Canada: Materiality Scrapes In Private M&A Transactions

Representations and warranties in private M&A transactions are typically heavily negotiated, with sellers often attempting to qualify their representations with materiality to avoid being found liable for immaterial breaches and for immaterial damages. It is also common during the course of negotiations for parties to agree to the inclusion of indemnity baskets. These provisions provide that the seller will not be liable for a breach of its representations unless the loss suffered by the purchaser as a result of such breach exceeds a certain minimum (or, "material") amount.

The Double Materiality Scrape

To counteract the seller-favourable implications of materiality qualifications and indemnity baskets, purchasers often attempt to include a double materiality scrape in the acquisition agreement. Such a clause excludes (or "scrapes") materiality qualifiers in the seller's representations for purposes of determining (a) whether a breach of a representation has occurred; and (b) the amount of indemnifiable losses resulting from that breach. An example of such a provision is as follows:

  • "For purposes of determining whether there has been a breach of a representation or warranty, and for purposes of determining the amount of losses resulting therefrom, all representations and warranties qualified by "materiality" shall be disregarded."

Purchaser's Position

The rationale from a purchaser's perspective of including such a clause is that materiality is already addressed in the indemnity basket. As such, without a materiality scrape the purchaser would be subject to a "double materiality" standard. In other words, it would first need to overcome the materiality qualifier in the representation, and then prove that the losses sustained as a result of that breach exceeded the minimum amount set out in the indemnity basket. Additionally, purchasers rationalize the inclusion of materiality scrapes on the grounds that they reduce the time spent negotiating materiality qualifiers in the representations and warranties, and can also avoid post-closing disputes over the meaning of "material" if the seller is found to be in breach of a representation qualified by materiality.

Seller's Position

Sellers, on the other hand, typically resist broad materiality scrapes, arguing that such clauses render the materiality qualifiers in their representations pointless. Moreover, sellers will often contend that these clauses saddle them with an unreasonable burden of having to disclose everything they can possibly imagine in the disclosure schedule to ensure they are not in breach of a representation that would more appropriately be qualified by materiality.

Middle Ground Approach – the Single Materiality Scrape

When parties are at an impasse with respect to the inclusion of a double materiality scrape, one possible "middle ground" approach is to agree to a single materiality scrape. This clause states that the materiality qualifiers will continue to apply to determine if the seller has breached a representation but, if a breach is found to have occurred, the materiality qualifier will be ignored for purposes of determining damages. As a result, subject to the indemnity basket and any other indemnity limitations set out in the acquisition agreement, the purchaser will be entitled to recover the full amount of its damages resulting from such breach.

Materiality Scrapes Trending Higher

According to the most recent Private Target Mergers & Acquisitions Deal Points Studies published by the American Bar Association for Canada and the U.S., materiality scrapes are becoming increasingly common in private M&A transactions. Where the parties agreed to an indemnity basket, only 11% of the agreements in Canada included a materiality scrape in 2012, but by 2015 these clauses were found in 39% of transactions reviewed. Likewise, only 14% of such deals in the U.S. included materiality scrapes in 2004, but by 2017 85% of transactions included these clauses.

In respect of the "middle ground" approach discussed above, the most recent deals studied indicate that their use has been diminishing in favour of the double materiality scrape in recent years. Specifically, in 2014, 100% of the deals studied in Canada with materiality scrapes were single materiality scrapes, and by 2014 that number fell to 43%. Likewise, in the U.S. 72% of transactions with materiality scrapes were limited to single materiality scrapes in 2006, but by 2017 that number fell to 57%.

These trends suggest that the double materiality scrape is gaining in popularity, perhaps due to the increasingly robust North American M&A market, where purchase price premiums paid by purchasers come with corresponding demands for increased levels of protection.


About Norton Rose Fulbright Canada LLP

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For more information about Norton Rose Fulbright, see nortonrosefulbright.com/legal-notices.

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