.

Buyers benefit from the right to sandbag.  Pro-sandbagging provisions ensure that indemnity clauses in favour of the buyer will be enforceable, regardless of what is discovered by due diligence, and they provide a safeguard in instances where a misrepresentation is identified too late to be raised as an issue in price negotiations.  From a buyer’s perspective, pro-sandbagging provisions enable the buyer to effect a “purchase price adjustment” post-closing through indemnification.

Enforceability of Sandbagging Provisions

The enforceability of pro- and anti-sandbagging provisions has not been directly considered in Canada. Prior to Bhasin, one could confidently assert that, in considering the enforceability of pro- or anti-sandbagging clauses, Canadian courts would start with the general principle that the court should respect the intentions of contracting parties.

As an example, in Transamerica Life Canada Inc. v ING Canada Inc. (“Transamerica”) the Ontario Court of Appeal overturned a motion court’s decision to strike pleadings from  the statement of defence which referred to an implied duty of good faith in the share purchase agreement.2  In the underlying action, the purchaser of all of the shares of an insurance company pursued damages for breaches of warranties in the purchase agreement which had come to its attention prior to closing. The Court of Appeal restored the struck pleadings because the agreement included a price adjustment mechanism which, rather than post-closing claims for indemnification, the parties had agreed would govern such disputes.  The Court determined that it was at least arguable that a duty of good faith “would not be independent of or unconnected to the bargained for agreement but rather would be directed at preventing [the purchaser] from defeating one of the objectives of its agreement with [the vendor].”3 The outcome of the underlying case is not reported, but if it was ultimately determined that sandbagging would allow the purchaser to bypass the price adjustment clause, and thereby defeat the intentions of the parties, sandbagging may not have been permitted. The Court noted, however, that “Canadian courts [had] not recognized a stand-alone duty of good faith”.4  Such a duty would only be implied if it was required in order to give effect to the intentions of the parties.

In Bhasin, however, Justice Cromwell, writing for a unanimous Supreme Court introduced a general duty of good faith pursuant to which “parties must not lie or otherwise knowingly mislead each other about matters directly linked to the performance of the contract.”5

In Bhasin, the appellant’s business was based exclusively on the sale of the respondent’s investment products.  The appellant sought damages when the respondent exercised a non-renewal option in the dealership agreement that governed the relationship between the parties.  The Supreme Court recognized an organizing principle of good faith and honest performance in Canadian contract law and determined the respondent had breached the duty of honest performance by exercising the non-renewal option for the purpose of advancing the interests of another dealer, to the detriment of the appellant.  For a summary of the Bhasin decision click here6 and for a discussion of key implications of the judgment click here.7

The duty established in Bhasin applies to all contracts.  However, the meaning and scope of the duty, and its application with respect to sandbagging in particular, remains uncertain.  The Supreme Court offered some guidance, but the guidance comes with the caveat that the application of the Bhasin principle will be depend on the case.  For example, Justice Cromwell wrote: “[t]he precise content of honest performance will vary with context and the parties should be free in some contexts to relax the requirements of the doctrine so long as they respect its minimum core requirements.”8  Indeed, counsel to the successful appellant in Bhasin suggested, in the wake of the ruling, that “[l]awyers will face a fresh set of challenges when it comes to drafting new agreements in light of the good faith organizing principles and, where appropriate, developing provisions that relax the duty of honest performance.”9  With respect to Justice Cromwell’s remarks that the requirements could be relaxed in some contexts, counsel to the appellant predicted that “sophisticated commercial parties” will be able to relax good faith obligations by using “express language.”10
Canadian courts may look to the United States for guidance about whether sandbagging is compatible with good faith. In the U.S., where the general contractual duty of good faith has existed for some time, there is no inherent conflict between sandbagging and good faith and courts have generally enforced both pro- and anti-sandbagging provisions in M&A agreements.11  Outcomes and analysis vary from state to state, however, when M&A agreements are silent on sandbagging. In Delaware, when the M&A agreement is silent, the buyer has generally been permitted to sandbag.12  In New York, when the M&A agreement is silent, courts have permitted sandbagging, but only when the buyer demonstrates that it intended to purchase the vendor’s promise of the truth of a particular representation or warranty.13  It is difficult to establish this intention when the vendor alerted the buyer to the misrepresentation prior to closing.  In California, when the M&A agreement is silent, courts have held that the buyer’s right to sandbag is contingent on the buyer’s reliance on a particular representation or warranty.14  Without reliance, the buyer has not been permitted to sandbag. Although regional variations exist in the U.S., these differences do not relate to the interplay between sandbagging and good faith. If Canadian courts follow the U.S. example, sandbagging, in itself, will not trigger good faith concerns.

Drafting Tips

Pending further judicial instruction about the enforceability of sandbagging provisions in Canada, parties can minimize uncertainty by drafting thorough and detailed sandbagging provisions.

When negotiating sandbagging provisions, parties have been, and continue to be, well-served to consider how knowledge of a misrepresentation will be defined and proved. If parties agree to include an anti-sandbagging provision, for example, a buyer may reduce the practical difficulties of disproving prior knowledge by incorporating any or all of the following elements into the clause: (i) a narrow definition of knowledge, such as an “actual” standard rather than a standard of “implied or “constructive” knowledge; (ii) limiting knowledge to specific individuals involved in the transaction; (iii) placing the onus of proof on the vendor; and (iv) imposing timing requirements on knowledge, for example, by setting a pre-closing cut-off date.

Parties seeking to include pro-sandbagging provisions in an M&A agreement should also ensure that these provisions can be coherently read in the context of the whole agreement. For example, in the Transamerica case, the court considered the appropriateness of pleadings in a statement of defence, suggesting that permitting the purchaser to sandbag the vendor would frustrate a purchase price adjustment mechanism negotiated by the parties.  Ultimately, the court decided to permit those pleadings.  Parties seeking to include both price-adjustment mechanisms and pro-sandbagging provisions should pay careful attention to how these provisions may be read together and draft clearly so that the commercial understanding between the parties to allow for both purchase price adjustments and for sandbagging is readily apparent.

Take-Aways

M&A transactions frequently involve a temporary relationship between sophisticated parties. For these reasons, together with the legitimate purposes that sandbagging provisions can serve, Canadian courts will likely permit parties to relax the requirements of the good faith doctrine in the M&A transaction context.  Although pro-sandbagging clauses may, on the surface, appear to be at odds with the duty of good faith, Canadian courts will likely continue to enforce provisions which demonstrate the intention of the parties and either expressly acknowledge the duty or indicate the parties’ intention to relax the duty.  That said, the following considerations should be top-of-mind when negotiating and drafting sandbagging provisions:

  • Clarity – courts are more likely to respect the intentions of parties when such intentions are explicit. Parties who wish to permit sandbagging should expressly reflect this understanding in a detailed provision.
  • Comprehensiveness – parties should ensure that sandbagging provisions anticipate potential issues including those related to knowledge, materiality, proof and the interplay between the sandbagging provisions and other provisions of the contract.
  • Caution – parties should recognize that courts may ultimately determine that pro-sandbagging provisions are not enforceable in a given situation.

1 Bhasin v Hrynew, 2014 SCC 71.

2 Transamerica Life Canada Inc. v ING Canada Inc. [2003] OJ No 4656 (CA).

3 Ibid at para 55.

4 Ibid at para 53.

5 Bhasin, supra note 1 at para 73.

6 Brandon Kain, et al. “Honesty is the Best Policy – What Parties Need to Know about Good Faith and Canadian Contract Law”, online <http://www.financierworldwide.com/honesty-is-the-best-policy-what-parties-need-to-know-about-good-faith-and-canadian-contract-law/>.

7 Heidi Gordon, “Good Faith, Honest Performance and M&A: Top 5 Takeaways Stemming from Bhasin v Hyrnew”, online <https://www.canadianmergersacquisitions.com/2015/02/19/good-faith-honest-performance-and-ma-top-5-takeaways-stemming-from-bhasin-v-hrynew/>.

8 Ibid at para 77.

9 Neil Finkelstein, et al. “Honour among Businesspeople: the Duty of Good Faith and Contracts in the Energy Sector”, online: (2015) 53 Alta L Rev 349 at 375 < https://www.mccarthy.ca/pubs/2015_53_Alta_L_Rev_349.PDF>.

10 Ibid at 373.

11 See CBS Inc. v Ziff-Davis Publishing Co. et al., 553 NE (2d) 997 (NY 1990) [CBS] (widely considered the leading case on sandbagging in the United States).

12 See e.g. Interim Healthcare, Inc. v Spherion Corp., 884 A (2d) 513 (Del 2005), aff’d, 886 A (2d) 1278 (Del 2005).

13 See e.g. CBS, supra note 11.

14 See e.g. Grinnell v Charles Pfizer Co., 79 Cal Rptr 369 (App Ct 1969); Telephia, Inc. v Cuppy, 411 F Supp (2d) 1178 (ND Cal 2009).