Indemnification in M&A Contracts Part V: Materiality Scrapes
The Materiality Scrape
To understand materiality scrapes, you first have to understand a little more about the representations and warranties in the Purchase Agreement themselves. As part of the Purchase Agreement, each party, but in particular the seller, is asked to make certain representations regarding the assets, state of the business, etc. For example, the seller might represent:
- The Seller Company has filed all tax returns; OR
- The Seller Company is properly organized under the laws of the State of Texas
Generally, the buyer asks for a large number of different representations and warranties, not all of which will be strictly accurate for a business with active operations. Simply, no business is perfect. A seller, as part of the negotiation of the Purchase Agreement, will make an effort to limit those representations and warranties, by adjusting the language or adding “qualifying language.” This qualifying language is called “materiality” language or “materiality qualifiers” and includes phrases like “material,” “material adverse effect,” “to the knowledge of Seller, “reasonable,” “commercially reasonable,” etc. A potential buyer dislikes materiality and knowledge qualifiers because they require the buyer/seller to argue about items such as “what the Seller knew,” and whether a claim is “material” or not, which can lengthen the indemnification process. For example, it may be difficult to determine what the seller’s CEO knew pre-closing when an issue arises 2 years post-closing. And both buyer and seller may have different viewpoints about whether a $10,000 claim by a third party is “material” or just a nuisance.
The Materiality Scrape is the buyer’s answer to materiality qualifiers. Materiality Scrapes state that the parties will disregard any materiality qualifiers for purposes of determining whether
- a breach of the representation or warranty occurred;
- the amount of losses/damages, or
- both (1) and (2).
In addition, buyers argue that the deductible or basket already acts as a “materiality threshold,” at least concerning item (2) above and that giving effect to materiality qualifiers in the representations and warranties would therefore give rise to “double materiality” in favor of the seller.
The Materiality Scrape comes in 2 varieties:
Single Materiality Scrape
For example: Materiality Scrape. Notwithstanding anything in this Agreement to the contrary, solely for the purpose of the amount of Losses of Indemnified Persons (but not for determining whether a breach occurred), the representations and warranties of the Company in this Agreement that are qualified by knowledge, materiality or Material Adverse Effect shall be deemed to be made without such knowledge, materiality or Material Adverse Effect qualifiers.
A single materiality scrape eliminates materiality qualifier language for either (1) a breach of the representation or warranty; OR (2) the amount of losses/damages, but NOT BOTH. Most commonly, a single materiality scrape will state that materiality qualifiers will apply to determine if a breach of the representations and warranties occurred, but materiality qualifiers will be disregarded for purposes of determining losses/damages if a breach of the representations and warranties did occur.
Double Materiality Scrape
For example: Materiality Scrape. For the purposes of determining (a) whether any breach of any representation or warranty contained in this Agreement has occurred and (b) the amount of Loss resulting from any such breach, the determination shall, in each case, be made without references to the terms “material,” “materiality,” “Material Adverse Effect,” “material adverse effect” or other similar qualifications as to materiality (other than specific monetary thresholds) contained in any such representation or warranty.
A double materiality scrape eliminates materiality qualifier language for purposes of determining whether a breach of the representations and warranties occurred, and for purposes of calculating losses/damages resulting from that breach. Double materiality scrapes have become progressively more common and tend to be ubiquitous in larger deals.
We know indemnification and M&A transactions generally are a lot to digest and selling (or buying) a business can be complicated. That is why it is critical to consult with an attorney who is comfortable doing these types of transactions to be sure you get them right. Hopefully, this post will help you understand indemnification in M&A transactions better and provide a starting point for consideration of these items in the context of the larger sale transaction.
 Readers of this series should note that each transaction is different and generalizations herein may not apply to every transaction. This is particularly true where Representations and warranties insurance has been obtained for the transaction.