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Any business owner who has sold a business through a merger, stock sale or asset sale has gone through what I like to call the “death march,” wading through the various proposed representations and warranties. The owner has to recall and describe anything that would qualify as an exception to the long list of disclosures required by the buyer in the purchase agreement.

Inevitably, the sell-side lawyer and business people heavily negotiate with the buyer team to increase the number of representations and warranties that would be qualified by “materiality” in order to limit the disclosures to areas of significance to the business.

However, after all of the compromises are made, one sentence — which is usually found at the end of the purchase agreement — can undo all of the protection that the seller thought he or she had negotiated by inserting qualifiers, such as “material” or “material adverse effect” into certain representations and warranties.

Deal term surveys have indicated an increase in the use of the legal provision called a “materiality scrape.”
The typical materiality scrape is a double materiality scrape. It eliminates or reads out any materiality qualifiers in a representation and warranty for purposes of determining whether or not a breach has occurred and the amount of indemnifiable losses as a result of the breach.

For example, in a purchase agreement that includes a materiality scrape, the typical representation and warranty “seller is in compliance, in all material respects, with all laws” would be read for indemnification purposes as “seller is in compliance, in all respects, with all laws.”

The word “material” would be completely disregarded and the seller would be liable for any losses incurred by the buyer as a result of the seller’s failure to comply with all applicable laws.

Buyer’s reasons for including the materiality scrape include the following:

  1. The purchase agreement usually contains an indemnification threshold (a basket) that serves to protect the seller. This prohibits the buyer from recovering losses until the total losses for seller’s breaches of representations and warranties exceed a pre-agreed threshold amount. The materiality scrape protects the buyer from “double materiality” hurdles because the buyer will have to prove materiality and have losses that exceed the threshold amount.
  2. When determining the amount of losses resulting from a breach, the purchase agreement should be clear that the resulting losses recoverable from the breach should not just be those above a material amount. 
  3. Excluding materiality qualifiers can serve to eliminate or reduce post-closing disputes over what constitutes “material.”
Seller’s reasons for excluding the materiality scrape include the following:

  1. The materiality scrape could give the buyer an incentive to search for any claim, no matter how minor, to pursue the seller post-closing for immaterial breaches of representations and warranties. 
  2. The seller will have an increased burden to disclose every immaterial exception to a representation and warranty. This could create inefficiencies in finalizing the disclosure schedules and ultimately closing the transaction.
  3. Often, the materiality scrape does not apply to determining whether closing conditions have been satisfied. In this instance, the representations and warranties will be read for purposes of closing to include the materiality qualifiers. Therefore, the same representation and warranty that was true at closing may not be true immediately after closing, and the seller could be held accountable for a breach immediately after the closing. 
  4. The use of materiality qualifiers in certain representations and warranties is central to the meaning of the clause, and removing “materiality” in some instances can cause unintended applications. For example, the financial statement representation is based on generally accepted accounting principles, which provide that the financial statements “fairly present in all material respects” the financial condition of seller. 
While no one wants to terminate a transaction negotiation over one sentence in a purchase agreement, a materiality scrape has a significant impact on the overall risk allocation of the transaction between buyer and seller. Therefore, the following compromises are often used to bridge the gap in negotiation:
  • Increase the amount of the indemnification basket.
  • Specifically exclude certain representations and warranties from the materiality scrape to avoid unintended applications.
  • Instead use a “single materiality scrape” — the materiality scrape only applies to the determination of losses, but not for purposes of determining whether a breach has occurred. 
Like most negotiated points in a purchase agreement, the inclusion or exclusion of a provision will likely depend upon which party has the stronger negotiating position.
While it is not uncommon for both parties to feel like they have a few cuts and bruises at the end of a negotiation, sellers should understand the potential effect that the inclusion of one powerful provision can have on an overall transaction.

Click here to see Christal's original article on Crain's Cleveland.