Background
This opinion arises from the acquisition by AW Site Services, LLC (AWS) of a waste disposal business that was owned and operated by John Arwood. The court noted that Arwood lacked business sophistication and started in the waste business as a child, collecting cans and bottles from the side of the road. Arwood ran the target business without formal accountings or records and did not have “the know-how or inclination” to prepare financial records or formulate valuations. As a result, AWS took the laboring oar in valuing the business’s assets.
AWS required and Arwood agreed to “full and unfettered access” to the business’s raw financial data and limited records (including access to Arwood’s own personal bank and credit card accounts). AWS prepared financial statements for the business, valued the business, and prepared the draft asset purchase agreement ‒ which included Arwood’s representations and warranties. Arwood never offered any input or negotiation when he agreed to AWS’s draft agreement, valuations, and purchase price.
After seven months of active due diligence by AWS, the parties signed the APA in October 2018. At the closing, AWS paid a $16 million purchase price. Post-closing, Arwood continued to work for AWS until litigation ensued.
After the closing, the business did not perform as well as AWS had expected. AWS discovered that, pre-closing, Arwood engaged in a “massive fraudulent scheme” by overbilling customers, causing an overstatement of the business’s pre-closing revenue. AWS asserted claims against Arwood for more than $11 million, seeking indemnification under the APA based on the alleged breach of Arwood’s representations and warranties in the APA, among other claims. In a post-trial opinion, the court held that, even though Arwood lacked scienter and AWS did not justifiably rely on Arwood’s misrepresentation, Arwood was obligated to indemnify AWS in the amount of $3.9 million (the indemnification cap set forth in the APA).
Analysis
Before determining whether Arwood had to indemnify AWS, the court considered whether a sandbagging defense would be available (i.e., whether Arwood might not be obligated to indemnify AWS because AWS knew that Arwood’s representations and warranties were false). In a 2018 opinion captioned Eagle Force v. Campbell, the Delaware Supreme Court appeared to cast doubt on that defense by stating:
We acknowledge the debate over whether a party can recover on a breach of warranty claim where the parties know that, at signing, certain of them were not true. [Defendant] argues that reliance [by the plaintiff on the defendant’s alleged misrepresentations] is required, but we have not yet resolved this interesting question.
In a dissenting opinion in Eagle Force, then-Chief Justice Strine wrote: “[T]o the extent [the buyer] is seeking damages because [the seller] supposedly made promises that were false, there is doubt that he can then turn around and sue because what he knew to be false remained so.”
The Court of Chancery in Arwood acknowledged that “there is something unsettling about allowing a buyer to lay in wait on the other side of a closing with a breach claim he knew before closing he would bring against the seller.” However, “the risk of such litigation, like any other risk, can be managed expressly in the bargain the parties strike.” The court emphasized that, under Delaware’s “profoundly contractarian” approach, the parties are able to negotiate and allocate risk according to their own tolerances and, therefore, “Delaware is, or should be a pro-sandbagging jurisdiction.”
Ultimately, the court ruled that sandbagging was not available as a defense to Arwood because he failed to show that AWS had “actual knowledge” of the falsity of his representation and warranty. Thus, the court was “satisfied” that sandbagging “is not implicated if a buyer, exercising reasonable care, should have known a representation was false but did not actually know.”
Key takeaways
Delaware is, or at least should be, a pro-sandbagging jurisdiction, in which one party to a contract may close and then sue for a breach that it knew existed pre-closing, because of Delaware law’s emphasis on freedom of contract and risk allocation among the parties. However, the sandbagging doctrine is not implicated unless the buyer, pre-closing, “actually knew” that the seller’s representations were false.
Client Alert 2022-105
