The use of materiality scrape has really gained traction in recent years in private M&A/PE deals. Within just one or two sentences, this clause can undo all the materiality protections which the Seller has heavily bargained for and consequently increase its post-closing indemnification risk. Sellers should therefore fully understand the effect of this Pro-Buyer clause and try to limit, if not eliminate, its application in order to reduce its risk exposure. As for the Chinese private M&A/PE market, although this practice is yet to be widely accepted, it could serve as a useful tool for the Buyer to shift the post-closing risk to the Seller.
What is a Materiality Scrape?
A materiality scrape refers to a practice that reads out the “materiality” or MAE qualifiers contained in a representation and warranty clause of a share purchase agreement, merger agreement or asset purchase agreement. In other words, with a materiality scrape, the word “materiality” or “MAE” will simple be ignored or disregarded as if it has never been written in the first place.
Take a typical employee-matter representation for example, a warrantor (usually the target company and the existing shareholders, together a “Seller”) to a share purchase agreement may state the following to the incoming investor (the “Buyer”):
Employee Matters: The Company has complied in all material respects with all applicable laws relating to employment, wages, hours, overtime, working conditions, benefits, retirement, termination, taxes, and health and safety.
With the effect of a materiality scrape, that representation will be read as:
Employee Matters: The Company has complied in all respects with all applicable laws relating to employment, wages, hours, overtime, working conditions, benefits, retirement, termination, taxes, and health and safety.
The difference with and without the materiality scrape is obvious.
As the above example shows, the materiality scrape has essentially turned a qualified representation into a “flat” one, which means that the Seller represents to the Buyer that other than those already disclosed, not a single non-compliance, no matter how immaterial it is, has ever occurred. Putting it differently, any minor non-compliance would constitute a breach of that representation for which the Seller could be held liable.
The result means a lot to the Seller, as it clearly exposes it to a greater risk of indemnification post-closing.
Application of Materiality Scrapes and Arguments from Both Sides
The materiality scrape is commonly used for determining: a) whether a breach of representation and warranty has occurred and; b) the amount of damages associated with or arising out of that breach.
From a risk allocation point, a Seller understandably always avoids giving a flat representation without having a materiality qualification serving as a “liability-free zone”. To push back the application of the materiality scrape, the Seller could make the following arguments:
Contrary to What the Seller had Bargained For. From a Seller’s perspective, applying the materiality scrape seems contrary to what the Seller has bargained for and more importantly, agreed by the Buyer. If both sides have no problem adding a materiality qualifier in a given representation, why that very qualifier would then be scraped when determining whether there is a breach and/or the damages associated with it?
Unreasonable Results. Unreasonable results may arise when applying the materiality scrape to certain representations. For instance, the wording of a typical 10b-5 representation mirrors, in large parts, the language of the SEC Rule 10b-5, which states that the Seller does not give any “untrue statement of a material fact or to omit to state a material fact to a statement necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.” If the materiality qualifier was to be scraped in that representation, the test in determining whether a Seller commits a 10b-5 representation breach will be lifted up from a generally accepted rule-based standard to a much higher one, which the Seller often views as unfair.
Process Delay with Little Value Added. Absent the protection of the materiality qualifier, the Seller, fearing that it could be held liable for any immaterial breach, may be incentivized to disclose anything and everything to the Buyer, which would significantly delay the deal process and create unnecessary antagonisms among the parties as they are likely to battle with each other over what should and should not be included in the disclosure schedule. At the same time, little value will be created since most of those extra disclosures are of no real importance to the Buyer.
Greater Post-Closing Litigation Risk. If a materiality scrape is used only in finding a breach but not in determining whether the closing conditions have been satisfied, the Seller could be forced to close and then be sued by the Buyer for any minor breach of representations that the Buyer does not even care about (because it closed the deal!).
By contrast, the Buyer could argue that a materiality scrape is warranted for the following reasons:
“Avoid Death by a Thousand Cut” or “Double-Dipping” Without the materiality scrape, the Seller is actually getting a double materiality protection or even triple materiality protection if the purchase agreement contains an indemnification basket provision and/or the de minimus claim provision. Because only a material breach counts toward the indemnification basket and the Buyer will not get any indemnification until that basket is full, the Buyer could have suffered grave losses caused by multiple breaches, none of them are material in themselves but are material in their cumulative effect.
“Reduce Dispute” Scraping the materiality qualifiers in finding a breach will reduce disputes among the parties over what constitutes a “material” breach of representation and warranties.
“Streamline Negotiations” Eliminating the materiality qualifiers would save all parties’ time in drafting and negotiating the purchase agreement and greatly improve the efficiency of the deal process, because they (especially the opposing counsels) do not need to fight on every single usage of the materiality qualifier.
The materiality scrape is a buyer-friendly clause, and a powerful mechanism in allocating the risk of breach and the associated damages among the parties. Sellers should bear in mind the effect of the materiality scrape and try to avoid unreasonably high risks when negotiating with the Buyer. Possible compromises that may be accepted by both sides include:
Accepting the materiality scrape but use de minimus claim provision to fend off immaterial claims;
Use specific dollar amount instead of materiality qualifiers in measurable breaches;
Use a true deductible basket rather than a tipping basket and try to increase the threshold of the deductible basket;
Exclude certain representations (e.g. 10b-5 representation, financial statement representation or representations that are not subject to indemnification basket) from the application of materiality scrape to avoid unreasonable results.