This content was published prior to the combination of Dentons and Durham Jones & Pinegar. Learn more about Dentons Durham Jones Pinegar. 

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.
• 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.
• 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.
• 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.
• “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.
• 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.
• 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.
• 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.”
• 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.
• 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.)
• 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.
• 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.
• 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.