MATERIALITY SCRAPE PROVISION – A TRAP FOR THE UNWARY

Materiality Scrape Provision, blog by South Bend business transaction attorney, Peter J. Gillin, Partner, Tuesley Hall Konopa, LLPRisk is a part of operating any business. After living with those risks for a time many business owners get good at handicapping what is and what is not an acceptable level of risk for their businesses. Transferring that hard-earned knowledge concerning the way a business operates is a key element in the purchase or sale of a business. A central theme to any purchase and sale agreement is the allocation of business risks between the buyer and the seller.  Within the structure of the agreement the seller’s representations and warranties provide an important vehicle for achieving this allocation. Representations and warranties are simply statements made by the seller concerning his business and its operations; the truth of which affect the value the buyer is willing to pay for the business. For example, a seller might represent that there is no litigation affecting his business or its future prospects. If that statement proved to be untrue, the purchase and sale agreement would likely provide the buyer with a remedy, the right to seek indemnification from the seller for damages. Damages serving as a means to adjust the amount buyer effectively pays for the business. The importance of the risk allocation achieved via the representations and warranties is underscored by the care with which buyers and sellers negotiate the precise wording of the seller’s representations and warranties. The seller’s goal in these negotiations is to reduce the likelihood that one of the statements he makes about his business proves untrue.  The buyer’s goal is to elicit from the seller as much relevant information about the business as he can so that he can make an informed decision whether to buy the business.

Wordsmithing is one of the kinder euphemisms people use to describe the time lawyers spend haggling over the wording of representations and warranties about seemingly esoteric details of a business like the environmental condition of seller’s real property, seller’s employee benefit plans, the quality of the equipment used in seller’s business, etc.  The net effect of these negotiations is to achieve a balance between the buyer’s interest in knowing as much as possible about the business he is buying and the seller’s interest in limiting his exposure to the prospect of future breach of contract claims.  Where this balance is struck ultimately depends more upon how badly a buyer or seller wants to complete a deal than it does upon any sense of fundamental fairness.  One of the more important tools that the seller has to limit his exposure to breach or representation claims is the concept of materiality.  The concept of materiality recognizes that some information about a business will be important to a rational buyer and some information will be considered trivial.  By qualifying his statements regarding the business using materiality, the seller reduces the likelihood that one of his statements will prove to be untrue by excluding the set of information concerning the business that is trivial.  Picking up on the earlier example, stating that there is no litigation which would have a material adverse effect on the business or its future prospects is a much more limited statement than indicating that there is no litigation affecting the business.  The effect of qualifying the representation in this way is to reduce the risk to seller that the statement proves to be untrue and, where applicable, to reduce the burden on seller to disclose minor litigation in the disclosure schedules, which accompany the purchase and sale agreement.  The justification for allowing such a qualification is an acknowledgment that litigation is a fact of life for most operating businesses and that a reasonable buyer’s decision to pay a certain amount for the business is really only affected by the existence of significant litigation which could affect the future success of the business.

The teeth behind the seller’s representations and warranties are typically found in indemnification section of the purchase and sale agreement.  Among other things, the indemnification section will typically provide the buyer with the right to seek money damages from the seller in the event that one or more of the seller’s representations and warranties prove untrue.  The idea being that the buyer relied on the truthfulness of those statements in determining the value of the business and ultimately making his decision whether or not to buy the business.  Often times the buyer and the seller will negotiate limitations to the buyer’s right of indemnification.  One of the limitations very often found in purchase and sale agreements is the concept of a basket.  A basket functions to limit the seller’s post-closing exposure to breach of representation and warranty claims until the damages claimed by the buyer exceed an agreed dollar amount.  There are two types of baskets often used in purchase and sale agreements tipping baskets and deductible baskets.  The difference between a tipping basket and a deductible basket relates to what happens after the damages claimed exceed the agreed dollar value.  With a tipping basket the seller is often liable from dollar one and with a deductible basket the seller is liable only for damage amounts above the deductible amount.  Similar to the justification for qualifying a representation by materiality, baskets are justified as a way to avoid niggling little claims that the business was not in pristine condition at the time of sale.

Sophisticated buyers have picked up on the overlap between the justification for qualifying representations by materiality and the justification for limiting seller’s exposure for breaches of representation via the use of a basket.  In essence buyers asked the question why should sellers enjoy both protections especially if the two protections working together leave buyers without recourse in situations where meaningful dollars are involved.  To balance this perceived unfairness, buyers often negotiate for a provision known as a “materiality scrape.”  A materiality scrape provides that any representations and warranties that have been qualified by materiality will be read without such qualifications for purposes of determining whether a seller indemnification obligation exists.  So for purposes of determining whether a breach exists, our representation concerning the absence of litigation affecting the business would be read as if the “material adverse effect” qualification to that representation were not included.  According to an ABA study of 2015 deals involving privately-held M&A targets, upwards of 70% of the deals reported included some form of materiality scrape.  This number was up from roughly 50% of deals reported in the same ABA study conducted in 2010.  Aggressive buyers will sometimes push to treat representations qualified to a seller’s knowledge in a similar fashion.  Data concerning these sorts of provisions is not tracked in the ABA study suggesting that “knowledge scrape” provisions are not used in a statistically significant number of private-target deals.

Materiality scrape provisions are often referred to as “double materiality scrape” provisions.  Double because materiality qualifiers are ignored for purposes of determining both (1) whether there has been a breach of a representation or warranty and (2) the amount of damages incurred by the buyer as a result of such breach of a representation or warranty.  According to the ABA study of 2015 deals, 57% of the deals reported included a double materiality scrape provision.  This number is up from 34% of the deals reported in the ABA study of 2010 deals.  These numbers suggest that the reach of materiality scrape provisions remains an issue which is negotiated and is often the subject of pragmatic compromise.  By limiting the scrape provision to the calculation of damages, the seller retains the protection of the qualification for purposes of determining whether the representation or warranty is deemed to be untrue.  Despite a trend which appears to be moving in favor of the inclusion of double materiality scrape provisions in deal documents, sellers have been successful in limiting materiality scrape provisions to the calculations of damages as a compromise in roughly half of the deals reported.

Materiality scrape provisions represent a trap for the unwary seller who can get lulled into a false sense of security.  After slogging through negotiations to qualify a set of representations and warranties and thereby limiting their scope to issues of significance to the business, a materiality scrape provision incorporated into the body of the indemnification section of the agreement effectively undoes all of those hard fought concessions.  Absent the leverage necessary to push the buyer to accept a transaction document without a materiality scrape provision, the seller has other tools to help mitigate the effects of such a provision.  Most significantly, the seller can limit his risk by fully disclosing (perhaps over disclosing) issues of potential concern to the business in the form of qualifications to the representations and warranties.  These qualifications would typically be set forth in the disclosure schedules which accompany the purchase and sale agreement.  The compilation and disclosure of information about potential weaknesses of the business is time-consuming and difficult, but the disclosure of that detail will work to undermine future arguments that the buyer would have paid less for the business had he only known more about it.  Another approach focuses on the size and nature of the basket that is used.  Given that a basket is being used as a proxy for identifying issues that are material enough to the business and its operations to warrant an adjustment to the purchase price, the seller can argue for an increase in the amount of the basket as a way to compensate for being held accountable for more expansive representations and warranties.  The seller might also press to treat the basket as a deductible (where the buyer bears the risk of the basket amount) as opposed to a tipping basket (where the seller is liable for the basket amount and any overage once the basket amount is reached).  The risks presented by a materiality scrape provision are manageable provided the seller plans for it adequately.

Fair value in the context of the sale of a business is often defined as the price at which the business will change hands between a willing buyer and a willing seller.  Lost in this simple definition are the challenges posed by differences in knowledge and understanding concerning the business. Conventions have evolved in the negotiation of purchase and sale agreements to address this disparity in the knowledge between the buyer and the seller. The representations and warranties section is one such convention. In negotiating this section, the buyer will ask the seller to make clear and unqualified statements about aspects of the business that he deems relevant to his pricing decision. Whereas, the seller will seek to qualify his statements regarding his business in order to limit his exposure to future breach claims. The qualification of representations and warranties by materiality and the limitation on indemnification claims via the mechanism of a basket are two tactics used successfully by sellers to reduce their risk of future claims. More and more buyers are fighting to limit the protections afforded by these two tactics on the grounds that working together they are overprotective of the seller’s interests.  The means by which buyers are achieving this limitation has involved the increased usage of materiality scrape provisions to exclude materiality qualifiers from the evaluation of indemnification claims. Materiality scrape provisions are here to stay but their impact and the additional risks they pose to sellers can be mitigated by sellers through careful disclosure and through thoughtful use of indemnification baskets.