United States: Healthcare M&A Corner – The Materiality Scrape: Buyers Rejoice; Sellers Beware

Last Updated: November 30 2018
Article by David A. Kahn

In counseling clients on M&A deals, it is critical to stress transaction nuances that may otherwise serve as an afterthought to a buyer or seller. While both parties reliably demonstrate laser focus on the big picture (i.e., the deal economics), there remain several purchase agreement provisions that can significantly affect a client's allocation of risk, including representations and warranties, and indemnification provisions.

First, some quick definitions:

  • Representation: A representation is an assertion as to a fact, true on the date the representation is made, that is given to induce another party to enter into a contract or take some other action. If a representation is not true it is "inaccurate"
  • Warranty: A warranty is a promise of indemnity if the assertion is false. If a warranty is not true it is "breached"
  • Indemnification: A contractual obligation whereby one party (the "indemnifying party") agrees to pay the other party (the "indemnified party") for certain losses incurred by the indemnified party after the closing of a transaction

Example: Seller represents and warrants as to certain contracts being valid and binding, in full force and effect, and if there are any consents required in order to assign a specific contract. Therefore, if a contract with a significant customer that has been included in a valuation has expired, or requires consent to assignment, seller is obligated to disclose this expiration or requirement as part of its representations and warranties. Failure to disclose such a material circumstance could prompt a claim for indemnification post-closing.

Representations and warranties allocate risk between buyer and seller, and serve as the foundation for an indemnification claim in case of a breach or inaccuracy. A buyer will push for the representations and warranties to be as broad as possible, while a seller will aspire to narrow the same.

Claims are most frequently brought by a buyer, who is more likely to suffer a post-closing loss so indemnification typically provides buyer with recourse after the transaction closes.

One trend I have observed over the past several years concerns the insertion of a concept known as the materiality scrape.

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

The aforesaid language actually describes an example of a "double" materiality scrape where the parties agree to ignore all materiality qualifications for determining both (A) whether or not a breach occurred, and (B) the amount of indemnifiable losses resulting from the breach. As a compromise, buyer and seller may agree on a "single" materiality scrape where materiality is disregarded for purposes of determining the amount of indemnifiable losses, but materiality qualifications continue to apply for purposes of determining whether or not a breach occurred.

Naturally, buyers and sellers heavily negotiate the scope of seller's representations and warranties, including materiality qualifiers. Sellers push to escape liability for immaterial breaches and immaterial losses.

  • Example: Seller makes a representation that it possesses all licenses that are required to own and operate its business, except where the failure to obtain such licenses would not have a material adverse effect on the business. After the closing, buyer discovers seller failed to possess a certain license to run its business. The parties would have to determine whether seller's failure to obtain such license was material to the company's business, and to what extent such failure caused buyer to experience losses

Buyers push for materiality scrapes for several reasons, including that purchase agreements often contain language stating buyer may not recover losses for seller's breaches of representations and warranties until buyer's total losses exceed a predetermined threshold. These are known as indemnity "baskets" and buyers will argue for the inclusion of a materiality scrape in order to avoid double materiality issues when such baskets are weaved into the purchase agreement. Sellers will argue that materiality scrapes render their representations and warranties qualifiers useless and that seller will need to disclose everything under the sun through the disclosure schedules.

Let's now visit the materiality scrape's application in the business world. The American Bar Association's Mergers and Acquisitions Committee recently performed a study on M&A agreements publicly filed in 2017 regarding materiality scrape provisions in transactions that contain indemnification baskets. The findings revealed that of the 72 agreements reviewed with indemnification baskets, 81% also incorporated materiality scrapes that deleted all materiality qualifications from the representations and warranties for any indemnification purpose (i.e., establishing a breach or inaccuracy of representations or warranties, calculation of losses, or both). Of those agreements, 45% encompassed materiality scrapes restricted to the calculation of losses.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.

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