Key Takeaways

  • A materiality scrape removes “materiality” qualifiers from a seller’s representations and warranties when calculating post-closing indemnification, often shifting risk toward the seller.
  • It comes in two forms: single scrape (applies only to loss calculations) and double scrape (applies to both determining breach and calculating damages).
  • The clause can significantly impact negotiation dynamics, risk allocation, and disclosure obligations in M&A deals.
  • Buyers favor materiality scrapes because they reduce the burden of proving that a breach is “material,” while sellers resist them to limit potential indemnification exposure.
  • Market trends show that materiality scrapes have become increasingly common, especially in private M&A deals, and are often a heavily negotiated point.

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 in these negotiations. The materiality scrape “scrapes” — or excludes — materiality and other similar materiality qualifiers in a seller's representations and warranties for post-closing indemnification.

Introduction

A materiality scrape can be an important part of a transaction in terms of dividing the responsibility for a company's liabilities. However, the importance of the provision as well as its overall significance to the risk profile in a merger and acquisition is often not fully appreciated.

In a business sale, a seller usually makes a series of warranties and factual representations about the business to a buyer. The scope of these warranties and representations is often the subject of major negotiations between both parties. In terms of “give and take,” it's important to determine which warranties and representations will be qualified as to the knowledge and/or materiality of the seller.

Similar qualifiers may be added to a merger/acquisition agreement in order to govern closing conditions and the parties' indemnification obligations.

These types of qualifiers serve some practical purposes. For example:

  • They limit a seller's warranties and representations to a buyer.
  • They limit disclosures that a seller has to make to a buyer.
  • They determine if a breach of a seller's warranties and representations has occurred.
  • They determine the total losses that result from a breach of warranties and representations.
  • They determine if the parties have satisfied conditions to closing the sale.

Warranties and representations are the breaches most often subject to a materiality scrape. You may find agreements or covenants — or an obligation to either do or not do something — subject to these provisions. However, this is less common.

You'll most often find qualities such as “materiality” or “material adverse effect" (MAE) subject to materiality scrapes. Less often, you'll find “knowledge scrapes.” These eliminate knowledge qualifiers.

Why Materiality Scrapes Matter in M&A Negotiations

The inclusion or exclusion of a materiality scrape can significantly influence how risk and liability are allocated between a buyer and a seller. By eliminating materiality qualifiers when assessing post-closing breaches, buyers are often in a stronger position to seek compensation for inaccuracies in representations and warranties, even if those inaccuracies might have been considered “immaterial” under the original agreement language.

This shift is why materiality scrapes are often among the most hotly negotiated provisions in a deal. Buyers argue that they have paid a price based on the assumption that representations are fully accurate, and any deviation—no matter how small—should warrant indemnification. Sellers, on the other hand, may push back, noting that removing materiality qualifiers can expose them to disproportionate liability for trivial issues that have no real impact on the transaction.

About Materiality Scrapes

Unfortunately, materiality scrapes present some problems.

For example, when determining the total damages resulting from inaccurate representation, materiality qualifications are to be disregarded. Logic dictates that a materiality qualification should only count when determining whether a representation is accurate.

However, an aggressive buyer may attempt to expand the materiality scrape to read out knowledge qualifiers in a seller's representations. The buyer may also try to apply those to covenants in the acquisition agreement.

The usual materiality scrape provision may sometimes be referred to as a “double" materiality scrape. This means that it applies for determining if a breach has actually occurred and the amount of indemnified losses that result from the breach.

Still, it's not uncommon to apply a materiality scrape to determine the total losses but not to determine if a breach has actually occurred. This is a “single” materiality scrape.

Types of Materiality Scrapes Explained

Materiality scrapes are commonly categorized into two types:

  • Single Materiality Scrape: This approach disregards materiality qualifiers only when calculating damages. The provision leaves the qualifiers intact when determining whether a breach occurred.
  • Double Materiality Scrape: This more aggressive version removes materiality qualifiers both when determining if a breach occurred and when calculating the resulting damages. It significantly increases the seller’s exposure but is favored by buyers for providing broader protection.

While the double scrape is more comprehensive, it’s also more contentious. Sellers often negotiate for a single scrape as a compromise, arguing that a double scrape may lead to claims over insignificant discrepancies.

The Purpose of Including Materiality Qualifiers in a Purchase Agreement

There are different reasons to include materiality and MAE qualifiers in a purchase agreement, as they have different effects. The materiality scrape may eliminate some of the qualifiers of those purposes but not all of them.

Materiality and MAE qualifiers are usually relevant in the following contexts:

  • To determine whether closing conditions have been met. For example, closing conditions might require that the warranties and representations made by the seller are true in all material respects at the time of closing or that there are no MAEs in effect at the time of closing.
  • To determine the extent of a seller's disclosure. For instance, a representation may require the disclosure of all “material” contracts.
  • To determine whether a breach of representation has occurred. In this instance, qualifiers are used to find out if a seller has presented some specific facts contrary to the representation.
  • To determine the total losses resulting from a breach. In other words, when a representation is qualified by materiality, are resulting losses subject to indemnity only above a “material amount?”

Large corporations that take part in mergers and acquisitions always have legal counsel involved in the negotiations process. Even if your business is small- to medium-sized, it's important to have professional legal guidance when conducting business transactions.

Market Trends and Best Practices

Materiality scrapes have become increasingly common in modern M&A transactions, particularly in North America. Recent deal studies show that a majority of private M&A agreements include some form of scrape provision, often favoring buyers.

Best practices when negotiating a materiality scrape include:

  • Defining thresholds clearly: Establishing baskets or caps can help balance risk.
  • Considering transaction size and complexity: Larger deals with more extensive due diligence may justify broader scrapes.
  • Aligning with disclosure obligations: Ensure the scrape does not conflict with agreed-upon disclosure schedules.
  • Seeking tailored legal counsel: Given their nuanced impact, materiality scrapes should be customized to the specifics of each transaction.

Negotiating Materiality Scrapes: Buyer vs. Seller Perspectives

Materiality scrapes are rarely accepted without discussion. Both parties typically approach the negotiation from very different perspectives:

  • Buyer’s Perspective: Buyers want as much certainty as possible regarding the representations and warranties on which they relied. By removing materiality qualifiers, they reduce the burden of proving that a breach is “material” and expand their ability to recover losses. This is particularly important in deals involving complex businesses or uncertain liabilities.
  • Seller’s Perspective: Sellers view materiality scrapes as an expansion of liability beyond what was intended. They argue that the inclusion of materiality qualifiers reflects the reality that not every breach should trigger indemnification. Sellers may push for narrower scrape language or higher indemnity caps to mitigate risk.

A common compromise involves agreeing to a single scrape or including de minimis thresholds and baskets to limit liability exposure.

Frequently Asked Questions

  1. What is a materiality scrape in an M&A transaction?
    A materiality scrape removes “materiality” qualifiers from representations and warranties when assessing indemnification claims, shifting more risk to the seller.
  2. What is the difference between a single and double materiality scrape?
    A single scrape applies only to loss calculations, while a double scrape removes materiality for both breach determination and damage calculations, offering broader buyer protection.
  3. Why do buyers prefer materiality scrapes?
    Buyers prefer scrapes because they reduce the burden of proving that a breach is material and increase the likelihood of recovering indemnification for inaccuracies.
  4. Why do sellers resist materiality scrapes?
    Sellers resist because scrapes can expose them to liability for minor issues that would otherwise not qualify as material breaches.
  5. Are materiality scrapes standard in all M&A deals?
    They are not universal but are increasingly common in private M&A transactions. Their inclusion and scope depend on negotiation dynamics and deal-specific factors.

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