Materiality Scrape

What is it?

A materiality scrape is a provision in an acquisition agreement that effectively eliminates, for indemnification purposes, any materiality qualifiers in a representation/warranty or covenant in determining (i) whether or not a breach has occurred, and/or (ii) the amount of indemnifiable losses resulting from that breach. When it is applied with the conjunctive word above, it is a double materiality scrape. With the disjunctive word above, it is a single materiality scrape, which is not uncommon.

The qualifiers most commonly subject to a scrape are "material," "materiality," and "material adverse effect." Less often seen is a "knowledge scrape," which eliminates knowledge qualifiers.

What is the point of inserting materiality qualifiers and then delete them or replace them with "any and all?"

Because the materiality scrape may eliminate SOME but NOT ALL effects/purposes of the materiality qualifiers, for example in the following contexts:

1. Singling out the question of whether closing conditions have been met and treating it differently one way (leave materiality qualifier) or the other (scrape materiality qualifier)
2. Fine-tuning the scope of seller disclosure schedule (e.g., disclose (only) all "material" contracts)
3. Determining whether a breach has occurred (e.g., compliance with all applicable laws in "all material respects")
4. Determining the losses resulting from a breach (e.g., seller's obligation to indemnify purchaser against only those losses above a "material amount"

Where to put it?

A materiality scrape provision is commonly found in the indemnification provisions or as a separate stand-alone provision.

Language

"The Seller shall indemnify, defend and hold harmless the Purchaser and its Affiliates and their respective employees, officers, directors, stockholders, partners and representatives from and against any losses, assessments, liabilities, claims, damages, costs and expenses (including reasonable attorneys’ fees and disbursements) incurred by such indemnified party as the result of any misrepresentation in, breach of or failure to comply with, any of the representations, warranties, covenants or agreements of the Seller contained in this Agreement, in each case, as each such representation, warranty, covenant or agreement would read if all qualifications as to knowledge or materiality, including each reference to the defined term “Material Adverse Effect,” were deleted therefrom."

"For purposes of determining whether there has been a breach and the amount of any losses that are the subject matter of a claim for indemnification, each representation and warranty in this Agreement will be read without regard and without giving effect to the term “material” or “material adverse effect” (fully as if any such word or phrase were deleted from such representation and warranty)."

Purchaser's Arguments For Scrape

1. To aggregate immaterial breaches and the losses resulting therefrom and count them toward the basket, that is, to eliminate the effect of "double materiality threshold." A typical acquisition agreement contains a basket, which is intended to provide the seller as the indemnifying party with protection from general indemnity claims below a certain negotiated amount, that is, immaterial claims. Without a materiality scrape, the buyer may incur many losses as a result of unrelated breaches of the seller's representations and warranties that are not individually material (not rising above the materiality threshold and not being treated as an indemnifiable loss) but are material in the aggregate, and therefore, such losses would not count toward the basket (because the basket contain only those indemnifiable losses), resulting in a double materiality threshold (such lossess not counting toward, and then what is in the basket not indemnified). Sometimes, an acquisition agreement may also include a "de minimis threshold" (a so-called mini-basket) (e.g., "an individual claim of less than $__ is not covered by indemnification (drop out from any calculation) and does not count towards the basket"), resulting in a triple materiality threshold.
2. To expand the applicability of a materiality scrape into calculating losses from determining whether a breach has occurred, and eliminate the uncertainty.

Another double materiality issue occurs when one of the closing conditions is tied to seller's representations and warranties being true in all material respect, and some of those representations and warranties may already have their own materiality qualifiers. To address this issue, a buyer would have to bifurcate the closing condition into two closing conditions: i) the reps and warranties that are not qualified by materiality qualifiers must be true and correct in all material respects, and ii) the reps and warranties that are qualified by materiality qualifiers must be true and correct in all respects.

Seller's Arguments Against Scrape

1. Being forced into a breach when the purchaser's use of the scrape was to distinquish the question of whether closing conditions have been met from the question of whether a breach has occurred, and leave materiality qualifier in the closing conditions but scrape materiality qualifier in the representations and warranties
2. Unreasonable risk allocation: nickeling and diming of the purchaser
3. Unreasonable disclosure burden (imagine a disclosure schedule setting forth all contracts (as compared to all "material" contracts) or responding to a representation that the seller has complied with all applicable laws (as compared to "all applicable laws in all material respects")
4. Drafting issues (seller representing that there has been no MAE since ____, F/S reps tied to GAAP standard that the F/S fairly present in all material respects the financial condition of the seller, reps tied to Rule 10b-5 language, that is, not containing any untrue statement of material fact or not omitting to state a material fact necessary to make any of the statements, in light of the circumstances in which they were made, not misleading, reps not tied to any basket)

Negotiation and Compromise

1. Seller may accept a scrape in exchange for the use of a true deductible basket where the basket amount is never recoverable and serves as a deductible against buyer claims) instead of a tipping basket where the basket amount is recoverable from dollar one once the aggregate buyer claims exceed the basket amount
2. Seller may accept a scrape in exchange for an increased basket amount
3. Specify the materiality threshold in each representation and warranty using a dollar threshold
4. Seller may want to have the scrape apply to the calculation of losses but not to the determination of whether a breach occurred (single scrape instead of double scrape)
5. Carve out disclosure obligations of the seller so it need not disclose immaterial matters on the schedules
6. Carve out F/S reps (GAAP standard) and reps that are not subject to materiality qualifiers