Of Scrapes and Scraps

…a new tool to balance buyers’ and sellers’ risk in M&A transactions.

Published May 24, 2017

Background

In M&A transactions, the purchase agreement is typically the most heavily negotiated document between the buyer and seller. And within the purchase agreement the representations and warranties are often a key point of contention.

In a typical scenario, the seller in a purchase transaction seeks to qualify as many of its representations and warranties as possible, often by referring “to the knowledge of” the seller, or by setting a “materiality” standard. These qualifications limit the burden and the risk imposed on the seller by curbing disclosure requirements and closing conditions, and creating a narrower risk of breach of the agreement post-closing. Conversely, the buyer is typically opposed to any such qualifications, as each qualification comes with a corresponding increase in the buyer’s exposure with respect to each qualified representation or warranty. Traditionally, this is the starting point, and the parties and their lawyers then proceed to scrap it out in order to narrow the space between their positions with a view to ending up at a mutually-agreeable compromise. These compromises tend to involve one party “winning” (usually the party with the greater bargaining power), and the other party making a sacrifice to get the deal done.

Recently however, a new tool has emerged that can help parties overcome the traditional zero-sum game of duke-it-out negotiation of representations and warranties. This tool is known as the scrape.

In the first of a series of four articles, we will look at two types of scrapes, the knowledge scrape and the materiality scrape. Let’s start with the latter.

Materiality Scrapes

A materiality scrape, simply put, is a clause in a purchase agreement which allows materiality qualifiers to be ignored for specific purposes (key among them being indemnification). A common form of a materiality scrape that might be found in a purchase agreement is as follows:

“For the purposes of this Section, the representations and warranties of the seller given in this Agreement will be deemed not to be qualified by any references to materiality, Material Adverse Effect or similar qualification applicable to such representation and warranty.”

By inserting this clause, the buyer can be assured that disputes around materiality will not factor-in to any dispute related to, for instance, determining whether or not there has been a breach of a representation or warranty in the agreement, or quantifying the amount of loss resulting from a breach.

An obvious question that arises is then: why include the materiality qualifiers in the first place? The simple answer is that qualifiers can serve many different purposes simultaneously. For instance, they can be used to: (i) create a threshold to ensure closing conditions have been met; (ii) set out the scope of a buyer’s disclosure; (iii) determine whether a breach of a representation or warranty has occurred; and (iv) determine the quantum of losses resulting from a breach. A properly drafted materiality scrape allows the parties to ignore materiality qualifiers for certain purposes, while maintaining them for others.

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 today.  613-747-2459 ext.308, maquilina@hazlolaw.com