M&A Drafting: Double Materiality Doesn’t Exist

I’ll now revisit something I last wrote about in 2013: double materiality.

Here’s a statement of fact (in the language of the Ancient Ones, a “representation and warranty”) and the associated bringdown condition, neither qualified by materiality:

The Seller’s financial records contain no inaccuracies.

The Buyer’s obligation to consummate the transaction contemplated by this agreement is subject to satisfaction of the following conditions: … that the statements of fact made by the Seller in article 2 were accurate on the date of this agreement and are accurate at Closing; …

And here they are, qualified by materiality:

The Seller’s financial records contain no material inaccuracies.

The Buyer’s obligation to consummate the transaction contemplated by this agreement is subject to satisfaction of the following conditions: … that the statements of fact made by the Seller in article 2 were materially accurate on the date of this agreement and are materially accurate at Closing; …

In M&A commentary, it’s accepted that qualifying both statements of fact and the bringdown condition by materiality results in double materiality. But usually, that’s all you’re told, with no explanation of the implications. For example, here’s Kling & Nugent, Negotiated Acquisitions of Companies, Subsidiaries and Divisions § 14.02:

Sellers probably win this argument more often than Buyers as to the inclusion of some concept of “materiality” although Buyers are generally successful in arguing against “double” materiality, i.e., that representations qualified by materiality should not then be tested against a condition that contains another materiality qualification.

The clearest explanation of double materiality I’ve found is from a low-key source, chapter 17 (Anatomy of an Acquisition Agreement), Energy & Mineral Law Foundation, Proceedings of the 33rd Annual Institute § 17.09 (2012) :

Simply put, if the closing condition states that all warranties are materially accurate, and some warranties have materiality qualifiers, there is a risk to the purchaser that there is a double materiality qualifier on those warranties. The effect of that double materiality qualifier could be that a seller could argue that the closing condition has been fulfilled even if there is arguably a material breach of a warranty because there are two materiality thresholds to overcome, thus making a double material, or extra material, breach required to cause the failure of a closing condition.

That’s how I’ve always understood it—that qualifying a statement of fact by materiality acts as a discount on the accuracy required, and that having the bringdown condition subject to a materiality standard too applies a discount on the statement-of-fact discount, the effect being that even if the statement of fact is inaccurate, the buyer might nevertheless be compelled to close because of the reduced level of accuracy required by the condition.

It’s common practice for drafters to seek to neutralize double materiality. To do so, either they incorporate in the bringdown condition a materiality qualification only with respect to those statements of fact that do not themselves contain a materiality qualification, or for purposes of the bringdown condition they strip out materiality qualifications from those statements of fact that have them and apply instead a materiality qualification across the board.

But those contortions are pointless, because double materiality is an illusion.

In effect, the conventional wisdom applies the logic of arithmetic to the relationship between the statement of fact and the bringdown condition. Here’s my illustration of that:

Acme’s financial records are at least 90% accurate.

that the statements of fact made by the Seller in article 2 were 90% accurate on the date of this agreement and are 90% accurate at Closing;

If the financial statements are 85% accurate, the statement of fact would be inaccurate. But due to the discount-on-a-discount effect, the financial statements would have to be less than 81% accurate (90% × 90%) for the bringdown condition not to be satisfied with respect to that statement of fact.

But the discount-on-a-discount analysis misconstrues materiality. Something is material if it would affect the buyer’s decision. That’s demonstrated by one of my definitions of material (taken from the manuscript of my article on the ambiguous material):

“Material” and “Materially” refer to a level of significance that would have affected the decision of a reasonable person in the Buyer’s position regarding whether to enter into this agreement or would affect the decision of a reasonable person in the Buyer’s position regarding whether to consummate the transaction contemplated by this agreement.

Here are the statement of fact and bringdown condition mocked up to reflect the significance of materiality on materiality, or rather the lack of significance:

Acme’s financial records contain no inaccuracies other than inaccuracies that wouldn’t reasonably be expected to change the Buyer’s mind.

that the statements of fact made by the Seller in article 2 were accurate on the date of this agreement and are accurate at Closing, except, in both cases, for inaccuracies that wouldn’t reasonably be expected to change the Buyer’s mind;

This oversimplification shows that if a statement of fact and the bringdown condition are both qualified by materiality, then instead of effecting a discount on a discount, they both look to the same external standard, which is a function of the effect on the buyer.

The effect would be the same if instead of using materially (or in all material respects, which means the same thing), you qualified the statement of fact, or the bringdown condition, or both, by material adverse change or material adverse effect.

So double materiality doesn’t exist, yet everyone murmurs “double materiality” and nods sagely. As a result, acquisition contracts are a little more complex than necessary, and a bit of time might well be wasted in discussing double materiality.