Not long ago, sellers in private M&A deals rarely encountered what has become a buyer-favorite deal term, the "materiality scrape." According to the ABA's biannual Private Target Mergers & Acquisitions Deal Points Study, use of the double materiality scrape in surveyed transactions from 2006 to 2017 has increased from 16% to 49%, while use of the single materiality scape has increased from 6% to 37%.1
We anticipate that the materiality scrape, and particularly the double materiality scrape, will continue its steady rise, with its use further bolstered by the increasing popularity of representations and warranties insurance policies.
What Is a Materiality Scrape?
A materiality scrape is a provision advocated by buyers in a purchase agreement whereby any materiality qualifiers (e.g., "material", "Material Adverse Effect", "in all material respects", etc.) in the seller's representations and warranties are disregarded, or "read out", for purposes of calculating damages (a single materiality scrape) and for determining whether a breach of a representation or warranty has occurred in the first place (when paired with the scrape for calculating damages, a double materiality scrape).
Rationale for and Against the Materiality Scrape
Buyers justify the materiality scrape by noting that a basket or deductible in a purchase agreement already serves the purpose of insulating sellers from immaterial claims. If a seller eliminates immaterial claims by means of the materiality qualifiers sprinkled throughout the seller's representations and warranties, then arguably the seller is twice-protected for the same concern when there is a basket or deductible and no scrape. If there is also a de minimis claims threshold, then the buyer will contend that the seller is hiding behind three levels of protection. Another argument put forth by buyers is that the concept of "materiality" is inherently subjective and inevitably will lead to disputes post-closing as to what is, or is not, material.
Sellers argue that materiality scrapes largely eviscerate sellers' carefully crafted and heavily negotiated representations and warranties. By including a double scrape, the materiality qualifiers exist solely for purposes of increasing the likelihood of satisfaction of the "bring down" of the representations and warranties as a closing condition. Additionally, sellers worry that disregarding materiality qualifiers can lead to countless small claims by buyers, despite any comfort provided by a basket or deductible. Sellers also argue that their disclosure burden is increased when materiality qualifiers are disregarded because sellers are then forced to prepare their disclosure schedules with an eye toward buyers bringing indemnification claims based on buyers' post-closing scrutiny of the disclosures without the wiggle room offered by the materiality qualifiers.
Another argument voiced by sellers is that disregarding materiality qualifiers in certain representations and warranties (e.g., a "full disclosure" representation or the "No Material Adverse Effect" representation) renders those representations and warranties nonsensical or as having unintended consequences.
As an ever-increasing percentage of transactions include a materiality scrape, sellers should consider how to mitigate the impact of the scrape when their arguments for outright exclusion of the scrape fail. Sellers are often successful in preventing the inclusion of a double scrape by offering the single scrape as a compromise. Sellers will agree to disregard materiality qualifiers for purposes of calculating damages but not for purposes of determining whether a breach exists. Wary buyers, however, often find this "compromise" to be one-sided in favor of sellers as many practitioners question whether a materiality qualifier would ever be relevant in the calculation of damages once it has been determined that a breach has, in fact, occurred.
Should the suggested compromise of the single scrape not persuade buyers' counsel, sellers should consider limiting the effect of the double scrape with existing commonplace seller-friendly devices.
By increasing the basket amount, converting the basket into a true deductible as compared to a first-dollar basket and/or adding a de minimis claims threshold, sellers can lessen the impact of the double scrape.
For further information on baskets, see Recent Trends in Private M&A Deal Terms on pages 3-5 of M&A Perspectives. Sellers can also push for carving out the impact of the double scrape on certain representations in which materiality is fundamental to the representations. These representations include the "full disclosure" representation, the "No Material Adverse Effect" representation and the financial statements representation that includes the GAAP-based standard of the financial statements presenting fairly, "in all material respects", the financial position of the business. Sellers may also persuasively argue that any representations (often called "fundamental representations") that buyers have successfully excluded from the basket should be carved out from the scrape as there is no "double protection" of sellers.
The Triumph of the Materiality Scrape
Whether one finds the arguments of buyers or sellers more compelling, the reality of the marketplace is that materiality scrapes are more prevalent than ever, and their use is continuing to expand. A primary driver of the rise in the double materiality scrape is the rapidly increasing use of representations and warranties (R&W) insurance in private M&A transactions. Most R&W insurance policies will provide coverage for buyers after giving effect to a double materiality scrape. Sellers, who have limited or no post-closing indemnification exposure when buy-side R&W insurance is employed, typically are more generous with their representations and warranties and often will agree to a double scrape as they see little downside. With sellers and insurers willing to agree to a double scrape, buyers are successfully including such a provision in more transactions.
While fewer than 500 R&W insurance policies were placed in 2013 and fewer than 1,000 were placed as recently as 2015, it is estimated that more than 2,000 were placed in 2017.2
With the expected continued proliferation of R&W policies as more insurers enter the market, policy pricing declines and claims history further develops, we can expect to see the continued inclusion of the double materiality scrape in private M&A transactions. For further information on R&W insurance, see Insuring the Deal: Key Trends and Terms in Representation and Warranty Insurance on pages 9-12 of M&A Perspectives.
1 Statistics and trends based on data provided by 2016 and H1 2017 Private Target Mergers & Acquisitions Deal Points Studies prepared by the American Bar Association Subcommittee on M&A Market Trends.
2 Gallagher, Market Conditions, Representations and Warranties Insurance, Aaron M. Zeid, Esq., January 2018.
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