“Sandbagging” in M&A context occurs when a party, usually the buyer, seeks to recover for a breach of warranty, the inaccuracy of which it had knowledge before the closing of the transaction. Although sandbagging is not a new concept, it is an issue that continues to elicit intense negotiation from both buyers and sellers. And when the contract fails to address the sandbagging issue, the law governing the agreement will have a significant impact on a buyer’s right to recover for a breach of warranty claim.
Under Vietnamese law, it is not clear whether sandbagging rule (or anti-sandbagging rule) will automatically apply to a breach of warranty. On one hand, there are provisions under Vietnamese laws which appear to support the application of sandbagging rule:
- Under Article 131 of the Civil Code 2005, when a party enters into a transaction due to its misunderstanding of the contents of the transaction caused by inadvertent mistakes made by the other party, the first-mentioned party will have the right to request the other party to change the contents of such transaction. Under this Article 131, the timing when the first-mentioned party acquires knowledge of the mistake made by the other party appears to be irrelevant. In fact, it appears that the only condition for a party to make a claim under Article 131 is the "reliance" on the accuracy of the information provided by the other party. Therefore, the buyer may rely on this Article 131 to argue that since he enters into the contract based on the warranties given by the seller, which happens to be inaccurate, he should be entitled to request for “changes to the contents” of the contract, regardless of the timing when he became aware of such inaccuracy. Since Article 131 is also not clear about what is considered as “change the contents” of the transaction, in this case, if the indemnification to the buyer is in the form of a post-closing price adjustment, it can be considered as a “change to the contents” of the transaction under Article 131; and
- According Article 303 of Commercial Law, a party may claim for compensation of damages if he can prove that (i) the other party is in breach of the contract; (ii) there are actual losses; and (iii) the breach of contract by the other party is the direct cause of the losses. Article 303 does not mention about the timing when the non-breaching party becomes aware of the breach (i.e. either before or after closing) as a fact that must be proved in order to make the claim.
On the other hand, there are certain provisions under Vietnamese laws which imply that the anti-sandbagging rule may apply, in particular:
- According to Article 444.1 of the Civil Code, the seller [of an object] must secure the use value or properties of the object for sale. If after the purchase, the buyer discovers a defect that devaluates or reduces the use value of the purchased object, the buyer must promptly inform the seller of such defect and shall be entitled to request the seller to repair or change the defective or devalued object and compensate for damage. According to Article 444.3 of the Civil Code, the seller, however, will not be liable for defects of the object if, among other things, the buyer already knew or must have known of the defect when purchasing the object.
- Article 44.4 of Commercial Law further provides that the seller will not be liable for defects of goods which the buyer or the buyer’s representative has known or should have known but failed to notify the same to the seller within a reasonable time limit after the examination of the goods. Although the wording of Article 444 of the Civil Code and Article 44 of Commercial Law tend to apply to the sale and purchase of tangible goods, it can be interpreted in a broader sense to cover the sale and purchase of shares or other assets. In this light, the seller may rely on Article 444.3 of the Civil Code and Article 44.4 of Commercial Law to argue that the buyer is not entitled to claim for indemnification of warranty breachif the buyer already knew about such breach before the time of making the purchase (i.e. before closing); and
- Article 305 of Commercial Law provides that the party claiming damages must apply appropriate measures to mitigate the loss caused by a contract breach, including the loss of direct profit which it would have earned. If the party claiming damages fails to do so, the breaching party may request a rebate of the value of damages to the extent of the loss that would have been mitigated. Under Article 305, if the buyer already knew about the breach of warranties before closing, he is required to conduct necessary measure to limit loss that he may incur, e.g. to inform the seller so that the seller can remedy the breach, or to request the seller to reduce the purchase price accordingly. Failure to do so may give the seller the right not to indemnify for the loss arising out of such warranty breach.
In practice, it may be difficult to determine whether the buyer “knew” about the warranty breach or if he "relied" on the warranty to enter the contract. In practice, it is common (but not in all cases) to take into account the source of the buyer’s pre-closing knowledge of the inaccuracy of the seller’s warranty. If the buyer acquired knowledge of the breach by itself or via third parties (other than the seller), then the buyer will have a strong argument that he relied on the warranty of the seller to proceed with the transaction, although he is aware of the potential breach before closing. On the other hand, if the buyer became aware of the breach because it was disclosed to him by the seller, the buyer cannot argue that he relied on the seller's warranty to enter the contract, and should be deemed to have known about the breach. However, unfortunately, Vietnamese laws fail to address the relevance of the source of the buyer’s pre-closing knowledge of the inaccuracy of the seller’s warranty to the post-closing claim on warranty breach.
Given the uncertainty of the law, it is suggested that the parties should agree on the application of sandbagging rule prior to signing and explicitly provide the same in the transaction documents.
This post is contributed by Pham Thuy Anh, an associate of VILAF.