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.