A “materiality scrape” (or “materiality read-out”) is a buyer-friendly provision that has become one of the most commonly negotiated points in private M&A transactions. A materiality scrape provision “scrapes” or excludes materiality, material adverse effect (MAE) and other similar materiality qualifiers contained in the seller’s representations and warranties for purposes of post-closing indemnification. In other words, these qualifiers are read out and disregarded for purposes of determining both whether a breach of a representation has occurred and the amount of losses that have resulted from such breach for indemnification purposes. This article identifies some of the principal arguments made by buyers and sellers with respect to including or excluding a materiality scrape, as well as common negotiated compromises and recent deal trends.

Materiality Scrape Provision

A basic example of a blanket materiality scrape provision reads as follows: “For purposes of this Article X [indemnification article], any inaccuracy in or breach of any representation or warranty made by the Seller in this Agreement shall be determined without regard to any materiality, Material Adverse Effect or other similar qualification contained in or otherwise applicable to such representation and warranty.” An aggressive buyer might try to expand the materiality scrape additionally to read out knowledge qualifiers contained in the seller’s representations and to apply to covenants made in the acquisition agreement. Such an expansion of the materiality scrape is rarely agreed to by sellers and is not discussed in this article.

Principal Arguments

Buyers

Buyers negotiate for a materiality scrape primarily as a way to counteract the limitation on the seller’s indemnification obligations provided by an indemnity basket. An indemnity basket assures that a seller will not be liable for certain indemnification claims (typically limited to breaches of representations and warranties) until the aggregate amount of losses in respect of such indemnification claims exceeds a certain minimum amount (typically set at an agreed percentage of transaction value). Moreover, private acquisition agreements may also contain a “mini-basket” or “de minimis threshold” providing that a seller will not be liable for any individual or series of related losses which do not exceed a certain minimum amount (typically small). With an indemnity basket, the seller may not be as concerned about immaterial breaches of representations because losses arising out of such breaches may be below the de minimis threshold or otherwise fall within the indemnity basket and thus not give rise to indemnification obligations.

As such, buyers principally argue that materiality should be addressed through the indemnity basket, as the indemnity basket functions as a layer of materiality for breaches of representations and therefore without a materiality scrape buyers would be subject to “double materiality” (or “triple materiality” in the event the acquisition agreement contains a mini-basket). Buyers often also argue that a materiality scrape promotes efficient negotiations (i.e., the parties will not have to spend so much time negotiating materiality qualifiers in representations and warranties) and reduces post-closing disputes (i.e., the parties will not have to spend so much time disputing what “material” means).

Sellers

Sellers typically resist a blanket materiality scrape, arguing that materiality qualifiers in representations are important not only for purposes of being able to accurately make certain representations and warranties (especially in light of the typically broad and comprehensive scope of the seller’s representations requested by the buyer) but also for purposes of determining a proper risk profile related to the sale of the target company, as it may be difficult in all cases for sellers to adequately evaluate the potential exposure arising out of breaches of representations for purposes of calculating an appropriate indemnity basket amount. Sellers often also argue that a blanket materiality scrape would increase the seller’s disclosure schedule burden, forcing the seller to disclose “everything under the sun” even if immaterial so as not to be in breach of a representation that would otherwise be qualified by materiality, which results in unnecessary time and expense for both parties. Furthermore, sellers often contend that the materiality scrape renders all of the materiality and MAE qualifiers negotiated into the seller’s representations somewhat meaningless (especially if the materiality and MAE qualifiers are also read out of the “bringdown” closing condition (and replaced with an aggregate materiality of MAE standard), as is commonly the case).

As a business matter, sellers typically maintain that buyers should bear some level of risk in connection with buying a business, as every business has its fair share of surprises (both good and bad), and that recovery for breaches of representations should be somewhat difficult and should be limited to matters that are material to the target company. Otherwise, buyers would be incentivized to “nickel and dime” the seller with every claim no matter how small.

Compromise Positions

As the materiality scrape has become more common recently, various ways of limiting the scope or impact of the materiality scrape have emerged, including as set forth below.

  • Limit the materiality scrape to the calculation of losses arising out of a breach and not to the determination of whether or not there has been a breach. This approach clarifies that if it is determined that the buyer is entitled to recover losses arising out of a breach of a seller’s representation containing a materiality qualifier, then the buyer should recover the full amount of such losses (subject to any limitations on indemnification set forth in the acquisition agreement, such as a deductible), not just an amount of losses in excess of a material amount. This approach has become somewhat less common in recent times, as parties generally already take the view that materiality qualifiers in representations will not impact the calculation of recoverable losses in any event. Moreover, scraping materiality qualifiers in representations for purposes of determining breaches of representations is the crux of the materiality scrape.
  • Increase the size of the indemnity basket. A materiality scrape for purposes of determining breaches of representations requires the seller to rely on the protection afforded by the indemnity basket with respect to immaterial breaches of representations. Anecdotally, increasing the size of the indemnity basket has become a common negotiated compromise in deals where the seller agrees to a materiality scrape, the thought being that the amount of the indemnity basket (and mini-basket if included) will be exceeded sooner if immaterial breaches of representations are counted towards the indemnity basket.
  • Include a mini-basket or de minimis threshold (or increase the size of the mini-basket or de minimis threshold). As a complement to increasing the size of the indemnity basket, this approach further limits the seller’s indemnification obligations by providing additional protection with respect to immaterial breaches of representations.
  • Structure the indemnity basket as a deductible. Indemnity baskets can be structured as a deductible (i.e., the seller would be liable only for losses in excess of the amount of the deductible), a threshold (i.e., the seller would be liable for the total amount of losses from the first dollar once the threshold amount is exceeded) or a combination of the two (i.e., the seller would be liable for the total amount of losses in excess of a deductible amount once a higher threshold amount is exceeded). Scraping materiality qualifiers for purposes of determining breaches of representations makes it more likely that the indemnity basket will be exceeded, as immaterial breaches will be counted towards the indemnity basket. From a seller’s perspective, this makes it more advisable to structure the indemnity basket as a deductible so that the seller would be liable only for amounts in excess of the deductible.
  • Exclude certain representations and warranties. Materiality is an essential component of certain representations, such as a full disclosure representation (which tracks the language of Rule 10b-5 of the Securities Exchange Act of 1934), a financial statements representation (which tracks standards under GAAP) and a no MAE representation (which would not make sense without the MAE qualifier), and parties often agree to exclude such representations from the materiality scrape. Additionally, as a result of the increased disclosure burden that comes with a materiality scrape, parties often also agree to exclude from the materiality scrape the representations that require lists of material items on disclosure schedules (such as material contracts and material licenses). Furthermore, sellers often seek to exclude from the materiality scrape the representations that are carved out of the indemnity basket (since the materiality scrape is tied to the indemnity basket) as well as other representations that may be of particular concern to the seller (such as labor, tax or environmental matters).
  • Replace MAE with a lower materiality threshold. Owing to the fact that the MAE standard is such a high bar that is seldom crossed, sellers sometimes suggest replacing MAE qualifiers with a lower materiality threshold (such as “material” or “in all material respects”) in lieu of a materiality scrape.
  • Use dollar thresholds instead of materiality qualifiers. Rather than making a representation that the target company is in compliance in all material respects with all applicable laws, the seller could make a representation that the target company is in compliance with all applicable laws other than any such non-compliance which would not reasonably be expected to result in indemnifiable losses in excess of a specified dollar amount. This approach might help to eliminate some of the ambiguity around what constitutes materiality or an MAE and allows the parties to tailor dollar limits to specific representations, but the parties might find it difficult to quantify certain risks in order to agree on an appropriate dollar amount.

Deal Trends

The following sets forth a summary of recent deal trends with respect to materiality scrapes and indemnity baskets.

ABA Study

The 2011 Private Target M&A Deal Points Study published by the American Bar Association (the “ABA Study”), which analyzed publicly available acquisition agreements for transactions completed in 2010 with a signing value of at least US$25 million involving private companies being acquired by public companies,1 indicated the following deal trends with respect to materiality scrapes and indemnity baskets:

  • 49% of all deals contained a materiality scrape. This represented a steep increase from previous years, as this percentage was up from 24% of all deals completed in 2008 and 22% of all deals completed in 2006.
  • Out of the 49% of deals that contained a materiality scrape, 66% of such deals limited the materiality scrape to the calculation of losses only (which was up from 32% of deals completed in 2008).
  • 59% of all deals (not just those containing a materiality scrape) had an indemnity basket structured as a deductible.
  • 47% of all deals (not just those containing a materiality scrape) had an indemnity basket equal to >.5%–1% of transaction value; 41% of all deals (not just those containing a materiality scrape) had an indemnity basket equal to .5% or less of transaction value; and 12% of all deals (not just those containing a materiality scrape) had an indemnity basket equal to >1%–2% of transaction value.
  • 17% of all deals (not just those containing a materiality scrape) had a mini-basket (which was down from 23% of all deals completed in 2008 and 18% of all deals completed in 2006).

These deal trends suggest that (1) the inclusion of a materiality scrape increased significantly between the period of 2006 and 2010, but a blanket materiality scrape was still not the majority position, (2) where included, the materiality scrape was limited to the calculation of losses in two-thirds of deals, (3) most deals (whether or not containing a materiality scrape) had an indemnity basket structured as a deductible, (4) almost half of all indemnity baskets (whether or not the deal contained a materiality scrape) were sized at >.5%–1% of transaction value, and (5) most deals (whether or not containing a materiality scrape) did not have a mini-basket.

It should be noted that the ABA Study did not separately analyze indemnity baskets for deals that did and did not contain a materiality scrape, and, as indicated above, most deals analyzed in the ABA Study did not contain a blanket materiality scrape. As such, parties should bear in mind that these statistics may not accurately reflect what may be an appropriate indemnity basket size in instances where the acquisition agreement contains a materiality scrape (assuming a correlation between the size of the indemnity basket and the existence of materiality qualifiers throughout the seller’s representations).

Independent Study

We conducted an independent study of deals signed in the first half of 2013 with a signing value of at least US$25 million involving the acquisition of private US companies,2 which indicated the following deal trends with respect to materiality scrapes and indemnity baskets (percentages are approximate):

  • 62% of all deals contained a materiality scrape.
  • Out of the 62% of deals that contained a materiality scrape, 44% of such deals limited the materiality scrape to the calculation of losses only and 26% of such deals limited the materiality scrape by excluding certain representations and warranties.
  • 64% of all deals (not just those containing a materiality scrape) had an indemnity basket structured as a deductible.
    • 75% of deals containing a materiality scrape had an indemnity basket structured as a deductible.
  • 38% of all deals (not just those containing a materiality scrape) had an indemnity basket equal to >.5%–1% of transaction value; 27% of all deals (not just those containing a materiality scrape) had an indemnity basket equal to .5% or less of transaction value; 14% of all deals (not just those containing a materiality scrape) had an indemnity basket equal to >1%–2% of transaction value; and 3% of all deals (not just those containing a materiality scrape) had an indemnity basket equal to >2% of transaction value.3
    • 49% of deals containing a materiality scrape had an indemnity basket equal to >.5%–1% of transaction value; 29% of deals containing a materiality scrape had an indemnity basket equal to .5% or less of transaction value; 14% of deals containing a materiality scrape had an indemnity basket equal to >1%–2% of transaction value; and 5% of deals containing a materiality scrape had an indemnity basket equal to >2% of transaction value.4
  • 41% of all deals (not just those containing a materiality scrape) had a mini-basket.
    • 56% of deals containing a materiality scrape had a mini-basket.

These deal trends suggest that (1) the inclusion of a materiality scrape is trending upward, (2) where included, materiality scrapes tend to be limited in some way in most deals, but not necessarily to the calculation of losses only, (3) limiting the materiality scrape to the calculation of losses appears to be losing traction as the majority position in deals containing a materiality scape, (4) deals containing a materiality scrape tend to have an indemnity basket structured as a deductible, (5) indemnity baskets for deals containing a materiality scrape tend to be sized at >.5% - 1% of transaction value, and (6) deals containing a materiality scrape tend to also have a mini-basket.

Interestingly, the most common size of the indemnity basket for all deals in this independent study, as well as for only those deals containing a materiality scrape, remained the same as in the ABA Study (>.5% - 1%). As indicated above, parties should consider whether the standard size of the indemnity basket as reflected in previous deal studies (like the ABA Study) should be adjusted in light of the increasing prevalence of materiality scrapes in recent deals.

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Conclusion

Recent deal trends suggest that materiality scrape provisions are becoming more and more common and will continue to be used by buyers as a risk allocation mechanism in private M&A transactions. It remains to be seen whether the inclusion of a blanket materiality scrape in an acquisition agreement will evolve into a majority position in market practice, with the materiality issue being addressed solely through the indemnity basket and other indemnity provisions rather than through qualifications to the seller’s representations. In any event, parties should closely consider the use and implications of a materiality scrape, including with respect to how it relates to the size of the indemnity basket.

Alex Herman assisted with research for this article.