Consequences of violations of Representations and Warranties
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.
What is a materiality scrape?
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.
Arguments against a materiality scrape
The 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.
How can buyers and sellers compromise?
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.