Effect of Investigation
What is the Effect of Investigation section? The Buyer and Seller may view the role and consequences of due diligence differently, so this section is used clarify how knowledge gained during due diligence affects the parties’ rights under the Agreement.
The Middle Ground: This clause states that the parties’ indemnification rights are not affected by its pre-Closing knowledge (or that of its Representatives) or by the waiver of any of the Conditions to Closing. It is often referred to as a “sandbagging” provision because the non-breaching party can claim indemnification after Closing even if it knew or should have known prior to Closing that a representation or warranty was inaccurate.
Purpose: This provision is included to fortify the parties’ indemnification rights in situations where one party knew or should have known prior to the Closing that one or more of the other party’s representations was false. Because the Buyer is typically the one conducting an investigation and gathering information, it is most helpful to the Buyer. It lessens the Buyer’s transaction risk, helps it protect the value it receives from the deal, and makes for a much quicker transaction process for both sides.
Without this provision, the Buyer would need to either (i) investigate every time a Seller’s statement doesn’t match up to the Buyer’s information and make an indemnification claim before the deal is even done, or (ii) complete no investigation whatsoever. Both of those options are detrimental to the Buyer and may cause headaches for the Seller (or blow up the deal), so most parties will turn to this provision to allow the Buyer to conduct a thorough but measured due diligence investigation.
Buyer Preference: Because knowledge of a breach may not equate to knowledge of its consequences, and because it is the Seller’s duty to provide accurate representations, most buyers insist that a sandbagging provision be included in the Agreement. The Buyer wants to include this provision even in states that, as a default rule, allow for sandbagging. State statutes may require the Buyer to prove additional elements beyond the falsity of the representation or warranty, so including the provision in the Agreement simplifies the process for making an indemnification claim.
Seller Preference: The Seller will likely try to exclude this provision or add an anti-sandbagging provision that explicitly removes the Buyer’s indemnification rights if it has knowledge of the breach prior to Closing. Alternatively, if the Seller learns that the Buyer knows of a breach prior to the Closing, the Seller may seek to obtain a waiver from the Buyer for that specific breach rather than fighting to have the entire sandbagging provision thrown out. In terms of time allocation, most sellers will prefer to spend time making sure their representations are accurate rather than using up time and negotiating leverage to avoid the cost of a misrepresentation (and buyers will prefer that too, making for a smoother negotiation).
Differences in a Stock Sale Transaction Structure: None.
