In an agreement for the sale of a business, there will
be a number of representations and warranties by the seller across the spectrum
of the company’s business, including its ownership of assets, its financial
condition, its compliance with a variety of laws (among others, employment and
environmental laws), and the existence of any adverse material events. If an
issue arises post-closing that violates the representations and warranties,
then the indemnity provisions in the agreement will dictate that the seller
must compensate the buyer for any resulting loss, including payment of attorneys’
fees, settlements, judgments, etc.

A materiality scrape is
a provision in the agreement that provides that when determining either: (1)
whether a representation or warranty in the agreement has been breached; and/or
(2) the amount of any loss resulting from such breach, all materiality
qualifiers in the agreement are disregarded (i.e., “scraped”). The practical effect
of such a provision is to “read out” any materiality qualifiers in the seller’s
representations and warranties, such that seller will be liable for any breach
and/or any loss resulting therefrom.

Obviously, a seller
would prefer to have materiality qualifiers in the agreement to limit its
indemnity obligations. The buyer’s argument in favor of a materiality scrape, however,
is generally twofold: (1) if the agreement has an indemnity “basket” (i.e., a
threshold amount of loss which must be reached before seller has a duty to
indemnify), then a materiality threshold is already in the agreement, and the
scrape prevents doubling up on materiality hurdles; and (2) excluding the materiality
threshold precludes future disputes over what is and is not material.

Seller has two chief arguments
against the use of a materiality scrape. The first is that utilizing such a
provision will result in both buyer and seller getting in the weeds about every
possible flaw in the company. Pre-closing, seller will be incentivized to list
every matter it can think of in the disclosure schedules, not matter how minor,
while post-closing, buyer will be incentivized to assert every claim no matter
how trivial to reach the basket amount. Seller can also argue that a
materiality scrape leads to absurd results. A typical M&A agreement
contains a number of provisions that utilize a materiality standard, for
instance, a representation and warranty that the seller has made no material
misrepresentations in conjunction with the agreement. Reading that qualifier
out of the agreement essentially nullifies the governing legal standard for stock
purchases that has been in place for decades.

The last point segues
nicely into how a buyer and seller can compromise on the matter. One way to do
so is to exclude the materiality scrape from applying to certain
representations and warranties. Another is to use an indemnity basket which
excludes the entirety of the basket threshold amount from seller’s indemnity obligation,
rather than a “tipping basket” which requires that, once the threshold amount
is met, seller indemnify buyer from dollar one of the loss. Lastly, the parties
can agree to use a “single scrape”, i.e., nullifying any materiality qualifier
in determining the amount of damages, but not when determining whether a breach
has occurred in the first instance. Using one or more of these types of
provisions will better allocate the risk among the parties, and a seller coming
into a deal prepared to negotiate this issue will be in a far better position
to achieve a more desirable result.

Jeffrey Petersen

This post
is for informational purposes only and does not constitute legal advice.