John Arwood et al. v. AW Site Servs., C.A. No. 2019-0904-JRS (Del. Ch. Mar. 10, 2022; amended Mar. 24, 2022) (Slights, V.C.)

In this post-trial memorandum opinion, the Court found that a seller breached a representation made in an asset purchase agreement (“APA”), despite the fact the buyer should have known that the representation was false at closing.  In so ruling, the Court reasoned that Delaware law permits “sandbagging” by a buyer, but that sandbagging is not implicated where the buyer was reckless in not realizing the representation was not true at closing.

The dispute in this case arose out of the 2018 sale of the assets of Arwood Waste Inc. (“Arwood Waste”), a waste management business run by John Arwood (“Arwood”).  Arwood Waste had various lines of business, including serving as a nationwide “middleman” between commercial and residential customers seeking to rent dumpsters and portable toilettes, and the local haulers and suppliers who would fill the orders.

In early 2018, private equity fund Broadtree Partners, LLC (“Broadtree”) and Arwood Waste began discussing a possible transaction.  The talks progressed and the parties eventually proceeded to due diligence.  Because Arwood Waste kept no formal financial records, Broadtree was granted nearly unfettered access to Arwood Waste’s business records, billing software, and other accounts and records.  Using this access, Broadtree developed financial statements it later used to value the business.  The parties eventually reached an agreement, under which Broadtree, through its acquisition vehicle AW Site Services (“AWS”), would purchase all of Arwood Waste’s assets.  The APA contained several standard representations and warranties, including that the financial statements developed by Broadtree were accurate and that the seller had materially complied with the law.

Shortly after closing, AWS discovered that the business’s profits were materially lower than they were pre-closing.  The discrepancy was due to two pre-closing practices of Arwood Waste: employees’ regularly fabricating certain overage fees to charge customers when the company failed to obtain receipts from haulers, and indiscriminately charging filing fees related to mechanic’s liens on the property of customers who refused to pay bills, regardless of whether mechanics lien could legally be filed or if a mechanics lien was actually filed.  The discovery of these specious practices precipitated the deterioration of the parties’ relationship, resulting in AWS refusing to release certain funds held in escrow.  Arwood sued and AWS filed counterclaims alleging, inter alia, fraud and breach of the representations and warranties made in the APA.

In its post-trial opinion, which focused largely on AWS’s counterclaims, the Court found that Arwood did not commit fraud in connection with the APA.  Specifically, the Court held AWS failed to establish scienter, relying on circumstantial evidence including Arwood’s granting Broadtree boundless access to Arwood Waste’s business, that Arwood intended to have a continuing professional relationship with AWS following the acquisition, and the fact Broadtree was highly sophisticated and Arwood was relatively unsophisticated.  All of this evidence cut against the argument that Arwood acted with the requisite intent to defraud AWS.

Similarly, the Court found AWS did not justifiably rely on any representation made by Arwood Waste.  Broadtree was granted boundless access to Arwood Waste’s information, and it knew Arwood himself was unable to provide an accurate picture of the business.  Broadtree was also aware it could not trust Arwood Waste’s information, and passed “warning sign after warning sign,” yet proceeded to closing anyway.  Moreover, Broadtree lowered the purchase price following due diligence, which the Court viewed as evidence that Broadtree was aware of risks relating to the available information.  Therefore, the Court held AWS failed to prove its fraud claim.

The Court then confronted a question not yet resolved by the Delaware Supreme Court: whether “sandbagging”—the practice of knowing a representation or warranty is false, proceeding to closing, and then suing for breach of that representation—was permitted by Delaware law.  The Court began by noting that reliance is not an element of a claim for breach of a representation.  Recognizing the question was then a matter of public policy, the Court pointed out that “Delaware is ‘more contractarian’ than most states,” and that Delaware courts enforce both good and bad contracts; to prohibit sandbagging would be to deviate from this long-established principle.  While the Court noted concerns that sandbagging creates perverse incentives, as well as other potential ethical objections to the practice, it reasoned that parties to a contract are free to manage the risk of sandbagging by expressly permitting or prohibiting it, or by remaining silent on the issue.  Given Delaware’s contract friendly policy, and the ability to allocate risks associated with sandbagging through private ordering, the Court held that sandbagging is permitted by Delaware law.

The Court next found that sandbagging is not implicated where a buyer did not have actual knowledge that a representation or warranty was breached prior to closing.  Here, the Court’s analysis was brief, relying largely on a Delaware Supreme Court dissent that suggested sandbagging requires actual knowledge, comporting with what commentators have said on the issue.  The Court also clarified that where such a lack of knowledge is the product of reckless indifference, sandbagging is likewise not implicated.  Thus, the Court determined that anything short of actual knowledge, including reckless indifference, is insufficient to implicate sandbagging.

Applying the above principles, the Court reasoned that Broadtree’s reckless indifference regarding overbilling and Arwood Waste’s practices regarding mechanics liens, both of which violated the law, did not implicate sandbagging.  Nevertheless, Arwood represented in the APA that the company was in compliance with applicable laws.  Accordingly, the Court found that Arwood breached a representation.

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