Wearing my “structure of M&A contracts” hat, this week I revisited a relatively recent addition to indemnification provisions in acquisition agreements—the “materiality scrape” provision. (What a charming moniker—it brings to mind scraping muck off the sole of one’s shoe.) In particular, I read a couple of useful articles, one by a team of lawyers at Goodwin Procter (click here for a copy), the other by Tyler B. Dempsey of Troutman Sanders LLP (click here for a copy).
A materiality scrape is a pro-buyer provision that specifies that when determining whether any given representation is inaccurate for purposes of the indemnification provisions, or determining the amount of damages arising from any such inaccuracy, or both (depending on how the materiality scrape is drafted), any materiality qualification is to be disregarded. The ABA’s 2007 Private Target Deal Points Study found that 22% of the 143 acquisition agreements in the study contained such a provision.
Materiality-scrape provisions present a number of problems. First, materiality qualifications necessarily are to be disregarded for purposes of determining the amount of damages arising from an inaccurate representation—nothing is accomplished by saying so. That’s because as a matter of logic a materiality qualification should be relevant only for purposes of determining whether a representation is inaccurate.
Materiality-scrape provisions are also problematic in that they could encompass provisions that would make no sense if stripped of materiality—for example, Since December 31, 2007, no MAC has occurred. They could also serve to automatically, and therefore problematically, render inaccurate representations keyed to schedules—for example, Schedule 4.2 contains a list of the Seller’s material contracts. So it would be best to draft materiality-scrape provisions so as to capture only materiality qualifications in the form of exceptions to representations.
But materiality-scrape provisions exhibit a more fundamental shortcoming. In any acquisition agreement that contains a bringdown condition that’s subject to a materiality standard—and that’s the vast majority of them—any materiality exceptions in the representations would serve only to limit the indemnification obligations of the representing party. (In other words, they wouldn’t be necessary to prevent the other party from walking from the deal because of a less-than-material inaccuracy in a representation.) Including a materiality-scrape provision would neutralize that one function.
It follows that it would be much more efficient instead to (1) eliminate both the materiality-scrape provision and all materiality exceptions to representations and (2) make any seller indemnification obligations subject to a basket. (A basket is a threshold, expressed as a dollar amount, that indemnifiable losses must reach before the seller becomes liable.)
The basket would constitute the seller’s sole protection against being subject to indemnification claims for relatively minor inaccuracies in its representations. The parties could devote their energies to negotiating the amount of the basket rather than wasting them on negotiating a bunch of materiality qualifications to the seller’s representations, then using a materiality scrape to make those qualifications disappear in a puff of smoke.
Here’s the lesson to be drawn from this: M&A contracts are intricate contraptions—pull a lever here and a trap door opens over there. Many drafters appear to have only a shaky grasp of the topic, as it’s easy to spot stuff in acquisition agreements that, due to how the logic works, is either redundant or makes no sense. Add to the list use of a materiality-scrape provision in a contract with a brindown condition subject to a materiality standard.
If you think I’m mistaken, I’d be interested to hear it.
I’m not sure I think you’re mistaken, but I don’t see how your suggestion improves anything. Reps serve three purposes: making the disclosure burdens reasonable; supporting closing conditions; and giving a basis for indemnification claims (to grossly oversimplify things).
So let’s say we have the rep “Except as set forth on Schedule N, nothing bad has occurred since 1/1/08.”
– For the disclosure piece, some paralegal or first year now has to go through and disclose every single bad event OR we have to qualify the rep. The qualification is typically “nothing materially bad has occurred” or “nothing bad has occurred except as would be a MAC” or “nothing likely to be worse than $x has occurred.”
– For the closing piece, the company can either breach, albeit immaterially because something bad has always happened if there is no limit, or we have to qualify the closing condition (“the reps are true in all material respects” and the rep has no qualifier) OR we give an unqualified closing condition (“the reps are all true” but we qualify the actual reps “nothing materially bad has happened” or one of the other qualifiers described above)
– For the indemnity, we have to assume that there is some amount of pain that sophisticated buyers are willing to tolerate. This ends up with all the caps and baskets and minibaskets and whatnot. But still, you have the same dichotomy: typically, “I seller will indemnify you for all breaches of reps” (with reps qualified by materiality) or “I seller will indemnify you for all material breaches of reps” (with reps not so qualified). This is the part where “the business people” get involved and want to know EXACTLY how much pain they’re exposed to. So rather than lawyers saying “well, it’s material breaches, and that’s typically [10%] and so on,” you stop talking about materiality at all for the indemnity. You say “I seller will indemnify you for all breaches of reps without giving effect to any materiality qualifier for amounts in excess of $A but less than $A+B.” (Ignore the negotiation of whether you then go back to dollar one, whether there is a per-claim threshhold, etc.)
That’s why you scrape for the indemnity. But for disclosure and closing, you have to have a materiality qualifier somewhere. It seems to make sense to have the qualifier in the warranty so it’s consistent for the two places you do need it and take it out for the one place you don’t, rather than inserting materiality qualifiers in two other places just so it doesn’t exist in one.
Further, there are certain reps that you wouldn’t want qualified by materiality for closing purposes. For example, if you took out all of the qualifiers in the reps then made the closing condition that the reps are all materially true, you might end up arguing that the due authorization or qualification rep (which you might be black or white on) not being true is immaterial or material in the grand scheme of things. Perhaps it’s better to qualify only the reps you want qualified and avoid that discussion.
Anyway, just some quick thoughts.
10803: I don’t agree that representations serve a stand-alone “disclosure” function. Instead, representation accuracy is relevant only for purposes of satisfying the bringdown condition and for purposes of indemnification.
If the bringdown condition is subject to a materiality standard, immaterial representation inaccuracies are relevant only for purposes of indemnification, unless you make representations too subject to a materiality standard. You can do that in the representations themselves or effectively do so by means of an indemnification basket.
I suggest that using a basket makes more sense: it gives you one item to negotiate, as opposed to negotiating materiality or other related qualificatios in perhaps numerous representations.
And regarding the merit of incorporating a materiality standard in the bringdown condition, I suggest that that horse has left the stable: in the ABA 2007 Deal Points survey, 98% of the 143 agreements in the study incorporated materiality in the bringdown condition.
But your comment reminded me of a potentially useful distinction. Materiality qualifications can serve to address (1) inaccuracies that the seller is aware of at signing, (2) inaccuracies that the seller is aware of at closing and that are due to changes that occur between signing and closing, and (3) inaccuracies that the seller is unaware of, both at signing and at closing. A seller may elect to address the first of these by means of materiality exceptions in the representations, on the grounds that it wants the basket to be solely for that which is unknown at signing. In other words, it wants to take the signing inaccuracies off the table rather than get into the uncertain business of having a dollar value assigned to them.
Ken
Ken, you wrote: “If the bringdown condition is subject to a materiality standard, immaterial representation inaccuracies are relevant only for purposes of indemnification”. I don’t agree. First, a misrep is a breach of the agreement. Pile enough of those together and you have a breach of contract lawsuit. You may also theoretically have termination rights under the termination section is there are enough immaterial misreps (although in most well-negotiated M&A documents, termination for breach is limited by materiality, but then again I’ve seen enough materiality limitations that include a material breach or a series of breaches that, aggregated together, are material).
Materiality scraping provisions basically serve as a nickel-and-diming purchase price adjustment, a means to close and sue. They allow a buyer to close the deal (because it is forced to by reason of the rep bringdown condition being qualified by materiality) but then sue to recover under the indemnity for the various immaterial breaches. With a small basket/deductible, the buyer might even recover money. But at worst the buyer gets the basket chewed through. When I represent seller, I push hard for materiality scraping to be eliminated and the most effective way I get clients to back me on it (and winning the day in the negotiation) is by characterizing it as a purchase price adjustment. Ennables the client to tell her counterparts at the buyer “Why do you want to nickel and dime me?”
Eddie: In an M&A contract structured efficiently, you only get to terminate because of inaccurate representations if those inaccuracies would prevent the bringdown condition from being satisfied. That won’t happen if the inaccuracies aren’t material and the bringdown condition is qualified by materiality.
Materiality serves a purpose in representations, in the bringdown condition, and in indemnification provisions (in the form of a basket). It would be redundant to include it in termination provisions too.
The cumulative effect of non-material inaccuracies is something that you’d address in the brindown condition with “individually or in the aggregate” language. It wouldn’t be a factor that materializes separately in termination provisions.
So nothing in your comment suggest that the reasoning in my post is flawed. But this stuff isn’t conducive to analysis by blog-post comment. I’m hopeful that before too long I’ll have produced a full analysis for public consumption. In the course of working on it, I’ll revisit your comment.
Ken
I generally agree with 10803. The reps and warranties play may roles, and one of the key roles is that at signing they confirm contractually the key diligence performed by the buyer. Materiality qualifiers affect risk allocation, but they also in many cases are needed so that the seller can say to the buyer that the reps and warranties are accurate. The deal is, in the first order, a business deal and the parties want to be able to stand by the accuracy of the statements in the reps and warranties. If one were to strip materiality qualifiers out, that would force sellers to dump lots more information in the disclosure schedules, in many cases to the dismay of the buyer. It's often in the interest of both parties to have those qualifiers because it helps filter out information that neither party wants to bother with in the contract or its schedules. The agreements are complicated but there is no room for a simple solution of just removing materiality qualifiers from the reps themselves.
If the rep reads, “Schedule X lists all litigation, other than those that are not material”, and you choose not disclose an immaterial litigation, and there is a materiality scrape, then it stands to reason that buyer can sue for the amount of that immaterial litigation. (Of course, there may then be a basket.)
If the reps are qualified by materiality in the closing conditions, and there is a materiality scrape, I think all material qualifiers become irrelevant.