Sandbagging clauses in distressed M&A
It is tempting to make market predictions when the year begins, but they should always be taken with a grain of salt. This is particularly true at a moment when the world faces several high-stake geopolitical and environmental uncertainties. However, at least one trend seems to keep momentum in 2024: activity in mergers and acquisitions (M&A) of distressed assets is likely to remain strong in Brazil, as local companies continue to struggle with very high domestic interest rates, the local currency remains vulnerable to fiscal problems, and M&A investment is typically long-term oriented.
M&A deals tend to be complex from a legal standpoint given information asymmetry between buyer and seller. When seller is in financial distress, there is the added risk that creditors may seek to interfere with the transaction, whether to challenge it or hold buyer liable for pre-transaction contingencies.
Some mechanisms are typically used in ordinary M&A transactions to address asymmetry. They range from buyer’s access to and due diligence review of information on the asset, to representations and warranties made by seller for the benefit of buyer.
These mechanisms may prove insufficient or unfeasible when the deal involves a distressed asset: access to information may be difficult, seller may be unable to deliver the customary representations and warranties, and there may be a very short window to complete the transaction.
The so-called “sandbagging” clauses could play a key role in those situations. A pro-sandbagging provision preserves buyer’s right to seek indemnity from seller for breach of representations even if buyer knew about the breach at the time it closed the transaction. Conversely, an anti-sandbagging provision expressly prohibits buyer from pursuing a claim against seller for known contingencies.
In principle, pro-sandbagging clauses are admissible under Brazilian law, but parties should still take care and avoid copying and pasting boilerplate provisions from agreements governed by foreign law.
Objective good faith is an overarching legal principle in Brazil. Brazilian law-governed agreements must be negotiated, entered into, performed and interpreted in accordance with good faith standards. This has multiple practical implications. Parties may not exercise their rights under the agreement in a way that is abusive, i.e., in a way that exceeds the economic or social purpose of the relevant right (for instance, unreasonably denying consent requested by the other party, in certain cases). In addition, the parties must meet certain primary duties even if they are not expressly articulated in the agreement, such as cooperation (each side must act so as to assist the other side to implement the transaction) and disclosure (each side must inform the other side about facts that may affect the transaction).
To highlight the intricate interplay between pro-sandbagging provisions and the principle of good faith, consider the situation where buyer learns that a given representation made by seller is inaccurate and that this is unknown to seller, and buyer elects to close the transaction without disclosing the relevant facts to seller. Buyer’s claim will not be as airtight as in common law jurisdictions (e.g., the U.S. or U.K.) should it rely solely on the pro-sandbagging clause to seek remedies against seller. If seller can prove that buyer knew the facts and concealed them from seller with a view to bringing a claim after closing, that may be construed by courts as a waiver of the claim.
The Civil Code was amended in 2019 to reduce judges’ and arbitrators’ leeway (and, especially when it comes to judges, perceived inclination) to tamper with the balance and risk allocation agreed upon by parties to a private transaction. Essentially, courts of law and arbitral tribunals may only revise and ‘rewrite’ agreements on an exceptional and limited basis.
This statutory change does not mean that pro-sandbagging clauses should be now deemed valid in any and all cases. The status of the principle of good faith as the backbone of Brazilian private law remains unaffected. If anything, it has been strengthened, as the need to interpret contracts from the standpoint of good faith has been expressly reinforced in the Civil Code. Add the aforementioned tendency of Brazilian courts to tamper with contracts to that mix, and the result is that pro-sandbagging clauses are not much more protected than they were before the 2019 amendment.
The enforceability of pro-sandbagging clauses in the specific framework of distressed M&A deals remains to be seen, as case law is meager. It will not be surprising if courts – especially bankruptcy courts – are even more lenient in favor of debtors than in an ordinary M&A dispute. Since the Business Insolvency Act was enacted in 2005, bankruptcy courts have consistently interpreted the law with a view to preserving businesses at the expense of creditors; if pro-sandbagging clauses are viewed as pro-creditor tools that jeopardize jobs and tax revenue, chances are that the principles of good faith (Civil Code) and business preservation (Business Insolvency Act) will trump the pro-sandbagging arrangement agreed upon by seller.
This relative legal uncertainty must be considered during the negotiation of M&A transactions in Brazil, especially when distressed assets are involved. Buyer, beware: taking for granted that a pro-sandbagging clause is enough to enable a claim against seller would be a mistake, and carefully drafting provisions about risk allocation between the parties continues to be a vital task.
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