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By: John R. Remakel
Minnesotans are not the only ones who are scraping car windows, sidewalks and driveways these days, Buyers in M&A transactions are also increasingly scraping “materiality” qualifiers out of representations and warranties in purchase agreements. This growing trend is demonstrated in recent M&A deal studies, including the American Bar Association’s Private Target Mergers and Acquisitions Deal Points Study, which showed that in 2004 materiality scrapes were found in only 14% of purchase agreements involving privately held target companies. That percentage jumped to 70% in 2014, and according to the most recent ABA private target deal study, soared to around 92% of private deals in 2020-2021.
What is a “Materiality” Scrape and what purpose does it serve?
It is customary for sellers in M&A transactions to negotiate for various qualifications in purchase agreements to limit or narrow the scope of the representations and warranties they are making, including adding materiality, knowledge and material adverse effect (MAE) qualifiers. Sellers want assurances that buyers will not clawback purchase price by making immaterial breaches of representations and warranties claims after closing. They also want to avoid the burdensome effort of having to disclose everything and anything in the disclosure schedules to the purchase agreement. Buyers, on the other hand, want to ensure the business they are acquiring is actually the business that they paid for. Breaches of representations and warranties potentially shift risk and liability to the buyer and/or result in a devalued business – i.e., the buyer overpaid.
Recognizing that no business is perfect, most purchase agreements include an indemnity basket or deductible that prevents a buyer from making an indemnity claim for breaches of representations and warranties below a certain negotiated dollar threshold. Buyers argue that materiality and MAE qualifiers in representations and warranties when coupled with a basket or deductible creates “double materiality” standard – not only does the buyer have to show that a claim is ”material” (which is often vague and undefined) but they also have to “fill the basket” with multiple claims before they can obtain relief through indemnification – and so, to avoid double materiality, buyers will require materiality scrape provisions similar to the following:
“For determining whether there has been a breach of a representation and warranty and the amount of any losses resulting therefrom, the representation and warranties of the Seller shall not be deemed qualified by any references to materiality and material adverse effect.”
Materiality scrapes like the above example eliminate and read out the words “materiality” and “material adverse effect” altogether from the representations and warranties in the purchase agreement. For instance, a representation and warranty that “The Seller is in compliance in all material respects with all environmental laws” will instead read “The Seller is in compliance with all environmental laws”. Without some of the compromises described below, the application of the materiality scrape could result in overly broad representations and warranties in certain circumstances.
Corresponding increases in Deductibles and Prevalence of RWI
Sellers do not have to look very far to lay blame for the increase in material scrapes – i.e., themselves. While it does not account for the entire increase in materiality scrapes, a historically Seller-friendly market has driven more sellers to demand and receive deductible baskets in purchase agreements. According to the most recent ABA private target deal study, the prevalence of deductibles in private deals has increased from 54% in 2004 to 75% in 2020-2021. This coupled with the rise in representations and warranties insurance (RWI), where certain levels and types of risk from breaches of representations and warranties in purchase agreements is shifted to insurance, has resulted in materiality scrapes being the norm.
Finding Middle Ground
While it is becoming exceedingly difficult for sellers to push back on materiality scrapes in purchase agreements, there are several compromises that both buyers and sellers can reach to reduce the severity of materiality scrapes:
- Increase the deductible or basket amount for indemnification claims and introduce “mini baskets” for smaller claim amounts (e.g., individual claims that are less than $5,000 or $10,000 do not get counted).
- Like an insurance policy, treat deductibles or baskets as a “true” deductible that only provides coverage to buyers for amounts over the negotiated threshold amount.
- Draft representations and warranties in purchase agreements with more particularity – including introducing specific dollar amount thresholds and time-based “lookback” provisions.
- Limit the applicability of the scrape to only calculating losses (i.e., “single materiality” scrape) and not to whether the breach of the representation and warranty occurred.
- Add carveouts to certain representations and warranties from the materiality scrape – e.g., financial statement representations, representations that require the Seller to disclose that something is “material” or that a “material adverse event” has occurred, fundamental representations that are not covered by the deductible or basket.
John Remakel is a shareholder at the law firm Monroe Moxness Berg PA and advises clients on mergers and acquisitions, corporate finance and other general business law matters. He also leads the firm’s securities law practice and focuses on fund formation, private securities offerings, joint ventures and other strategic transactions, with clients across a variety of industries and sectors.