Sandbagging: between the parties' autonomy and good faith

The Brazilian M&A market is expected to be vigorous in 2022. Numerous publicly-traded companies, as well as relevant private equity investment funds, are either capitalized or in the process of fundraising – or both. The current value of the Brazilian Real against the US dollar also encourages the acquisition of local targets by foreign investors. Macroeconomic uncertainties, as well as the 2022 presidential election, will probably play a secondary role, as M&A transactions are usually more long-term oriented.

During the negotiation of an M&A transaction, a series of potentially conflicting interests arise and must be accommodated by the parties. Sandbagging clauses are one among many tools to reach that result.

A pro-sandbagging clause preserves a party’s right to bring a claim against the other party for breach of representations, warranties, or covenants regardless of whether the potential claimant had knowledge of the circumstances giving rise to the claim before closing the transaction. The opposite applies in the case of an anti-sandbagging clause.

The admissibility of (or limits to) sandbagging clauses must be assessed with care when the relevant agreement is governed by Brazilian law. Whilst sandbagging is in principle compatible with Brazilian law, using model clauses from other jurisdictions or transplanting clauses from contracts governed by foreign law to a Brazilian law-governed contract may be problematic in some cases.

Contracts in Brazil must be negotiated, entered into, and performed according to good faith, which creates certain implicit duties such as the duty of disclosure. For example, if the buyer learns that a representation made by the seller is inaccurate and that this is unknown to the seller, but elects to close the M&A transaction anyway, and subsequently seeks remedies against the seller grounded on the existence of a pro-sandbagging clause – instead of bringing this matter to the seller’s attention prior to closing – there is a chance that the buyer may lose the case; evidence that the buyer became aware of the inaccuracy before closing the deal and nevertheless decided to move forward with it tends to be considered a waiver of its claim against the seller.

Furthermore, aspects such as good faith and public morality represent statutory limits to the exercise of contractual rights. Exceeding these limits may be deemed a wrongful act, allowing the counterparty to oppose the exercise of such right or seek compensation if it is exercised.

Lately, some have been tempted to claim that pro-sandbagging clauses are now absolutely accepted in Brazil, as the statutory landscape changed in 2019 to reduce the room for courts and tribunals to disregard or relativize the content of agreements based on open-ended legal principles. Indeed, the so-called “Economic Freedom Act” introduced the rules that (a) absent any evidence to the contrary, courts must assume that there is a balance between the parties’ respective positions in contract negotiations, (b) the parties may establish objective criteria for the interpretation of their agreement, and (c) the allocation of risks established by the parties must be respected. Courts of law and arbitral tribunals may only revise contracts on an exceptional and limited basis.

However, the 2019 changes have not affected the aforementioned principle of good faith – the obligation to negotiate, execute and perform contracts pursuant to the good faith principle remains the same. On the contrary, the need to interpret contracts from the standpoint of good faith has in fact been reinforced. Add the perceived tendency of Brazilian courts to tamper with contracts to that mix, and the result is that this renewed strength of the contractual autonomy principle will need to be battle-tested.

This relative legal uncertainty must be considered during the negotiation of M&A transactions in Brazil. Parties should not assume that the literal interpretation of a sandbagging clause will prevail in full in a dispute in Brazil under any circumstance. The wording of the relevant clauses must be carefully chosen and the contract as a whole must be meticulously negotiated in order to correctly allocate the risks between the parties.