당신은 주제를 찾고 있습니까 “materiality scrape clause – S\u0026C Corporate Partner Rita-Anne O’Neill on Drafting Materiality Scrape Provisions“? 다음 카테고리의 웹사이트 Chewathai27.com/you 에서 귀하의 모든 질문에 답변해 드립니다: Chewathai27.com/you/blog. 바로 아래에서 답을 찾을 수 있습니다. 작성자 Sullivan \u0026 Cromwell LLP 이(가) 작성한 기사에는 조회수 516회 및 972601 Like 개의 좋아요가 있습니다.
A materiality scrape provides that when determining (a) whether any given representation or warranty (a “rep and warranty”) in an M&A Agreement is inaccurate, or (b) the amount of damages or losses resulting from any such inaccuracy or breach, or both, any “materiality” or Material Adverse Effect (“MAE”) qualifiers in …A “materiality scrape” is a buyer-friendly provision often contained in an M&A purchase agreement (such as a stock purchase agreement, merger agreement, or asset purchase agreement) that effectively eliminates or disregards (i.e., “scrapes”), for specified purposes, materiality qualifiers that are present in a …Materiality Qualifiers means a qualification to a representation or warranty by use of the word “material,” “materially” or “materiality” or by a reference regarding the occurrence or non-occurrence or possible occurrence or non-occurrence of a Material Adverse Effect or a “materially adverse effect.”
materiality scrape clause 주제에 대한 동영상 보기
여기에서 이 주제에 대한 비디오를 시청하십시오. 주의 깊게 살펴보고 읽고 있는 내용에 대한 피드백을 제공하세요!
d여기에서 S\u0026C Corporate Partner Rita-Anne O’Neill on Drafting Materiality Scrape Provisions – materiality scrape clause 주제에 대한 세부정보를 참조하세요
This is an excerpt from the ABA’s Market Check video series. To view the full video and others in the series, visit: www.ambar.org/blshotshot
materiality scrape clause 주제에 대한 자세한 내용은 여기를 참조하세요.
Materiality Scrape Sample Clauses – Law Insider
Materiality Scrape. For purposes of calculating the amount of any Losses incurred in connection with a breach of any representation or warranty (but not a …
Source: www.lawinsider.com
Date Published: 7/18/2021
View: 1471
Purchase Agreement: Materiality Scrape | Practical Law
This Standard Clause has been revised to include the formulation commonly referred to as a single materiality scrape, which limits the materiality scrape to the …
Source: content.next.westlaw.com
Date Published: 4/26/2022
View: 5022
Examples of materiality scrape clauses in contracts – Afterpattern
8.5.3 Materiality Scrape. For purposes of (a) calculating the amount of any Damages, and (b) determining whether a breach of a representation or warranty …
Source: afterpattern.com
Date Published: 4/21/2022
View: 3374
Don’t Be a Materiality Scrape Goat – Сox & Palmer
A materiality scrape is a provision in a purchase agreement that “reads out” materiality qualifiers from representations or warranties in the …
Source: coxandpalmerlaw.com
Date Published: 11/18/2022
View: 120
Materiality scrapes in private M&A transactions – Deal Law Wire
This clause states that the materiality qualifiers will continue to apply to determine if the seller has breached a representation but, if a …
Source: www.deallawwire.com
Date Published: 11/25/2022
View: 7462
Materiality Scrape Clause (Indemnification) – Lexis
This clause contains what is known as a “materiality scrape” and may be used in the context of the indemnification provision of an acquisition agreement.
Source: advance.lexis.com
Date Published: 3/24/2021
View: 5535
Materiality Scrape: Everything You Need to Know – UpCounsel
A materiality scrape — also called a materiality read-out — is a common provision in private merger and acquisition transactions. It tends to favors the buyer …
Source: www.upcounsel.com
Date Published: 9/10/2021
View: 6744
주제와 관련된 이미지 materiality scrape clause
주제와 관련된 더 많은 사진을 참조하십시오 S\u0026C Corporate Partner Rita-Anne O’Neill on Drafting Materiality Scrape Provisions. 댓글에서 더 많은 관련 이미지를 보거나 필요한 경우 더 많은 관련 기사를 볼 수 있습니다.
주제에 대한 기사 평가 materiality scrape clause
- Author: Sullivan \u0026 Cromwell LLP
- Views: 조회수 516회
- Likes: 972601 Like
- Date Published: 2019. 9. 16.
- Video Url link: https://www.youtube.com/watch?v=j52eFk2taFw
What is a materiality scrape?
A “materiality scrape” is a buyer-friendly provision often contained in an M&A purchase agreement (such as a stock purchase agreement, merger agreement, or asset purchase agreement) that effectively eliminates or disregards (i.e., “scrapes”), for specified purposes, materiality qualifiers that are present in a …
What are materiality qualifiers?
Materiality Qualifiers means a qualification to a representation or warranty by use of the word “material,” “materially” or “materiality” or by a reference regarding the occurrence or non-occurrence or possible occurrence or non-occurrence of a Material Adverse Effect or a “materially adverse effect.”
What is a knowledge scrape?
Similar to a “materiality scrape,” some buyers may seek to include a “knowledge scrape,” which effectively removes all knowledge qualifications from the representations and warranties in the acquisition agreement for indemnification purposes.
What is a 10b 5 rep?
A target’s or seller’s representation and warranty in a purchase agreement that the information provided by it is complete and correct in all material respects and does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statement not misleading.
What is a sandbagging clause?
Simply stated, a “sandbagging” or “pro‑sandbagging” provision provides that a buyer’s remedies against the seller under the governing agreement are not impacted regardless of whether the buyer had knowledge, at or prior to closing, of the facts or circumstances giving rise to an indemnification claim.
What is an anti sandbagging provision?
An “anti-sandbagging” clause is any provision that is designed to deny the buyer the benefit of any contractually bargained- for representation or warranty to the extent that the buyer is aware of the fact that the representation or warranty was untrue when made by the seller, at signing or, in some cases, either at …
Why do we scrape materiality?
Buyers argue that a materiality scrape is needed in order to allow for the recovery of their damages or losses resulting from immaterial and unrelated breaches of the seller’s reps and warranties that individually are not material, but that in the aggregate are material. Simplify Negotiations.
What constitutes a material adverse effect?
First, a MAC typically is defined as any event, development or condition occurring that has had, or would be reasonably expected to have, a material adverse effect on the business, financial condition or results of operations of the company and its subsidiaries (taken as a whole).
What is a Mae qualifier?
MAE Qualification means except for any failures, non-compliances, facts, events or circumstances which, when aggregated with all other failures, non-compliances, facts, events or circumstances, would not have, or reasonably be expected to have, a Material Adverse Effect on Seller.
What is an indemnity clause?
An indemnification clause may allow: The indemnified party to recover certain types of losses, such as attorney’s fees, which are not typically recoverable under a common law cause of action. The indemnifying party to reduce its liability by incorporating: Liability cap.
What is an indemnification holdback?
Indemnity holdbacks are a temporary reduction in the amount of purchase price paid to the seller at closing, held in escrow to be drawn upon to cover seller’s indemnity obligations to the buyer, thereby reducing the purchase price.
Can you cap indemnity?
As indemnities are usually used for specific risks which exceed the general liability cap, they should carry their own financial cap (or be unlimited). Risks identified as being suitable for an indemnity may be capped to the level of insurance carried by the indemnifying party.
Who does Rule 10b 5 apply to?
In sum, SEC Rule 10b-5 is applicable to any person that commits securities fraud, i.e., the intentional misrepresentation of material information in connection with securities trading, including insider trading.
What is Section 10 B of the Securities Exchange Act?
Section 10(b) makes it unlawful to “use or employ, in connection with the purchase or sale of any security” a “manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe.” 15 U.S.C. § 78j(b).
What does materiality assessment mean?
A materiality assessment is designed to help you identify and understand the relative importance of specific ESG and sustainability topics to your organization. This involves looking at a variety of factors through two particular lenses: potential impact on your organization and importance to stakeholders.
What is materiality concept in simple words?
Materiality is an accounting principle which states that all items that are reasonably likely to impact investors’ decision-making must be recorded or reported in detail in a business’s financial statements using GAAP standards.
What are the 2 types of materiality?
- Overall Materiality (for the Financial Report as a whole)
- Overall Performance Materiality.
- Specific Materiality (for particular classes of transactions,
What is materiality example?
A classic example of the materiality concept is a company expensing a $20 wastebasket in the year it is acquired instead of depreciating it over its useful life of 10 years. The matching principle directs you to record the wastebasket as an asset and then report depreciation expense of $2 a year for 10 years.
“Materiality Scrapes” in M&A transactions
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A “materiality scrape” (sometimes referred to as a “materiality read‑out” provision) is a pro‑buyer provision commonly included in merger and acquisition agreements (an “M&A Agreement”). A materiality scrape provides that when determining (a) whether any given representation or warranty (a “rep and warranty”) in an M&A Agreement is inaccurate, or (b) the amount of damages or losses resulting from any such inaccuracy or breach, or both, any “materiality” or Material Adverse Effect (“MAE”) qualifiers in the seller’s reps and warranties will be disregarded or “scraped” for indemnification purposes. Thus, a materiality scrape effectively eliminates, for indemnification purposes, any materiality qualifiers in the seller’s reps and warranties for purposes of determining whether a breach of a rep or warranty has occurred. A materiality scrape can drastically alter the allocation of liability between the buyer and seller. Materiality scrapes are generally built into the indemnification provisions in the M&A Agreement, but sometimes are set forth in a separate, stand‑alone provision. However, while critical in allocating liability and economic risk, materiality scrapes are generally rather innocuous and often misunderstood, and their potential impact not fully appreciated.
This article summarizes the concept of a “materiality scrape”, the implications of including a “scrape” in an M&A Agreement, the arguments often made by buyers for including a “scrape” and the positions taken by sellers for resisting or trying to limit these provisions, and some of the commonly employed compromise positions that are often agreed upon.
“Materiality Scrapes”
Sellers typically make several factual reps and warranties to the buyer in an M&A Agreement regarding the seller’s business. Those reps and warranties are usually heavily negotiated, with sellers often attempting to qualify their reps and warranties with “materiality” and/or “knowledge” qualifiers, in an attempt to avoid being responsible for immaterial breaches of reps and warranties, immaterial damages or losses resulting from a breach, and avoid liability for matters of which they are not aware. Parties to M&A transactions usually will negotiate and agree on an indemnification “basket” in order for the seller to avoid indemnification claims for immaterial breaches of reps and warranties and/or immaterial damages or losses. An indemnification “basket” provides a mechanism whereby the seller will not be liable for a breach of its reps and warranties unless the damages or losses suffered by the buyer as a result of such breach exceed a certain materiality threshold or specified dollar amount.
A materiality scrape is a pro‑buyer provision often negotiated into M&A Agreements by buyers. These provisions have become increasingly more common in recent years, and in fact are now included in the vast majority of M&A Agreements for transactions involving private companies. A materiality scrape can be included in the agreement for any M&A transaction, whether structured as a stock purchase, an asset purchase or a merger.
For example, assume an M&A Agreement contains a materiality scrape and a seller rep and warranty reading as follows: “The Seller is not party to any material litigation.” The effect of the materiality scrape would be to disregard or “scrape” the word “material” from that representation, such that for indemnification purposes that rep and warranty would be read for indemnification purposes simply as “The Seller is not party to any litigation.”
In order to mitigate or “soften” the impact of materiality and MAE qualifiers and indemnification “baskets” on buyers, buyers often try to include what is referred to as a “double” materiality scrape in the M&A Agreement. A materiality scrape is referred to as a “double” materiality scrape if it applies for purposes of determining both (a) whether a breach of a rep and warranty has occurred and (b) the amount of indemnifiable damages or losses resulting from the breach.
The qualifiers that are most commonly subject to a materiality scrape are materiality and MAE qualifiers related to the determination of:
Whether a breach of a rep or warranty has occurred,
The amount of damages or losses suffered by the buyer as a result of such breach,
The scope of the disclosure required in the seller’s Disclosure Schedules to the M&A Agreement, and
Whether the conditions to closing the transaction have been fulfilled.
Buyer and Seller Positions
Buyers and sellers have drastically different positions or views regarding materiality scrapes and reasons for wanting to include such a provision (if on the buy‑side), or exclude (or at least limit) these provisions (if on the sell‑side). Both buyers and sellers have logical reasons and compelling arguments and defensible positions regarding materiality scrapes.
Common Buyer Arguments
Among the arguments often advanced by buyers for including a materiality scrape are the following:
“Scrape” Needed to Avoid Impact of “Double Materiality.” Buyers argue that a materiality scrape is needed because the concept of materiality is addressed through the indemnification “basket”, and, therefore, without a scrape the buyer would be subject to a “double materiality” standard. Without a scrap, the buyer would first need to overcome the materiality or MAE qualifiers in the seller’s reps and warranties, and then would be required to prove that the damages or losses resulting from the breach exceed the dollar threshold provided for in the indemnification basket.
Buyers argue that a materiality scrape is needed because the concept of materiality is addressed through the indemnification “basket”, and, therefore, without a scrape the buyer would be subject to a “double materiality” standard. Without a scrap, the buyer would first need to overcome the materiality or MAE qualifiers in the seller’s reps and warranties, and then would be required to prove that the damages or losses resulting from the breach exceed the dollar threshold provided for in the indemnification basket. Meet Threshold/Indemnification Basket Amount. Most M&A Agreements contain an indemnification dollar threshold, or “basket”, that is designed to give the seller (which generally will be the party responsible for providing indemnification) protection against indemnification claims that fall below the agreed‑upon dollar threshold. Baskets are designed to protect sellers against immaterial or “nickel and dime” indemnification claims by a buyer, similar to a deductible in a liability insurance policy. Buyers argue that a materiality scrape is needed in order to allow for the recovery of their damages or losses resulting from immaterial and unrelated breaches of the seller’s reps and warranties that individually are not material, but that in the aggregate are material.
Most M&A Agreements contain an indemnification dollar threshold, or “basket”, that is designed to give the seller (which generally will be the party responsible for providing indemnification) protection against indemnification claims that fall below the agreed‑upon dollar threshold. Baskets are designed to protect sellers against immaterial or “nickel and dime” indemnification claims by a buyer, similar to a deductible in a liability insurance policy. Buyers argue that a materiality scrape is needed in order to allow for the recovery of their damages or losses resulting from immaterial and unrelated breaches of the seller’s reps and warranties that individually are not material, but that in the aggregate are material. Simplify Negotiations. By disregarding or “scraping” materiality and MAE qualifiers from the seller’s reps and warranties, the negotiation of the M&A Agreement is simplified because the parties will not need to specifically negotiate each individual materiality and MAE qualifier.
By disregarding or “scraping” materiality and MAE qualifiers from the seller’s reps and warranties, the negotiation of the M&A Agreement is simplified because the parties will not need to specifically negotiate each individual materiality and MAE qualifier. Eliminate Materiality Disputes. Disregarding materiality and MAE qualifiers for indemnification purposes can eliminate post‑closing disputes between the buyer and seller regarding what is and what is not “material.”
Common Seller Arguments
Among the arguments often made by sellers for not including (or at least limiting) a materiality scrape are the following:
“Scrapes” Make Materiality Qualifiers Irrelevant. Sellers resist materiality scrapes and argue that they make materiality and MAE qualifiers in their reps and warranties irrelevant.
Sellers resist materiality scrapes and argue that they make materiality and MAE qualifiers in their reps and warranties irrelevant. “Nickel and Dime” Claims. Sellers argue that all M&A transactions involve some degree of risk and that buyers should be responsible for a portion of that risk and a certain amount of any damages or losses suffered or liability that results. Sellers argue that the inclusion of a materiality scrape, and disregarding materiality and MAE qualifiers when determining damages or losses, disproportionately allocates the risk of loss to the seller and encourages the buyer to make small, immaterial “nickel and dime” indemnification claims in order to reach the dollar threshold or “basket” amount.
Sellers argue that all M&A transactions involve some degree of risk and that buyers should be responsible for a portion of that risk and a certain amount of any damages or losses suffered or liability that results. Sellers argue that the inclusion of a materiality scrape, and disregarding materiality and MAE qualifiers when determining damages or losses, disproportionately allocates the risk of loss to the seller and encourages the buyer to make small, immaterial “nickel and dime” indemnification claims in order to reach the dollar threshold or “basket” amount. Encourages “Kitchen Sink” Claims. Sellers argue that the inclusion of a materiality scrape incentivizes buyers to look for and assert every possible indemnification claim, regardless of materiality, so the indemnification dollar threshold or “basket” can be met, thus encouraging buyers to essentially “throw in the kitchen sink” and make an indemnification claim for every possible breach.
Sellers argue that the inclusion of a materiality scrape incentivizes buyers to look for and assert every possible indemnification claim, regardless of materiality, so the indemnification dollar threshold or “basket” can be met, thus encouraging buyers to essentially “throw in the kitchen sink” and make an indemnification claim for every possible breach. Increased Disclosure Obligation. If materiality and MAE qualifiers are disregarded or “scraped” from the seller’s reps and warranties for indemnification purposes, sellers will generally “throw in the kitchen sink” in their Disclosure Schedules to the M&A Agreement in order to avoid possible liability for a breach of a rep or warranty. For instance, a common representation in M&A Agreements is a representation reading as follows: “Disclosure Schedule XYZ sets forth all of the seller’s material contracts.” If the M&A Agreement contained a “materiality scrape,” then, for indemnification purposes, that representation would be read simply as “Disclosure Schedule XYZ sets forth all of the seller’s contracts.” As a result, the omission by the seller of any contract—regardless of its materiality—from Disclosure Schedule XYZ could be deemed to be a breach of that rep and warranty, possibly triggering an indemnification claim by the buyer and potential liability for the seller. Consequently, the seller may be forced to “over disclose” and include every possible matter in their Disclosure Schedules, regardless of materiality or importance to the buyer. Such over disclosure or “kitchen sink” disclosure not only increases the time and cost for the seller to prepare its Disclosure Schedules, but also that of the buyer and its advisors to review and thoroughly evaluate and analyze the seller’s disclosure.
If materiality and MAE qualifiers are disregarded or “scraped” from the seller’s reps and warranties for indemnification purposes, sellers will generally “throw in the kitchen sink” in their Disclosure Schedules to the M&A Agreement in order to avoid possible liability for a breach of a rep or warranty. For instance, a common representation in M&A Agreements is a representation reading as follows: “Disclosure Schedule XYZ sets forth all of the seller’s material contracts.” If the M&A Agreement contained a “materiality scrape,” then, for indemnification purposes, that representation would be read simply as “Disclosure Schedule XYZ sets forth all of the seller’s contracts.” As a result, the omission by the seller of contract—regardless of its materiality—from Disclosure Schedule XYZ could be deemed to be a breach of that rep and warranty, possibly triggering an indemnification claim by the buyer and potential liability for the seller. Consequently, the seller may be forced to “over disclose” and include every possible matter in their Disclosure Schedules, regardless of materiality or importance to the buyer. Such over disclosure or “kitchen sink” disclosure not only increases the time and cost for the seller to prepare its Disclosure Schedules, but also that of the buyer and its advisors to review and thoroughly evaluate and analyze the seller’s disclosure. Avoid Nonsensical Results. Eliminating materiality and MAE qualifiers from certain reps and warranties can create nonsensical results. The concept of materiality is a key component of certain important reps and warranties that are almost always included in M&A Agreements. The application of a materiality scrape those reps and warranties makes no sense and at best causes nonsensical results. Such results can occur with the so‑called Rule 10b‑5 “full disclosure” rep and warranty (in reference to Rule 10b‑5 under the Securities Exchange Act of 1934), and the commonly‑required Generally Accepted Accounting Principles (“ GAAP ”) compliance representation, both of which are contained in almost every M&A Agreement. For instance, a Rule 10b‑5 “full disclosure” rep and warranty will state that “The Seller’s statements in [the M&A] Agreement do not contain any untrue statements of material fact or omit to state a material fact necessary to make any of those statements, in light of the circumstances in which they were made, not misleading.” Deleting or “scraping” the materiality qualifiers from such a rep and warranty results in it simply being read as “The Seller’s statements in [the M&A] Agreement do not contain any untrue statements of fact or omit to state a fact necessary to make any of those statements, in light of the circumstances in which they were made, not misleading.”
Eliminating materiality and MAE qualifiers from certain reps and warranties can create nonsensical results. The concept of materiality is a key component of certain important reps and warranties that are almost always included in M&A Agreements. The application of a materiality scrape those reps and warranties makes no sense and at best causes nonsensical results. Such results can occur with the so‑called Rule 10b‑5 “full disclosure” rep and warranty (in reference to Rule 10b‑5 under the Securities Exchange Act of 1934), and the commonly‑required Generally Accepted Accounting Principles (“ ”) compliance representation, both of which are contained in almost every M&A Agreement. For instance, a Rule 10b‑5 “full disclosure” rep and warranty will state that “The Seller’s statements in [the M&A] Agreement do not contain any untrue statements of material fact or omit to state a material fact necessary to make any of those statements, in light of the circumstances in which they were made, not misleading.” Deleting or “scraping” the materiality qualifiers from such a rep and warranty results in it simply being read as “The Seller’s statements in [the M&A] Agreement do not contain any untrue statements of fact or omit to state a fact necessary to make any of those statements, in light of the circumstances in which they were made, not misleading.” Possible “Glitch” Regarding Closing Conditions. If a materiality scrape is included in an M&A Agreement (thereby eliminating materiality and MAE qualifiers for purposes of determining whether a breach has occurred), but not also addressed in and taken into consideration in connection with the drafting of the closing conditions for the transaction, serious, unintended consequences can result for an unwary seller. The inclusion of a materiality scrape in an M&A Agreement that disregards or “scrapes” materiality and MAE qualifiers for the purpose of determining whether a breach of the seller’s reps and warranties has occurred, but that does not also apply in determining whether the closing conditions have been satisfied, may force the seller to close “into a breach” and then be subject to a breach claim and potential liability after closing.
Possible Compromise Positions
Lawyers have developed certain compromise positions in an attempt to address the different views between buyers and sellers regarding materiality scrapes. Among the common compromise positions that have been developed are the following:
True “Deductible” Baskets. With a “deductible” basket, the indemnifying party (which will usually be the seller) will not have any obligation to indemnify the other party until the agreed‑upon dollar amount of the “basket” has been reached. Once the basket or threshold dollar amount has been reached, the indemnifying party will (with a few common exceptions) be obligated to provide indemnification for all damages and losses in excess of the basket amount. A “deductible” basket is a pro‑seller concept.
With a “deductible” basket, the indemnifying party (which will usually be the seller) will not have any obligation to indemnify the other party until the agreed‑upon dollar amount of the “basket” has been reached. Once the basket or threshold dollar amount has been reached, the indemnifying party will (with a few common exceptions) be obligated to provide indemnification for all damages and losses the basket amount. A “deductible” basket is a pro‑seller concept. Increase Basket Amount. Increase the dollar amount of the basket (regardless of whether the basket is a “deductible” basket or a so‑called “tipping” or “dollar‑one” basket. (With a “tipping” or “dollar‑one” basket, once the aggregate dollar amount of claims exceeds the agreed‑upon basket amount, the indemnifying party will be obligated to indemnify for the full basket amount (that is, from “dollar one”), as well as all damages or losses in excess of the basket amount.)
Increase the dollar amount of the basket (regardless of whether the basket is a “deductible” basket or a so‑called “tipping” or “dollar‑one” basket. (With a “tipping” or “dollar‑one” basket, once the aggregate dollar amount of claims exceeds the agreed‑upon basket amount, the indemnifying party will be obligated to indemnify for the full basket amount (that is, from “dollar one”), as well as all damages or losses in excess of the basket amount.) Use a “Single” Materiality Scrape. Provide that the materiality scrape will only apply when determining the amount of damages or losses resulting from a breach, but not when determining whether a breach has occurred. Such a construct is referred to as a “single” materiality scrape (as opposed to a “double” materiality scrape), thus only resulting in the “scraping” or disregarding of materiality or MAE qualifiers when determining the amount of damages or losses. Said differently, a “single” materiality scrape provides that the materiality and MAE qualifiers will continue to apply in determine whether the seller has breached any of its reps and warranties, but, once a breach has been found to have occurred, the materiality and MAE qualifiers will be disregarded or “scraped” in determining the amount of any resulting damages or losses. Thus, a “single” materiality scrape will be read to mean that (a) materiality qualifiers would not be scraped in determining whether a breach of a rep or warranty has occurred, such that an immaterial breach of a rep or warranty would not trigger a breach, but (b) the materiality qualifiers would be disregarded or “scraped” in determining the amount of damages or losses resulting from any breach.
Provide that the materiality scrape will only apply when determining the amount of damages or losses resulting from a breach, but when determining whether a breach has occurred. Such a construct is referred to as a “single” materiality scrape (as opposed to a “double” materiality scrape), thus only resulting in the “scraping” or disregarding of materiality or MAE qualifiers when determining the amount of damages or losses. Said differently, a “single” materiality scrape provides that the materiality and MAE qualifiers will continue to apply in determine whether the seller has breached any of its reps and warranties, but, once a breach has been found to have occurred, the materiality and MAE qualifiers will be disregarded or “scraped” in determining the amount of any resulting damages or losses. Thus, a “single” materiality scrape will be read to mean that (a) materiality qualifiers would not be scraped in determining whether a breach of a rep or warranty has occurred, such that an immaterial breach of a rep or warranty would not trigger a breach, but (b) the materiality qualifiers would be disregarded or “scraped” in determining the amount of damages or losses resulting from any breach. Exclude Application of “Scrape” from Certain Reps and Warranties. Reps and warranties are generally structured in M&A Agreements in one of two different fashions—what I call “affirmative” or “inclusionary” reps and warranties, and “exceptions” or “negative” reps and warranties. An “affirmative” or “inclusionary” rep and warranty will require that all matters falling within the subject matter of the particular rep and warranty be disclosed on the seller’s Disclosure Schedules to the M&A Agreement. For example, an “affirmative” or “inclusionary” representation may read as follows: “Disclosure Schedule ABC sets forth all material litigation involving the Seller.” An “exception” or “negative” rep and warranty, on the other hand, only requires that exceptions to the respective rep and warranty be disclosed on the corresponding Disclosure Schedule. An “exception” or “negative” representation would read as follows: “Except as set forth on Disclosure Schedule XYZ, the Seller is not a party to any material litigation.” One way to lighten the seller’s disclosure obligation, and simplify and shorten the Disclosure Schedules (and, therefore, minimize the time and expense required for the seller to prepare and the buyer and its advisors to review those Schedules), is to exclude the application of the materiality scrape from certain reps and warranties. In the two above examples, doing so would result in the word “material” not being “scraped” or disregarded for indemnification purposes or when determining whether a breach has occurred. Doing so will lighten the seller’s disclosure obligation and not necessitate that the seller disclose even immaterial matters in its Disclosure Schedule.
Reps and warranties are generally structured in M&A Agreements in one of two different fashions—what I call “affirmative” or “inclusionary” reps and warranties, and “exceptions” or “negative” reps and warranties. An “affirmative” or “inclusionary” rep and warranty will require that matters falling within the subject matter of the particular rep and warranty be disclosed on the seller’s Disclosure Schedules to the M&A Agreement. For example, an “affirmative” or “inclusionary” representation may read as follows: “Disclosure Schedule ABC sets forth all material litigation involving the Seller.” An “exception” or “negative” rep and warranty, on the other hand, only requires that exceptions to the respective rep and warranty be disclosed on the corresponding Disclosure Schedule. An “exception” or “negative” representation would read as follows: “Except as set forth on Disclosure Schedule XYZ, the Seller is not a party to any material litigation.” One way to lighten the seller’s disclosure obligation, and simplify and shorten the Disclosure Schedules (and, therefore, minimize the time and expense required for the seller to prepare and the buyer and its advisors to review those Schedules), is to exclude the application of the materiality scrape from certain reps and warranties. In the two above examples, doing so would result in the word “material” not being “scraped” or disregarded for indemnification purposes or when determining whether a breach has occurred. Doing so will lighten the seller’s disclosure obligation and not necessitate that the seller disclose even immaterial matters in its Disclosure Schedule. Specify Dollar Thresholds. Specifying actual dollar thresholds in the reps and warranties, rather than relying on general “materiality” or “MAE qualifiers,” will add specificity to the reps and warranties and avoid disputes over what is and what is not “material” or constitutes a “MAE”. Furthermore, such exclusions are sometimes agreed to with respect to the Rule 10b‑5 “full disclosure” and the GAAP compliance reps and warranties in order to avoid the possible nonsensical results discussed above.
Trends in Usage of Materiality Scrapes
The American Bar Association (the “ABA”) publishes a Private Target Mergers and Acquisitions Deal Point Study every other year that analyzes various terms in middle‑market M&A transactions. In the ABA’s 2017 Study (the most recent available), the ABA found that the frequency of the use of materiality scrapes has steadily increased over the last 13+ years. Interestingly, the ABA’s 2017 Study found that 85% of the M&A Agreements that were reviewed contained a “double” materiality scrape, up from only 14% in 2003.
Takeaways
Address the issue of a materiality scrape in the Letter of Intent, if possible
If on the sell‑side, resist a materiality scrape or try to limit its scope
If on the buy‑side, try to include a materiality scrape in the Letter of Intent and definitely in the definitive M&A Agreement
Realize that materiality scrapes are customary in private company M&A transactions, and their prevalence is unlikely to change in the foreseeable future
Realize that “double” materiality scrapes are continuing to become more common
If on the sell‑side, try to include one or more of the above‑mentioned compromise positions
Readers should understand that this article only scratches the surface of the issues that need to be understood and considered in M&A Agreements in connection with indemnification claims and materiality scrapes. While certainly not an exhaustive list, other related issues that must be considered and carefully evaluated include the structure of any indemnification basket, the existence of any so‑called “mini‑baskets” or “sub‑baskets,” indemnification exclusions, the scope of the “fundamental representations,” the existence of a so‑called “knowledge scrape,” how MAE is defined, and whether any “materiality scrape” applies to any of the covenants in the M&A Agreement.
This article is provided for educational and informational purposes only and is not intended to, and should not be construed as, legal advice. Readers should consult their lawyer regarding the applicability of the information discussed herein to their particular situation and facts.
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The ‘Materiality Scrape’ Provision
Published by Bloomberg Law
Market Trends: What You Need to Know
Over the past almost 15 years covered by the ABA studies, materiality scrapes have morphed from being a somewhat uncommon provision, seen in about 14% of transactions in 2005, to something near-ubiquitous in M&A purchase agreements, now included in 93% of transactions. M&A deal points tend to evolve gradually, and slowly; in relative terms, increased inclusion of materiality scrapes in M&A purchase agreements reflects one of the most dramatic trends covered by the ABA studies.
Sometimes, buyers and sellers adopt a “compromise” position as to materiality scrapes whereby materiality is not disregarded (i.e., is not scraped) when determining whether a breach has occurred; but is disregarded (i.e., is scraped) in determining the losses or damages resulting from that breach (i.e., damages are not limited to whether or not they were material). Such a compromise provision might read along the following lines: “For the purpose solely of determining indemnified Losses, but not for the purpose of determining whether a breach of a representation or warranty shall have occurred, any materiality or Material Adverse Effect qualifiers or references in the Seller’s representations and warranties shall be disregarded.” This approach seems to have fallen into relative disfavor, and is currently seen in only about 25% of reported transactions.
Introduction
A “materiality scrape” is a buyer-friendly provision often contained in an M&A purchase agreement (such as a stock purchase agreement, merger agreement, or asset purchase agreement) that effectively eliminates or disregards (i.e., “scrapes”), for specified purposes, materiality qualifiers that are present in a representation and warranty. See examples of materiality scrapes below.
In terms of apportioning responsibility for a target company’s liabilities as between buyer and seller in an M&A transaction, a “materiality scrape” can be one of the most important provisions within the transaction documents. And yet this provision—and its significance to the overall risk profile of an M&A transaction—is often not fully understood or appreciated.
This article is intended to summarize the effect and implications of a materiality scrape, as well as to identify related market trends for private company M&A transactions. These trends are reflected in the American Bar Association’s Private Target Mergers and Acquisitions Deal Point Studies, which cover U.S. M&A transactions involving privately held targets.
What is a ‘Materiality Scrape’?
As sellers and buyers negotiate M&A purchase agreements, sellers seek to limit the potential for those representations and warranties to be proven wrong and to result in a buyer claim. One way in which sellers pursue this goal is to narrow the scope of representations and warranties, including by adding materiality, knowledge, or other qualifiers to the relevant language. For example, a representation by the seller that “the target company is not party to any material litigation” is narrower in scope than the same statement without the word “material.” The typical materiality scrape provision eliminates materiality qualifiers from one or more sections of the purchase agreement.
Using the example above if a purchase agreement contains a materiality scrape, the representation and warranty that states “the target company is not party to any material litigation” would be read, in determining whether a breach of that representation and warranty has occurred for indemnification purposes, as “the target company is not party to any litigation.” In other words, the statement is read as if the word material was never included in the first place—the materiality qualifier otherwise applicable to the representation is “scraped” away.
A materiality scrape provision is sometimes referred to as a “double” or “blanket” materiality scrape if it applies to determining both whether or not a breach has occurred and the amount of indemnified losses resulting from that breach. Although including a double materiality scrape is common in purchase agreements, as noted below, applying a materiality scrape to the determination of losses resulting from a breach, but not as to whether or not the breach occurred (a “single” materiality scrape), is sometimes utilized as a compromise approach to this deal point.
The types of breaches most commonly subject to a materiality scrape are breaches of representations and warranties. Occasionally, though much less typically, covenants (obligations to do, or refrain from doing, something) or agreements are subject to a materiality scrape.
The qualifiers most commonly subject to a scrape are materiality and material adverse effect (MAE). Occasionally though rarely seen is a “knowledge scrape,” which eliminates knowledge qualifiers from representations and warranties (or covenants).
Materiality and MAE Qualifiers
Materiality and MAE qualifiers serve different purposes within a purchase agreement, and the materiality scrape usually eliminates these qualifiers for some but not all of those purposes. Materiality and MAE qualifiers generally serve four different purposes:
Determining whether closing conditions have been satisfied (e.g., closing conditions may require that the seller’s representations and warranties be true and correct “in all material respects” at the closing or that there be no MAE in effect as of the closing
Determining the scope of the seller’s disclosure (e.g., a representation may affirmatively require disclosure of all “material” contracts)
Determining whether a breach of a representation has occurred (e.g., whether specific facts are contrary to the seller’s representation that it has complied with applicable laws “in all material respects”)
Determining the losses resulting from such a breach (in other words, where a representation is qualified by materiality, are the resulting losses that are subject to indemnity only those above a “material amount”?)
Implementation
Materiality scrapes are generally either embedded within the indemnification provisions of the purchase agreement or set forth as a standalone provision. The following (with italics added for emphasis) is an example of an embedded materiality scrape provision:
The Seller shall indemnify, defend and hold harmless the Purchaser and its Affiliates and their respective employees, officers, directors, stockholders, partners and representatives from and against any losses, assessments, liabilities, claims, damages, costs and expenses (including reasonable attorneys’ fees and disbursements) incurred by such indemnified party as the result of any misrepresentation in, breach of or failure to comply with, any of the representations, warranties, covenants or agreements of the Seller contained in this Agreement, in each case, with respect to any such representation or warranty, as if such representation or warranty would read if all qualifications as to materiality, including each reference to the defined term “Material Adverse Effect,” were deleted therefrom.
Comparatively, a “standalone” materiality scrape provision (covering only representations and warranties) may read:
For purposes of determining whether there has been a breach and the amount of any losses that are the subject matter of a claim for indemnification, each representation and warranty in this Agreement will be read without regard and without giving effect to the term “material” or “material adverse effect” (fully as if any such word or phrase were deleted from such representation and warranty).
The Buyer’s Position
The buyer’s arguments for requesting a materiality scrape provision generally take the form of one or more of the following:
Fill the Indemnity Basket. A typical purchase agreement contains a “basket,” which is intended to provide the seller (as the indemnifying party) protection from general indemnity claims below a certain negotiated amount. Thus, the basket protects the seller against “immaterial” claims. However, materiality or MAE qualifiers throughout the representations and warranties arguably create a “double materiality” threshold for the buyer to “fill the basket” before indemnity is triggered.
Consequently, absent a materiality scrape, the buyer could incur many losses as the result of unrelated breaches of the seller’s representations and warranties that are not individually material but are material in the aggregate, and such losses would not count toward the basket. Where agreements also have, in addition to a basket, a “de minimis threshold” (often called a “mini-basket”)—i.e., claims of less than $X are not covered by indemnification nor counted towards the basket—the buyer can argue that the absence of a materiality scrape creates a “triple materiality” threshold.
Eliminate Post-Closing Materiality Disputes. Eliminating materiality and MAE qualifiers can help reduce or eliminate post-closing disputes between the parties as to what is and what is not “material.”
Clarify Breach/Loss Issue. The materiality scrape provision eliminates the potential seller argument that the materiality qualifier applies to the level of recoverable losses, not just to breach, and takes the uncertainty out of this issue (to the extent there is uncertainty).
Streamline Negotiations. By reducing the significance of materiality and MAE qualifiers generally and across the board for purposes of determining allocation of risk of breach (and loss), the negotiation of the purchase agreement becomes more efficient, as the parties need not negotiate every usage of those qualifiers with the same level of attention.
The Seller’s Position
Not surprisingly, sellers have a different view of the world when it comes to materiality scrape provisions. Sellers’ arguments against including a materiality scrape usually include the following:
“Close and Sue.” If a materiality scrape eliminates materiality and MAE qualifiers from determining existence of a breach but not from determining whether closing conditions have been satisfied, the effect is that a seller can be forced to close “into a breach” and be held accountable immediately after closing for that breach.
“Nickeling and Diming.” The buyer should absorb some level of risk of loss in connection with the acquisition of a business, and a materiality scrape allows or even encourages buyers to hunt for any claim, no matter how minor, to pursue against the seller.
Increased Disclosure Burden. If materiality and MAE qualifiers are to be read out of the representations and warranties requiring either affirmative disclosure (e.g., “Schedule 4.3 sets forth all material contracts”) or negative disclosure (e.g., “except as set forth on Schedule 4.4, the seller is in compliance with all applicable laws in all material respects”), the seller will be forced to disclose everything and anything, even if immaterial and of no real interest to the buyer, creating significant inefficiencies.
Awkward Application in Certain Situations. Eliminating materiality and MAE qualifiers from certain representations and warranties creates potentially awkward results. For example:
If the seller represents that there has been no MAE since a certain date (a common representation), how can MAE be deleted from that statement?
The normal financial statement representation is usually tied to the GAAP standard that the financial statements “fairly present in all material respects” the financial condition of the target. Do the parties intend to deviate from the established GAAP standard via a materiality scrape provision?
The typical “full disclosure” representation is based on the language of Rule 10b-5 of the Securities Exchange Act of 1934 that the seller’s statements (and/or other information provided in connection with the transaction) do not contain any untrue statement of material fact or omit to state a material fact necessary to make any of the statements, in light of the circumstances in which they were made, not misleading. Similar to the GAAP issue above, are the parties intending to alter the normal 10b-5 standard?
Some representations and warranties may not be subject to the indemnification basket, most typically those relating to title, taxes, ERISA, and brokers’ fees. In the absence of a basket, should the materiality and MAE qualifiers remain in place in those representations?
Common Compromises
Some possible compromises to deal with the different perspectives of the seller and buyer include the following ways to lessen the impact of a materiality scrape:
Use a true “deductible” basket (where the basket amount is never recoverable but rather serves as a deductible against buyer claims) instead of a “tipping basket” (where the basket amount is recoverable from dollar one once the aggregate buyer claims exceed the basket amount). Using a deductible basket, which is pro-seller, arguably supports the rationale for a materiality scrape.
Increase the amount of the deductible basket or tipping basket.
Rely on specific dollar thresholds within the representations and warranties in lieu of materiality or MAE qualifiers.
Have the materiality scrape apply to the determination of losses resulting from a breach, but not as to whether or not the breach occurred, i.e., implement a single materiality scrape in lieu of a double materiality scrape. This is probably the most common compromise, though as discussed below is sometimes considered substantively flawed.
Except from the materiality scrape any affirmative disclosure requirements, so that the seller need not disclose immaterial matters within its disclosure schedules.
Specify that the materiality scrape does not apply to certain specific representations and warranties—e.g., the financial statement and full disclosure representations, and/or representations that are not subject to a basket.
Trends in Usage of Materiality Scrape Provisions
A materiality scrape is a pro-buyer provision. Accordingly, when M&A markets are buyer-friendly, one would expect to see greater usage of materiality scrapes (and vice versa).
Every other year since 2005 the American Bar Association has released the ABA studies. The ABA studies examine publicly available purchase agreements of transactions involving private companies. These transactions range in size but are generally considered as within the “middle market” for M&A transactions; the median transaction value within the 2019 study was $145 million.
The ABA studies show a relatively steady increase in the presence of materiality scrape provisions from 2004 through the last study. Most private company M&A deal points have relatively stable usage and trends in any direction usually are slow and incremental, particularly if relating to a deal point that has meaningful impact on risk allocation as between buyer and seller. The shift in practice norms for materiality scrapes over the 14+ years covered by the ABA studies is, in that context, therefore remarkable.
In the 2005 study, only 14% of the reported deals had materiality scrapes, but by 2019 that mix had completely changed. In the last ABA study, 93% of reported transactions included a materiality scrape.
As indicated above, a somewhat compromise position between buyer and seller is to allow for a single materiality scrape. Using the litigation representation example, above, that “the target company is not party to any material litigation,” this compromise position would mean that: (a) materiality would not be scraped in determining whether a breach had occurred, so that non-material litigation would not trigger a breach; but (b) materiality would be scraped in determining the losses or damages resulting from that breach (i.e., damages would not be limited to whether or not they were material).
The common criticism of this compromise is that it offers very little to the buyer seeking the materiality scrape in the first instance. Most lawyers would assert that a materiality qualifier in a party’s representation qualifies the representation only and, absent specific language to the contrary, has no direct bearing on calculating damages once the representation is breached. In other words, scraping materiality from damages calculation simply states the obvious, reflecting what would happen under normal contract principles, and therefore provides little or nothing to the party seeking a materiality scrape.
The real focus of the materiality scrape, and where it has substantive impact, is on the determination of a breach of the representation qualified by materiality, not on resulting damages. More recently buyers and sellers appear to have adopted this view and have generally disfavored limiting materiality scrapes to damage calculations.
Conclusion
The materiality scrape is here to stay and, as the ABA studies indicate, has, in one form or another, become almost universally present in private company M&A transactions. Of course, as with any substantive provision in an M&A agreement, inclusion of a materiality scrape depends on how the provision fits with the overall allocation of risk between buyer and seller, the attractiveness of economic or other substantive terms, and the relative negotiating strength of the parties. A materiality scrape packs a lot of punch within a relatively small amount of wording, and practitioners should carefully consider the impact and operation of such a provision within their deal documents.
Reproduced with permission from Bloomberg Law. Copyright ©2020 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bloomberglaw.com
Resources
Materiality Qualifiers definition
For purposes of this Article 8, for the specific purpose of determining the amount of Losses resulting from, directly or indirectly, a breach of a representation or warranty in this Agreement, but specifically not for purposes of determining whether a breach occurred, all Materiality Qualifiers will be ignored and each such representation and warranty will be read and interpreted without regard to any Materiality Qualifier.
Buyer and Sellers agree that certain representations and warranties contained in this Agreement are qualified by materiality references or by matters having or not having a Material Adverse Effect (collectively, the “Materiality Qualifiers”).
For purposes of determining whether there has been a breach of any representation or warranty in this Agreement, including the Schedules and Exhibits hereto, or in any certificate furnished in connection with the transactions contemplated hereby and the amount of a claim and related Losses, the Materiality Qualifiers shall be ignored and the representations and warranties shall be construed without regard to any Materiality Qualifiers therein contained.
For purposes of this Article X, in determining (a) whether a breach of a representation or warranty made by the Company or the Principal Stockholders in this Agreement or in any other Transaction Document, including any certificate delivered hereunder, has occurred and (b) the amount of Damages arising out of, relating to or resulting therefrom, all Materiality Qualifiers will be ignored and each such representation and warranty will be read and interpreted without regard to any Materiality Qualifier.
Basics in M&A: Indemnification Provisions
Appeared in Law360 on March 18, 2016. Originally appeared in Kaye Scholer’s Spring 2016 M&A and Corporate Governance Newsletter.
—by Danielle Rosato and Tracy Belton
In an M&A transaction, once the money has changed hands and the deal has closed, who should bear the burden when an unexpected liability occurs? Generally, the sellers desire to walk away from the transaction with the full benefit of the negotiated purchase price and minimal future liabilities related to the business or the asset that they sold. The buyer, by contrast, would like to minimize its liability for issues that arose under the watch of the previous owners and for damages arising from inaccuracies in how the business or asset was described during the negotiation.
» Click here to read more articles from our latest M&A and Corporate Governance Newsletter.Absent a contractual provision that addresses these concerns, buyers and sellers are left with general claims for breach of contract as their sole recourse. To give both parties more certainty as to who bears the burden of liabilities discovered after closing, parties can include provisions in the acquisition agreement, called indemnification provisions, that set forth the rules of the road. Indemnification is a contractual remedy and risk allocation mechanism that the parties to an M&A transaction negotiate to address certain post-closing issues and losses.[1] The diverging objectives of the parties, and the potential effect that indemnification could have on the economics of the deal as a whole, frequently cause indemnification provisions to be some of the most heavily negotiated provisions in an acquisition agreement.
The negotiation of the indemnification provisions is also often the most difficult section for non-M&A lawyers and junior lawyers to navigate. Deal lawyers use terms of art when discussing indemnification (such as “mini-baskets,” “baskets,” “materiality scrapes,” and “anti-sandbagging”) and the provisions themselves are littered with cross-references making them difficult to read and to understand. To assist with this minefield, this article sets forth general information about indemnification provisions, including the various terms of art used, and certain considerations of parties when drafting them. The purpose of this article is to serve as an introductory guide, to assist individuals unfamiliar with indemnification provisions, as well as to provide tips to deal lawyers negotiating them.
Indemnification Parties
Both the sellers and the buyer may desire to negotiate indemnification protections in an acquisition agreement. Generally, the person likely to recover damages in the event of an indemnifiable loss (the indemnitee) will negotiate for broad indemnification rights while the person likely to pay damages to the indemnitee for such loss (the indemnitor) will seek to limit the number of indemnifiable claims and the total damages associated therewith (see the section on Limitations below). After a closing, the buyer (as the new owner and operator of the asset or business that was sold) is most likely to be subject to the risk of post-closing losses and will often be the party to seek broader indemnification. Thus, this article will focus on the buyer as the indemnitee.
Indemnification Limitations
In negotiating indemnification provisions, the law permits great flexibility. The parties may choose to include indemnification as a remedy for any post-closing claim that they deem to be significant given the specific facts and circumstances of the deal. The parties may also choose to expand the scope of recoverable losses beyond what is typically available in litigation (e.g., include attorney’s fees, incidental, special, or consequential damages).
Because of this great flexibility to cover any and all claims, for any and all damages associated therewith, a key objective of an indemnitor is to limit the scope, the duration and the dollar amount of its indemnification obligations. Some of the most common mechanisms for such limitation are discussed below.
At the most basic level, the goal of indemnification is to provide the parties to a transaction with a streamlined means of seeking damages for issues that arise after the closing. Generally, indemnification provisions address damages arising from breaches of representations, warranties and covenants. However, the buyer will often want to expand the scope of its indemnification protection to address losses that could arise from certain liabilities identified by the buyer during the negotiation or the due diligence process and that would not otherwise be covered under customary indemnification for breaches of the representation and warranties. For example, assume the sellers made a representation that the company is not the subject of any ongoing governmental investigation, except for one specific ongoing investigation. If, after the closing, the government brought a claim against the company based on that investigation, the buyer would not have recourse against the sellers for a breach of the sellers’ representation, because the sellers disclosed the investigation. If the buyer would like to be indemnified for any damages arising from the disclosed investigation, it would need to include a specific indemnification provision addressing this point. Sellers generally resist these “special” indemnification items because sellers take the position that there are risks associated with any business and that the buyer, as the new owner of the business, should assume those risks.
The survival period sets forth the time during which the parties may bring an indemnification claim. Generally, buyers prefer long survival periods to ensure recourse regardless of when an issue arises. Conversely, sellers prefer short survival periods so that at some point the deal is “done” and they can use the proceeds from the sale without consideration of possible indemnification obligations.
Survival periods are often customized based on claim type. Survival periods for breaches of representations and warranties tend to range from between six months and two years after the closing; however, the survival period for certain “fundamental” representations and warranties will often be longer and sometimes indefinite. A “fundamental” representation is a representation that, at its core, is so basic and so important to the transaction that the buyer would not have agreed to the deal if it knew that the representation was false. For example, in a stock sale, the representation that the sellers own the stock that they are selling is often considered a fundamental representation. If the buyer knew that this representation was not true, it almost certainly would not have agreed to acquire such stock from the sellers, and regardless of when a claim relating to this fact arises, the buyer will want to be made whole. Sellers are generally amenable to longer survival periods for fundamental claims, but a hot button for negotiations is determining which of the representations and warranties are “fundamental.” Buyers often will try to include breaches of tax and environmental representations as “fundamental” because breaches of these representations can have such a high dollar impact on the buyer and, because of the nature of tax and environmental claims, can arise long after the closing.
Survival periods for breaches of post-closing covenants are also often indefinite. A post-closing covenant imposes an obligation on the parties to take certain actions after the closing. For example, the sellers may be required to make a post-closing regulatory filing, or perhaps the parties negotiated a post-closing obligation of the sellers to assist with transitioning the business to the buyer. Generally, sellers are amenable to longer periods of survival on their post-closing covenants because they have control over when the covenant is completed.
Survival periods for certain “special” indemnification items are negotiated on a case-by-case basis. Going back to our government investigation example, if a company is subject to a government investigation, it may take some time before the government formerly files suit against the company for a claim associated therewith (and the government may decide not to file suit at all). Consequently, the buyer will advocate that the survival period for a related claim should be quite long, if not indefinite, while the sellers will want to limit this period. Parties heavily negotiate the survival period for similar “special” indemnification claims.
In addition to limiting the scope of its indemnification obligations and the time period during which indemnification claims may be brought, the sellers will want to cap their damages for such claims. Caps are quite common for breaches of non-fundamental representations and warranties, and are often expressed as a percentage of the purchase price. Once again, buyers will often seek to have the fundamental representations treated differently and will argue that the cap for such claims should be unlimited. Sellers often agree to higher caps for fundamental representations but frequently only agree to cap their damages at the total amount of consideration they received in the transaction. Parties also heavily negotiate whether “special” indemnification claims should be capped and, if so, at how much.
Sellers also negotiate for other dollar amount limitations on their indemnification liability, specifically “mini-baskets” and “baskets.”
A “mini-basket” is the minimum amount an indemnitee’s losses must exceed for a single claim before it may bring such a claim.
A “basket” is the minimum amount an indemnitee’s total losses must exceed before it may bring any claim for indemnification.[2] A basket that is a true “deductible” means that the indemnitor will only be liable for losses that exceed the threshold amount. Think of this like your health insurance deductible. Your health insurance only picks up the tab after you pay for the first $x amount of the claim. A “tipping” basket means that the indemnitor will be liable for the entire amount of losses, from dollar one, once the threshold is exceeded (i.e., the basket “tips” and the indemnitor is liable for the full amount of any losses).
What is the purpose of these baskets? The purpose of a “mini-basket” is to delineate between material and immaterial claims. Sellers do not want to be bothered with every claim that arises after the closing. For example, presume an acquisition agreement included a representation that the company had the authority to do business in all states where such authority was required. Post-closing, the buyer learned that the company should have been authorized to do business in Virginia, but it was not, and that the buyer will have to pay $1,000 to obtain such qualification. No other losses occurred because of the lack of qualification. Under these facts, the sellers would argue that, because the fee is so small, the buyer’s losses are immaterial and the buyer should bear the cost. Buyers are more inclined to agree to a “mini-basket” when paired with a “materiality scrape,” discussed below.
The rationale for including a “tipping” basket is very similar to that of including a “mini-basket”: the sellers would like the buyer to be prevented from making claims under the indemnity until the buyer’s cumulative losses exceed a certain threshold (if they ever do). A “deductible” also prevents the buyer from bringing “immaterial” claims, but also acts as a risk allocation mechanism. By incorporating a “deductible,” the sellers are requiring the buyer to bear the burden of the first tranche of their losses. Note, this is a purely economic business point and the buyer will consider the effect of the deductible when agreeing upon a purchase price.
A “materiality scrape” is a provision that “scrapes” or deletes all materiality qualifications from the representations and warranties in the acquisition agreement for indemnification purposes. For example, presume an acquisition agreement included a representation that the company had authority to do business in all states where such authority was material to the conduct of its business. Post-closing, the buyer learned that the company should have been authorized to do business in Virginia, but it was not. Under these facts, the parties would have to determine whether the company’s failure to obtain authorization to do business in Virginia was material to the company’s business. To avoid this debate, buyers frequently seek to include a materiality scrape so that materiality is “read out” of the representation. Sellers are more inclined to agree to a materiality scrape if they have successfully negotiated a “mini-basket.” By incorporating a materiality scrape, the parties will only need to agree on whether the claim’s dollar amount exceeds the “mini-basket” in order to determine which party has the obligation to pay the fee.
Materiality scrapes, coupled with a mini-basket, have become rather common. An example materiality scrape might read as follows:
“For purposes of determining failure of any representations or warranties to be true and correct, the breach of any covenants and agreements, and calculating Indemnification Losses under this Article VII, any “materiality,” or “Material Adverse Effect” qualifications in the representations, warranties, covenants and agreements shall be disregarded.”
The above provision is an example of a “double” materiality scrape. A “double” materiality scrape requires the parties to ignore all materiality qualifications for determining both (1) whether or not a breach occurred and (2) the amount of indemnifiable losses resulting from the breach. While “double” materiality scrapes are more common, parties may instead choose to include a “single” materiality scrape. In the case of a “single” materiality scrape, materiality is read out of the relevant provisions for purposes of determining the amount of indemnifiable losses, but materiality qualifications continue to apply for purposes of determining whether or not a breach occurred.
A Note on Knowledge Scrapes
Similar to a “materiality scrape,” some buyers may seek to include a “knowledge scrape,” which effectively removes all knowledge qualifications from the representations and warranties in the acquisition agreement for indemnification purposes. A “knowledge scrape” is much less common in acquisition agreements than a “materiality scrape.”
Sellers may also seek to limit the dollar amount of their indemnification obligations by including provisions requiring the buyer to mitigate its damages and to pursue payments from third parties.
A mitigation provision requires the buyer to take efforts to minimize its indemnifiable damages and, if the buyer fails to take such efforts, provides that the sellers will not be liable for any avoidable damages. As an example, let’s assume the acquisition included the sale of a building and the sellers made a representation that the building was in reasonably good repair at the time of the sale. After the closing, a water pipe which was in horrible condition prior to closing, bursts. The buyer does not turn off the water or do anything to mitigate the damage caused by the pipe bursting. If the sellers successfully negotiated a mitigation provision, they would not be liable for the damages that could have been avoided if the buyer had turned off the water or taken other efforts to minimize the resulting damage. Buyers are generally agreeable to some form of a mitigation obligation, but the standard of effort required to be used by the buyer (e.g., best efforts, commercially reasonable efforts, etc.) will often be negotiated.
Sellers also favor provisions requiring the buyer to seek payments from third parties, which would be deducted from the amount of damages that the Sellers are required to pay. Returning to our water pipe example, if such a provision was incorporated and the company had insurance in place that covered the incident, the buyer would be required to cause the company to make an insurance claim, and any money that it received as a consequence of such claim would reduce the total damages owed by the sellers. Let’s now assume that, instead of owning the building, the building was leased to the company, and in lieu of, or in addition to, any insurance held by the company, the landlord agreed to indemnify the company for water damage. Under these facts, the company would be required to take efforts to recover damages from its landlord and any money it received as a consequence of such efforts would reduce the total damages owed by the sellers. Buyers are often amenable to agreeing to pursue insurance claims but will often specify that the amount of damages owed by the sellers can only be offset by the amount of money actually received by the buyer, less any increase in its insurance premium resulting therefrom. Alternatively, the offset can be narrowed to any proceeds under insurance policies that have been paid for by the seller prior to closing. A buyer may also agree to pursue third-party sources of recovery, but because third-party claims can be more difficult to pursue and have the potential of negatively impacting an ongoing business relationship (i.e., the buyer may not want to sue an important customer or supplier), a buyer is more likely to push back on this type of provision. If such a provision was included, a buyer will often specify that any decrease in the damages owed by the sellers will be net of the costs and expenses incurred in seeking recovery from the third party.
In addition to limiting the scope, duration and dollar amount of indemnification damages, sellers may also try to limit the circumstances in which the buyer may bring a claim. A specific question that often arises during the negotiation of the indemnification provisions is: if the buyer knew about a claim before the closing, should it be able to wait until after the closing to bring a claim for damages against the sellers? Sellers will argue that the buyer should not be able to bring the claim in this instance; that the purpose of indemnification is to protect the buyer against unknown losses. Because the buyer knew about the losses and decided to close the transaction anyway, the seller’s position will be that the buyer should bear the burden of that loss.
Buyers will take the position that the acquisition agreement was heavily negotiated to include certain representations and warranties and that the parties should be entitled to rely on those representations and warranties. If there is a breach of a representation and warranty, the buyer does not want the sellers to be able to allege that the buyer “knew” about the breach by, for example, pointing to one of the thousands of documents in the data room and alleging that such document gave the buyer notice of the breach. From the buyer’s perspective, the point of the indemnity is to set forth clear rules of the road for post-closing breaches. Granting the seller an affirmative defense that the buyer knew about a claim prior to closing makes these rules murky and can lead to more litigation over claims.
The type of provision that addresses the parties’ debate above is referred to as an “anti-sandbagging” provision. An “anti-sandbagging” provision prevents a buyer from bringing an indemnification claim for breaches of representations and warranties that the buyer knew of prior to closing. An anti-sandbagging provision might read as follows:
“Notwithstanding anything in this Agreement to the contrary, no Buyer Indemnified Party shall be indemnified or reimbursed for any Damages resulting from the breach or inaccuracy of any representation, warranty, covenant or agreement in this Agreement if the party seeking indemnification for such Damages had actual knowledge of such breach or of any facts or circumstances rendering such representation or warranty inaccurate prior to the Closing.”
Funding the Indemnity
Another aspect of indemnification provisions that requires significant negotiation is how the indemnity will be funded. If an acquisition agreement is silent, the buyer would have to proceed directly against the individual sellers for its damages. Buyers generally dislike this recourse because there is no guarantee that the sellers will have the money to satisfy their indemnification obligations post-closing and proceeding directly against the sellers can be a lengthy process. In an effort to ensure that the Buyer will be able to collect on its indemnifiable damages in a time-efficient manner, it will often pre-negotiate from where the funds to pay for identifiable claims will come. The three most common approaches to funding an indemnity are: (1) an indemnification escrow account, (2) set-offs against future payments, and (3) a holdback of the purchase price.
An indemnification escrow account is a separate fund that the parties can establish at the closing of a transaction for the payment of indemnification obligations. The indemnification escrow is funded from the buyer’s purchase price. In other words, instead of the buyer paying the entire purchase price to the sellers, it will deposit a portion of the purchase price into an escrow account (generally held by a neutral third-party bank) to cover the sellers’ indemnification obligations. Buyers generally favor an indemnification escrow account because it provides security that there will be resources to pay for the sellers’ post-closing obligations and because it eliminates the chore of tracking down multiple sellers to recover its damages. Conversely, sellers dislike having a portion of their proceeds from the sale tied up and inaccessible. The escrow amount is generally a percentage of the purchase price and is held by the escrow agent for a certain time period to cover claims asserted during such period. If certain fundamental representations and warranties or “special” indemnity items survive beyond the escrow period, the indemnitee should consider what their alternative source of recovery will be after the escrow expires.
Sellers may also seek for the escrow account to be the sole source of recovery for the buyer, meaning that the buyer will only be permitted to seek money from the escrow account and will not be able to go after the individual sellers post-closing. In these instances, the escrow works like a cap on the sellers’ damages.
If the purchase price includes certain future or milestone payments, the parties may consider setoff as a mechanism for funding the indemnity. Setoff is the reduction of future payments by the amount owed under the party’s indemnification obligations. Setoff, however, may be precarious if the future payments are conditional or uncertain to occur.
An alternative source of funding the indemnity is the holding back of a portion of the purchase price. This mechanism is similar to an escrow account except that the buyer will maintain the held back funds until an agreed upon future date. When considering the use of a holdback, sellers may prefer the use of an escrow account because it reduces the amount of control the buyer has over the funds and increases the likelihood that any funds remaining after payment of indemnification claims will be promptly paid over to sellers upon the applicable release date.
A Note on Representation and Warranty Insurance
Another potential source of recovery, the use of which has increased significantly during the last five years, is representation and warranty insurance. If a buyer or the sellers purchase representation and warranty insurance, the insurer will cover a certain portion of the indemnifiable damages for certain claims. The amount and coverage of the insurance is negotiated by the party purchasing it.[3] The presence of representation and warranty insurance greatly impacts the negotiation of the acquisition agreement. For example, a buyer will likely agree to a substantially lower indemnification escrow amount if it has the ability to recover directly from its representation and warranty insurer. Sellers may also agree to make a more fulsome set of representations and warranties if a portion of their indemnification obligations are covered by insurance. In an auction process, a buyer may choose to purchase representation and warranty insurance in lieu of seeking a fulsome indemnification package from the seller so that its bid is more attractive.
Sole Recourse
If the sellers have successfully negotiated any of the above limitations to their indemnification obligations, it is likely that they will argue that indemnification should be the parties’ sole recourse. Providing for indemnification as the parties’ sole recourse protects the sellers’ benefit of the negotiation process and provides predictability. The buyer, however, will seek cumulative remedies if the limitations on the sellers’ indemnification obligations cause indemnification to be an inadequate remedy in light of potential post-closing issues and liabilities. Sometimes parties will compromise and agree to indemnification as the sole recourse for non-fundamental representations and warranties but allow for cumulative remedies for fundamental representations and warranties or breaches of covenants.
Fraud Exception
Buyers often try to negotiate in a fraud exception to all of the indemnification limitation provisions. Buyers will take the position that the sellers should not get the benefit of the limitation provisions if they engage in fraud. Returning to our government investigation example, let’s say that the sellers fraudulently hid the government investigation from the buyer and represented that there were no ongoing investigations. Post-closing, the buyer discovered that there was an ongoing investigation at the time of the closing and the investigation resulted in a claim against the company for substantial damages. Consequently, the buyer would like to bring a claim against the seller for its breach of a representation and warranty, but unfortunately for the buyer, the parties had agreed that breaches of non-fundamental representations and warranties would be subject to a cap and the cap is much lower than the buyer’s damages. Had the buyer known about the investigation, it would have tried to negotiate in a “special” indemnity, or an exception from the cap for damages relating to the investigation. Buyers will argue that in fraudulent cases such as this, the sellers should not get the benefit of the limitations on their indemnification obligations.
Sellers are generally amenable to the concept of a fraud carveout, but the parties may get into a debate over what “fraud” means. “Fraud” is defined differently under state law and may be defined to have a much broader scope than what one typically thinks of as being “fraud.” Drafters should be cognizant of the various definitions of fraud and should ensure that the acquisition agreement clearly sets forth the parties’ intended definition.
Who May Bring an Indemnification Claim?
Because indemnification is a contractual remedy, the parties have the ability to negotiate who will be entitled to recover under the indemnification provisions and from whom they may recover. This allows the parties to allocate certain rights and responsibilities to individuals or entities that may not otherwise be party to the acquisition agreement. For example, the buyer may desire to give its equity holders, employees, officer and directors the ability to recover against the sellers’ equity holders, while the buyer and the sellers are the only parties signing the agreement. Therefore, it is important that an explicit exception is made in the agreement’s third-party beneficiary clause to allow the non-party indemnitees to benefit from the indemnification provisions. It is also critical that indemnitees confirm that the person or entity making a representation, warranty or covenant is included as an indemnifying party.
Drafting Tip: Beware of the Dreaded Cross-Reference
Indemnification provisions are often littered with internal cross-references. For example, let’s say an agreement provides for indemnification for the following items:
Section 10.2(a) breaches of non-fundamental representations and warranties;
Section 10.2(b) breaches of fundamental representations and warranties;
Section 10.2(c) breaches of covenants;
Section 10.2(d) damages for pre-closing taxes; and
Section 10.2(e) damages arising from a specified litigation.
The agreement contains a mini-basket, basket and cap, but only for breaches of non-fundamental representations and warranties. The drafter addressed this by stating that “The foregoing limitations shall not apply to damages arising from the matters set forth in Sections 10.2(b) through 10.2(d).”At the last minute, the parties negotiate for another indemnification item—damages for a certain environmental matter. The drafter adds this as a new “10.2(f).” This claim was not supposed to be subject to the mini-basket, basket and cap. Unfortunately for the buyer, no one remembered to update the cross-references in the limitations section and now the limitations do indeed apply to this environmental matter.
Many times drafters will use the cross-reference function of Microsoft Word to set a cross-reference that auto-updates if the section references change. For example, if a new section was inserted before Section 10.2, the feature in Word would update all Section 10.2 cross-references to refer correctly to Section 10.3. Sounds great, right? The problem is that drafters rely too much on this function and are less careful with checking cross-references manually. The cross-reference function is faulty for a few reasons. First, it would not catch the error set forth in our above example because it would not know that the new 10.2(f) was supposed to be cross-referenced in the limitation section. Second, multiple people will be touching the acquisition agreement, and not all of those people will know how to use the cross-reference function. Those people may try to update the cross-reference manually by typing in the correct cross-reference. The problem with this fix is that if the cross-reference field is still there despite the manual change, the cross-reference will automatically revert to the original cross-reference when the document re-updates all of its fields (which often happens when the document is printed). Third, since not all drafters know how to use the cross-reference function, when drafting new provisions they may manually type in section reference. The other drafters may assume all cross-references are being automatically updated and may not realize in their 100-page agreement that the cross-reference on page 60 was manually inserted and will never auto-update.
Because of the severe impact that an incorrect cross-reference can have on the deal, it is important for multiple deal team members to be able to double-check these cross-references. It is also of critical importance that the entire deal team understands the indemnification “package” being served up or finalized so that everyone is capable of double-checking the cross-references in the indemnification provisions.
What’s Market?
Clients will often look to their lawyers to advise them on “what’s market” for the various aspects of the indemnification section (i.e., the length of the survival period, the size of the basket, cap, etc.). In addition to using a lawyer’s own personal deal experience to advise as to what is market, lawyers may look to many third-party organizations, such as the American Bar Association, which conduct deal surveys and publish what is market in certain industries or for certain deal sizes. It is important that lawyers keep educated on these deal surveys so they can effectively advise their clients. Of course, each deal is different and just because something is not “market” does not mean your client should not fight for it.
Parting Comments
The indemnification provisions in an acquisition agreement are extremely important to buyers and sellers but often are very difficult to read and to understand. It is important that all attorneys assisting in the acquisition agreement, no matter their level, take the time to understand the business deal in order to ensure that the acquisition agreement properly reflects such deal. A small mistake in an acquisition agreement’s indemnification could have a large dollar impact for your client.
Rule 10b-5 Representation (M&A Glossary)
Summary
A target’s or seller’s representation and warranty in a purchase agreement that the information provided by it is complete and correct in all material respects and does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statement not misleading. The representation refers to Rule 10b-5, promulgated under Section 10(b) of the Securities Exchange Act of 1934. Public company merger agreements usually include a Rule 10b-5 representation to prevent the use of fraudulent, manipulative or deceptive practices in the sale of securities.
Purchase Agreement: Materiality Scrape | Practical Law
Purchase Agreement: Materiality Scrape | Practical Law
A Standard Clause setting out the two variations of a materiality scrape that can be included in the indemnification section of a stock purchase, asset purchase, or private merger agreement to avoid the problem of double materiality. This Standard Clause has integrated notes with important explanations and drafting and negotiating tips.
Examples of materiality scrape clauses in contracts
8.7Materiality Scrape. For purposes of this Article 8 the existence of any inaccuracy or breach of any representation or warranty contained in this Agreement, and the amount of Losses related thereto, shall be determined without regard to any qualifications therein referencing the terms “materiality” and “Material Adverse Effect,” but with regard and after giving effect to any references to “Seller’s Knowledge” or similar knowledge qualifications.
Don’t Be a Materiality Scrape Goat
Share Don’t Be a Materiality Scrape Goat
Contemplating selling your business? Considering entering into a purchase agreement? Materiality scrape provisions are something you should be keeping an eye out for.
In many purchase agreements, vendors will make representations about what they are selling. These include a wide range of assurances— such as that it has good title to the assets/shares being sold, that the business hasn’t breached any contracts, and that it isn’t involved in ongoing litigation. These representations form the vital basis of the purchase contract and ensure buyers know what they are purchasing. Often, the representations are limited to “material” items. A representation that says there are no ongoing lawsuits would actually be that there are no ongoing material lawsuits. This ensures that for any representation, non-material claims will not lead to a breach of contract claim by the buyer.
Along with the materiality qualifications, it is also common for parties to negotiate de minimis cap on indemnity claims (or “indemnity baskets”). These are clauses that ensure a vendor will not be liable for any breaches until they reach a certain monetary threshold— a minimum. Both materiality and indemnity baskets protect vendors from non-material or small claims being brought against them for the representations they make in a purchase agreement.
What is a “Materiality Scrape?”
A materiality scrape is a provision in a purchase agreement that “reads out” materiality qualifiers from representations or warranties in the contract. They can be enormously beneficial for buyers, but might spell trouble for vendors who unknowingly give up protections in their purchase agreements.
A single materiality scrape typically reads out “material” for the purpose of determining losses resulting from a material breach of a representation. They may look something like this:
“For the purpose of calculating the amount of any losses arising from a breach of a representation or warranty, such representation and warranty will be read without regard to any qualification relating to materiality or with the word ‘material’.”
It is becoming increasingly common to see what is often referred to as a “double materiality scrape”. These are clauses that scrape “materiality” in determining both whether a breach has occurred, and the amount of losses resulting from the breach. They may look something like this:
“For the purpose of determining whether there has been a breach of a representation or warranty, and for determining the amount of damages arising, all qualifications or exceptions in any representation or warranty with the term ‘material’ shall be disregarded.”
Essentially, a single materiality scrape means that materiality qualifiers will apply for the purpose of determining whether there was a breach of a representation, but not in determining the amount of losses arising. A double materiality scrape means that materiality will not be considered at either stage.
Why do we have them?
Materiality scrapes are pro-buyer clauses. From the perspective of a buyer, indemnity baskets and materiality qualifiers mean that vendors are afforded double protection when it comes to claims. With no materiality scrapes, in order to prove a breach in a representation or warranty, a buyer would both need to prove that the breach was material and that the damages were over the threshold set by the indemnity basket in order to get a remedy. Materiality scrapes are intended to mitigate against this double protection.
What should I do if I am considering selling?
Materiality scrapes are becoming increasingly more common in Nova Scotia purchase agreements. If you are considering entering into a share purchase or asset purchase agreement as a vendor, you should always be aware of the possibility that a materiality scrape clause will be included in your agreement. A 2017 survey of deals in Canada indicated that 26% of the purchase agreements included some form of materiality scrape.
As a general note, a vendor may want to consider the following:
A single materiality scrape is often a compromise. In an agreement with an indemnity basket, a vendor may consider negotiating to a scrape that applies to the calculation of losses arising from a breach, but not determining whether there has been a breach.
Using a deductible indemnity basket instead of a tipping basket as a pro-vendor clause can be used in negotiations. In any purchase agreements, once the basket amount is reached, the purchaser can claim the entire amount of the loss from the vendor, including the basket amount. With an indemnity form of basket, the purchaser can only claim for losses in excess of the basket amount (i.e. the basket effectively acts as a deductible).
If there is no indemnity basket in your agreement, a single materiality scrape may read out materiality for the purposes of determining whether a breach has occurred, thereby completing eroding the protection that the materiality qualifier offers.
Our recommendation-always consult a lawyer before signing any agreement to ensure you understand broadly all the rights and the obligations a purchase agreement contains.
For further queries on what a materiality scrape might mean for you, contact Mohammad Ali Raza and David Reid, partners in the Business Group of Cox & Palmer’s Halifax Office. This article was written with contributions by Sarah Dobson, a law student currently working at Cox & Palmer.
This article originally appeared on The Lawyer’s Daily website published by LexisNexis Canada Inc.
Materiality scrapes in private M&A transactions
Representations and warranties in private M&A transactions are typically heavily negotiated, with sellers often attempting to qualify their representations with materiality to avoid being found liable for immaterial breaches and for immaterial damages. It is also common during the course of negotiations for parties to agree to the inclusion of indemnity baskets. These provisions provide that the seller will not be liable for a breach of its representations unless the loss suffered by the purchaser as a result of such breach exceeds a certain minimum (or, “material”) amount.
The Double Materiality Scrape
To counteract the seller-favourable implications of materiality qualifications and indemnity baskets, purchasers often attempt to include a double materiality scrape in the acquisition agreement. Such a clause excludes (or “scrapes”) materiality qualifiers in the seller’s representations for purposes of determining (a) whether a breach of a representation has occurred; and (b) the amount of indemnifiable losses resulting from that breach. An example of such a provision is as follows:
“For purposes of determining whether there has been a breach of a representation or warranty, and for purposes of determining the amount of losses resulting therefrom, all representations and warranties qualified by “materiality” shall be disregarded.”
Purchaser’s Position
The rationale from a purchaser’s perspective of including such a clause is that materiality is already addressed in the indemnity basket. As such, without a materiality scrape the purchaser would be subject to a “double materiality” standard. In other words, it would first need to overcome the materiality qualifier in the representation, and then prove that the losses sustained as a result of that breach exceeded the minimum amount set out in the indemnity basket. Additionally, purchasers rationalize the inclusion of materiality scrapes on the grounds that they reduce the time spent negotiating materiality qualifiers in the representations and warranties, and can also avoid post-closing disputes over the meaning of “material” if the seller is found to be in breach of a representation qualified by materiality.
Seller’s Position
Sellers, on the other hand, typically resist broad materiality scrapes, arguing that such clauses render the materiality qualifiers in their representations pointless. Moreover, sellers will often contend that these clauses saddle them with an unreasonable burden of having to disclose everything they can possibly imagine in the disclosure schedule to ensure they are not in breach of a representation that would more appropriately be qualified by materiality.
Middle Ground Approach – the Single Materiality Scrape
When parties are at an impasse with respect to the inclusion of a double materiality scrape, one possible “middle ground” approach is to agree to a single materiality scrape. This clause states that the materiality qualifiers will continue to apply to determine if the seller has breached a representation but, if a breach is found to have occurred, the materiality qualifier will be ignored for purposes of determining damages. As a result, subject to the indemnity basket and any other indemnity limitations set out in the acquisition agreement, the purchaser will be entitled to recover the full amount of its damages resulting from such breach.
Materiality Scrapes Trending Higher
According to the most recent Private Target Mergers & Acquisitions Deal Points Studies published by the American Bar Association for Canada and the U.S., materiality scrapes are becoming increasingly common in private M&A transactions. Where the parties agreed to an indemnity basket, only 11% of the agreements in Canada included a materiality scrape in 2012, but by 2015 these clauses were found in 39% of transactions reviewed. Likewise, only 14% of such deals in the U.S. included materiality scrapes in 2004, but by 2017 85% of transactions included these clauses.
In respect of the “middle ground” approach discussed above, the most recent deals studied indicate that their use has been diminishing in favour of the double materiality scrape in recent years. Specifically, in 2014, 100% of the deals studied in Canada with materiality scrapes were single materiality scrapes, and by 2014 that number fell to 43%. Likewise, in the U.S. 72% of transactions with materiality scrapes were limited to single materiality scrapes in 2006, but by 2017 that number fell to 57%.
These trends suggest that the double materiality scrape is gaining in popularity, perhaps due to the increasingly robust North American M&A market, where purchase price premiums paid by purchasers come with corresponding demands for increased levels of protection.
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Materiality Scrape Clause (Indemnification)
Summary
This clause contains what is known as a “materiality scrape” and may be used in the context of the indemnification provision of an acquisition agreement. This clause contains practical guidance, drafting notes, and alternate clauses. Since many of the representations in the purchase agreement are qualified by materiality, the buyer may suffer losses resulting from inaccuracies of those representations and warranties even though such losses are not material enough to constitute an actual breach. In the aggregate, these losses may be significant, but because the representations and warranties have not actually been breached (because of the materiality qualifiers) the buyer may not be entitled to indemnification from the indemnifying parties. In this situation, the indemnification basket and/or any de minimis requirement for indemnification claims serve as the “materiality” qualification for the representations. A materiality scrape is a buyer-friendly provision and sellers will likely …
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