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Of Scrapes and Scraps…(Part 3 of 4)

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Of Scrapes and Scraps…(Part 3 of 4) Aquilina Law May 24, 2017

Of Scrapes and Scraps…(Part 3 of 4)

On the rising use of materiality scrapes in agreements of purchase and sale (Part 3 of 4)

In our second article of our series on the use of “scrapes” in asset purchase agreements or share purchase agreements, we examined the advantages of the materiality scrape. In this third installment, we will review the disadvantages of scrapes and solutions to reconcile seller and purchaser viewpoints.

Arguments Against Scrapes

As mentioned above, the materiality scrape is, without a doubt, a buyer-friendly provision. The scrape seeks to eliminate qualifiers that are invariably to the benefit of the seller. As a result, in the abstract, a materiality scrape is a provision that sellers will resist, for a number of reasons.

One common argument put forth by sellers is that in a purchase transaction the buyer should be expected to take on some level of risk related to the business they are purchasing, and not be entitled to nickel-and-dime sellers by pursuing any claim against them, no matter how minor. A full materiality scrape would remove a qualifier for purposes of determining whether a breach has occurred and quantifying the resulting loss. With those measures removed, the buyer would have no disincentive to pursue frivolous and minuscule claims against the seller.

Another common argument is that removing materiality qualifiers substantially increases the disclosure burden on the seller to an unreasonable, and in many cases unfeasible, standard. By removing materiality qualifiers when it comes to things like disclosure of contracts, condition of assets, or completeness and accuracy of corporate and financial records, the directors and officers signing on behalf of a Corporation are put to an extraordinarily high standard of disclosure, which in many cases, cannot reasonably be met.

Finally, there is an argument to be made that removing materiality qualifiers for determining the existence of a breach, but not for closing conditions, could allow sellers to be in breach of an M&A agreement immediately upon closing.

All of these are valid arguments considering the interest of the seller in a purchase transaction. However, in most cases buyers and sellers are able to draft their way around these issues and come to a compromise that takes the interests of both parties into account.

Potential Solutions

One way to avoid many of these difficulties is to use a deductible or minimum threshold basket for indemnification claims. Many of the challenges arising from the use of a materiality scrape, from the seller’s perspective, are based on the concern that by lowering the threshold to make a claim, materiality scrapes are opening the floodgates to frivolous and minuscule buyer-side claims. Using a deductible basket effectively eliminates this concern and prevents nickel-and-diming by the buyer, by creating a specific threshold which serves as a deductible against any claim brought against the seller for a breach. For instance, a threshold of $10,000 could be set, in which case the buyer could only pursue claims greater than $10,000, and if successful, could only collect for losses resulting from the breach that are in excess of that $10,000 threshold. A minimum basket works in much the same way, except that once the threshold is met, the buyer can claim the full amount of the claim, not just the amount in excess of the deductible. It is evident that the appropriate threshold to be used will be a key consideration when implementing either of these concepts, and will depend on the nature of the potential claims and the bargaining positions of both parties.

Another way to avoid many of the concerns mentioned above is to replace, where possible, “materiality” with more specific language in the representations and warranties themselves. This more specific language could relate to a particular dollar value (e.g. contracts valued in excess of $10,000) or other relevant concept (e.g. only disclose intellectual property that is necessary for the conduct of the business being acquired). This approach allows the seller to avoid some of the pitfalls of a full scrape while maintaining the mutual benefits of increased certainty and streamlined negotiations. The benefits of this approach will, in each case, have to be balanced against the time and effort required to analyze each applicable representation and warranty and to come to terms on the particular language to be used.

Most importantly, in order to reach a consensus, parties and their lawyers should take full advantage of the versatility of materiality scrapes to get over any lingering issues. In particular, the materiality scrapes should only be used where it makes sense to do so, and should be expressly carved-out where they might create issues between the parties. For instance, parties could agree that the scrape apply to determination of losses, but not whether or not a breach occurred, or could explicitly exempt disclosure requirements from the scrape. As with so many other things, the way materiality scrapes are implemented, and the scope of their application will depend entirely on the nature of the transaction and the bargaining positions of the parties involved.

One additional consideration to take into account when using materiality scrapes is to carefully review all reps and warranties to ensure that the use of the scrape doesn’t lead to any confusing or illogical results. For instance, the effects of a materiality scrape on a “Material Contracts” or “Material Adverse Effect” representation are unclear, and create a level of ambiguity that is not in the interest of either party.

This article is for informational purposes only and does not constitute legal advice. If you wish to discuss your issue with a lawyer, contact Martin Aquilina today.

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