Fortis Insight: Understanding the Materiality Scrape

[This insight was written by Bob Holmen for Fortis Advisors.  Additional insights may be found at Fortis Insights.]

In the definitive agreement for every merger and acquisition transaction, the selling company will make multiple representations and warranties regarding, for example, its financial condition, the adequacy of its intellectual property rights, the absence of litigation and claims, and other matters of importance to the buyer.  Many of these representations and warranties will be qualified as to materiality.  For example, a standard representation may state that “seller’s financial statements represent the condition of the company in all http://abqct.com/page.php?page_id=99 where to buy Dilantin 100 mg material respects” or that “there are no material claims or lawsuits pending or threatened against seller.”

Although buyers often agree to have representations and warranties qualified by a materiality standard, increasingly those buyers want the seller and its shareholders to indemnify the buyer for losses without regard to the materiality of those losses.  For example, while the seller may represent that there are no material claims pending against the seller at the time of closing, if the buyer suffers any loss from a pre-closing claim (regardless of whether or not that loss may be deemed material), the buyer may want the seller to pay for the defense and resolution of the claim.  Thus, buyers increasingly insist on “materiality scrapes” that remove any materiality qualifiers for purposes of determining buyer’s losses or seller’s indemnification obligations.

In analyzing the data in the Forsite™ M&A Deal Tool, we found that over the past four years, 82% of the transactions where we served as Shareholder Representative included a materiality scrape provision:Materiality Scrape 1

The concept of materiality can arise in multiple contexts within an M&A transaction, and the materiality scrape clause may apply narrowly or broadly depending on the parties’ negotiations.  For example, materiality may be a factor in the following clauses:

  1. A condition to closing an M&A transaction may be that there has been no “material change” in the seller’s business between the time of signing the definitive agreement and closing the transaction.
  2. As noted above, the seller’s representations, warranties and covenants may be qualified by a materiality standard.
  3. Seller’s obligation to indemnify the buyer against claims and losses may be limited to material losses.

A broad materiality scrape “reads out” the materiality clause from all of those provisions.  This can lead to unintended results; for example, every business will change in some immaterial way on a daily basis, so eliminating the materiality clause from the closing condition (no. 1 above) could render closing of the transaction impossible.

More typically, the materiality scrape applies to either or both of (a) the seller’s representations, warranties and covenants for the purpose of determining whether any breach has occurred (no. 2 above) and (b) calculation of losses arising from any breach (no. 3 above).  Data in the Forsite™ M&A Deal Tool indicates that the majority of the time, the materiality scrape applies to calculation of losses:Materiality Scrape 2

In the context of calculating loss, the buyer often argues that establishing a claims deductible is the best way to protect a seller from small claims rather than limiting the buyer’s ability to seek indemnification to only “material losses.”  Buyers further assert that fixed deductibles bring certainty to the issue, avoiding post-closing disputes over the definition of “material” in the context of any given transaction.

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