INTRODUCTION
In M&A transactions, parties generally do not possess the same level of information. This information asymmetry is sought to be balanced through contractual provisions. Within this framework, it has become an established practice for the seller to provide certain representations and warranties regarding the target company, while the buyer seeks to identify the risks associated with the company through legal, financial, and commercial due diligence conducted prior to the transaction.
However; when a buyer, despite having actual or constructive knowledge of a defect before the transaction, relies on this matter as a basis for a breach of representations and warranties claim after the closing, this brings up a debated topic in M&A transactions known as “sandbagging.” This issue is of particular importance regarding the limits of liability for defects. While handled within the context of contractual risk determination in Anglo-Saxon legal systems, in terms of Turkish Law, sandbagging is evaluated within the provisions of the Turkish Code of Obligations No. 6098 (“TCO”) regarding liability for defects and the contractual provisions established within the framework of the parties’ contractual risk allocation.
I. GENERAL FRAMEWORK OF LIABILITY FROM DEFECTS IN M&A
In M&A transactions, matters regarding the assets, operations, contractual relationships, or legal status of the target company that are incompatible with the buyer’s reasonable expectations may be characterized as “defects”. These expectations are determined not only by the parties’ general assumptions but also by the transaction documents, disclosures, representations and warranties, and information disclosed during the pre-transaction due diligence process. Considering the legal nature of the share transfer and the economic integrity of the target company, the buyer acquires the shares together with the risks and liabilities attached to the target.
Regarding the regime of liability for defects, pursuant to Article 219 of the TCO, the seller is, as a general rule, liable for the absence of qualities it has in any manner represented to the buyer as existing in the subject matter of the sale, as well as for the existence of material, legal, or economic defects that are contrary to the agreed characteristics or that eliminate or substantially diminish its value or the expected benefit in terms of its intended use. This liability arises irrespective of whether the seller was aware of such defects and is established without the requirement of fault, provided that the defect existed at the time of the conclusion of the contract. However, pursuant to Article 222 of the TCO, the seller is not liable for defects that the buyer knew or ought to have known at the time of the conclusion of the contract had the buyer exercised ordinary care and diligence. Conversely, for defects that could have been identified through an ordinary inspection, the seller’s liability continues only if such liability has been expressly assumed under the contract.
II. THE EFFECT OF DUE DILIGENCE ON LIABILITY FROM DEFECTS
Regarding liability for defects, the most significant consequences of the legal, financial, and commercial due diligence reviews conducted by a potential buyer prior to a share transfer are the buyer’s actual knowledge of defects before the contract or the materialization of the scope of defects that the buyer should have known within the framework of ordinary care and diligence. Pursuant to Article 222/1 of the TCO, the seller is not liable for defects known to the buyer at the time the sales contract is concluded. Similarly, it is accepted that liability is exceptionally eliminated for defects that the buyer ought to have known had they exercised ordinary care and diligence. This regulation is based on the understanding that if a buyer enters into a contract despite knowing of a defect without raising any reservations, their interest is not deemed worthy of legal protection.
In M&A transactions, the primary element determining the buyer’s level of knowledge regarding defects is the pre-transaction due diligence. It is recognized in legal doctrine that as a result of this process, which exceeds the nature of an ordinary inspection, certain discrepancies that would normally be characterized as latent defects generally become explicit defects. Indeed, it no longer seems possible to categorize discrepancies as latent defects if they have come to the buyer’s knowledge or have become identifiable through a reasonable examination of the information and documents shared by the target company in the data room. Within this framework, whether matters learned or learnable during the due diligence process can be subject to a claim for breach of representations and warranties after the closing, constitutes the core of the sandbagging debate.
III. THE RELATIONSHIP BETWEEN REPRESENTATIONS AND WARRANTIES AND LIABILITY ARISING FROM DEFECTS
In M&A transactions, representations and warranties constitute one of the primary mechanisms providing for the contractual allocation of risks related to the target company between the parties. The seller’s representation and warranty of certain matters regarding the target, and the buyer’s entry into the contract in reliance on these, result in the contractual retention by the seller of risks associated with subsequently arising defects. However, the legal nature of representations and warranties is not entirely independent of the statutory liability regime for defects.
Under Turkish law, the seller’s liability for defects is, as a rule, predicated on the existence of a defect; however, pursuant to Article 222 of the TCO, this liability regarding defects that the buyer knew or could have known had they exercised ordinary care and diligence is eliminated. Conversely, the situation stated in Article 222/2 of the TCO where “the seller has expressly assumed the absence of such a defect” constitutes an exceptional circumstance that sustains the seller’s liability even for defects identifiable through an ordinary inspection. In the presence of such an “express assumption,” the seller’s liability will arise regardless of the buyer’s ability to detect the defect through an inspection.
Within this framework, the limits of representations and warranties regarding defects known prior to the contract form the basis of the sandbagging debate. Under Turkish law, buyer’s silence regarding a defect known before the contract without raising it during negotiations, only to later assert it as a breach of representations and warranties after the closing, is not considered an interest worthy of legal protection. Pursuant to Article 222/1 of the TCO, the seller’s liability for known defects is eliminated as a rule, and such claims shall be constrained by the framework of the principle of good faith and the prohibition of abuse of rights. Particularly, the validity and interpretation of sandbagging clauses in M&A agreements must be evaluated alongside the mandatory or non-mandatory nature of Article 222 of the TCO and the boundaries of the principle of good faith.
In Turkish law, sandbagging clauses in M&A agreements are contractual tools aimed at explicitly determining the parties’ allocation of risk regarding defects. While the principle of freedom of contract is fundamental in evaluating these clauses under Turkish law; the provisions of Article 222 of the TCO, the principle of good faith, and the prohibition of abuse of rights must be considered collectively. Therefore, the validity and scope of such clauses should be interpreted not merely according to their literal wording, but within the framework of the clarity of the parties’ intent regarding risk allocation, the specific characteristics of the disclosures made by the seller, and the due diligence process conducted by the buyer prior to the transaction.
IV. THE SANDBAGGING ISSUE AND RISK ALLOCATION IN THE CONTEXT OF LIABILITY FOR DEFECTS
Sandbagging is a problem in M&A transactions that arises when a buyer, despite having actual or constructive knowledge of a discrepancy that violates the representations and warranties in the share purchase agreement prior to closing, remains silent during negotiations without raising the issue and subsequently uses said discrepancy as the basis for a claim for damages after the closing. In terms of Turkish law, sandbagging is a matter that is to be evaluated within the framework of the liability regime for defects and the distinction between known/constructive defects provided under Article 222 of the TCO, unlike the Anglo-Saxon doctrine where it is treated as an independent concept.
As a rule, the burden of proof regarding the allegation that the buyer knew of the defect at the time of the conclusion of the contract remains on the seller. If the seller proves that the buyer was aware of the relevant defect, Article 222/1 of the TCO is applied as a mandatory provision, and pursuant to this provision, the seller’s liability for defects is eliminated. Unless a defect known to the buyer has been expressly assumed contractually, the risk arising from such discrepancy remains with the buyer. In such a case, it would be established that the buyer ought to have known of the defect had they exercised ordinary care and diligence, thereby potentially exonerating the seller from liability. Consequently, the buyer’s post-closing claim for damages based on such a defect may be evaluated within the scope of the principle of good faith and the prohibition of abuse of rights.
Conversely, if the seller fails to prove the buyer’s knowledge of the defect, the assessment is made based on whether the seller has expressly assumed the relevant defect in the contract. In cases where the seller has expressly assumed the absence of the defect under Article 222/2 of the TCO, the seller’s liability for the defect continues. In this instance, whether the buyer had prior knowledge of the defect is not decisive, as the risk has been explicitly allocated to the seller via the contract. Therefore, the resolution of the sandbagging debate in Turkish law requires a collective examination of not only the buyer’s actual knowledge level but also the scope of the due diligence review, the functioning of the disclosure mechanism, and the contractual risk allocation established by the parties through representations and warranties.
CONCLUSION
Under Turkish law, sandbagging is not recognized as a valid claim strategy for defects that the buyer knew or ought to have known within the framework of ordinary care and diligence; rather, a conclusion is reached by collectively evaluating the buyer’s knowledge of the defect and the risk allocation established in the contract. Within this framework, the buyer’s level of knowledge regarding the defect and the risk allocation provided by the parties in the contract are considered together; claims for damages asserted by the buyer based on a previously known defect are not deemed worthy of legal protection and are limited by the principle of good faith and the prohibition of abuse of rights.
Nevertheless, the risk allocation performed by the parties through the contract is of a decisive nature. Particularly in cases where the seller expressly assumes the defects, the seller’s liability may continue on a contractual level. Therefore, the resolution of the sandbagging debate in Turkish law is shaped depending on how the information obtained during the due diligence process and the disclosure mechanisms are reflected in the contract, as well as the scope and clarity with which the representations and warranties are structured.
