What Are Materiality Scrapes and What They Mean if You Buy or Sell a Business?

By: Antonino Gentile

OVERVIEW

If you buy a business, you want to ensure that you get the full benefit from the representations and warranties you get from the seller. If you sell a business, you want to ensure that you limit your exposure after the sale towards the buyer as much as you can. The often long and complex indemnification provisions of a purchase agreement were created to bridge the gap between these conflicting objectives.

One way to help bridge this gap is through the use of a provision called the “materiality scrape(s)”. Quite common in the US, this provision is not used as often in Canada, and even less in the Province of Quebec (while in the latter cases its use increases from year to year).

Whether you are looking to acquire or sell a business, the presence and impact of a materiality scrape provision in your purchase agreement is an important consideration that requires close attention and extensive negotiations.

Such a provision has an impact on two distinct sections of a purchase agreement: the representations and warranties, on one hand, and the indemnification, on the other hand.

A materiality scrape is a pro-buyer provision which results in seller-friendly reps and warranties’ qualifiers such as “materially”, “material adverse effect” or “in all material respects” being disregarded for indemnification purposes as it pertains to (i) determining of whether or not there has been a breach of seller reps and warranties, and/or (ii) calculating of losses or damages resulting from a breach.

Where materiality qualifiers alleviate the indemnification obligations of the seller by tempering what would otherwise require a strict adherence to seller reps and warranties, materiality scrapes, in many ways, remove the teeth from these qualifiers and make it easier for buyers to receive indemnification compensation from sellers for losses resulting from breaches of reps and warranties under a purchase agreement.

IMPLICATIONS

On the one hand, buyers typically justify a materiality scrape as follows:

• Avoids a Double Materiality Standard. Buyers will argue that agreements which include an indemnification basket (which imposes a threshold of losses that must be met before a seller’s obligation to indemnify a buyer is triggered) already provide sufficient protection for sellers against immaterial claims. Essentially, applying materiality qualifiers on top of an indemnification basket imposes a double materiality standard on buyers and makes it very difficult to obtain compensation from sellers for losses incurred after closing.

• Simplifies Negotiations. Removing the effect of materiality qualifiers from seller reps and warranties simplifies negotiations between the parties, both as it pertains to the terms and conditions of the purchase agreement and, in respect of eventual indemnification disputes and claims. For purchase agreements, it removes the need for tedious negotiations surrounding the application of materiality qualifiers to each individual seller rep and warranty. In indemnification disputes, a materiality scrape renders moot the questions of whether there has been a breach of reps and warranties or whether the losses resulting from said breach are material or immaterial.

On the other hand, sellers will argue against materiality scrapes as follows:

• Removes the Effect of Materiality Qualifiers. Sellers will point out that the principal reason for including materiality qualifiers in their reps and warranties is to mitigate their exposure, something that would ultimately be undone by including a materiality scrape.

• Increased Disclosure Obligations. From a pragmatic perspective, a materiality scrape greatly increases the disclosure burden for sellers. For example, a rep and warranty which reads “all material contracts” would only require a seller to disclose agreements which are significant from either a qualitative or quantitative perspective. A materiality scrape would make it so that the term “material” would not apply to the aforementioned rep, thereby increasing the disclosure burden of the seller and forcing them to disclose all contracts no matter how minor or immaterial, if they want to ensure that they are insulated from an indemnification liability standpoint.

Negotiations between buyers and sellers on the points listed above will often result in the following compromises:

• Deductible Baskets. Sellers may agree to settle on including a materiality scrape provided that the buyer agrees to make the indemnification basket fully deductible. This means that once the threshold of the basket is met, the buyer will only be entitled to claim losses from the first dollar that exceeds the basket threshold.

• Increased Basket Threshold. Sellers will likely also require an increase to the basket threshold as consideration for agreeing to include a materiality scrape.

• Single Materiality Scrapes. The most common compromise resulting from seller and buyer negotiations pertaining to materiality scrapes is to include a provision that removes the effect of materiality qualifiers when it comes to calculating the losses resulting from a breach of seller reps and warranties but not as it pertains to determining whether or not there has been a breach in the first place.

CONCLUSION

For sellers, materiality scrapes could significantly impact their indemnification and disclosure obligations and can result in substantial amounts being paid to buyers after closing. For buyers, they can contribute greatly to a more equitable allocation of standard transactional risks. Whether you are a buyer or a seller, the importance of paying close attention to materiality scrape provisions and grasping the intricacies and implications that they have on each party’s rights and obligations under a purchase agreement cannot be understated.

KRB has a dynamic and experienced team of M&A professionals that are available to support you through tough negotiations regarding materiality scrapes and all other key facets of your deal. Having the right advice from knowledgeable experts will make all the difference when it comes protecting your interests in an M&A transaction.