Don’t Be a Materiality Scrape Goat
Contemplating selling your business? Considering entering into a purchase agreement? Materiality scrape provisions are something you should be keeping an eye out for.
In many purchase agreements, vendors will make representations about what they are selling. These include a wide range of assurances— such as that it has good title to the assets/shares being sold, that the business hasn’t breached any contracts, and that it isn’t involved in ongoing litigation. These representations form the vital basis of the purchase contract and ensure buyers know what they are purchasing. Often, the representations are limited to “material” items. A representation that says there are no ongoing lawsuits would actually be that there are no ongoing material lawsuits. This ensures that for any representation, non-material claims will not lead to a breach of contract claim by the buyer.
Along with the materiality qualifications, it is also common for parties to negotiate de minimis cap on indemnity claims (or “indemnity baskets”). These are clauses that ensure a vendor will not be liable for any breaches until they reach a certain monetary threshold— a minimum. Both materiality and indemnity baskets protect vendors from non-material or small claims being brought against them for the representations they make in a purchase agreement.
What is a “Materiality Scrape?”
A materiality scrape is a provision in a purchase agreement that “reads out” materiality qualifiers from representations or warranties in the contract. They can be enormously beneficial for buyers, but might spell trouble for vendors who unknowingly give up protections in their purchase agreements.
A single materiality scrape typically reads out “material” for the purpose of determining losses resulting from a material breach of a representation. They may look something like this:
“For the purpose of calculating the amount of any losses arising from a breach of a representation or warranty, such representation and warranty will be read without regard to any qualification relating to materiality or with the word ‘material’.”
It is becoming increasingly common to see what is often referred to as a “double materiality scrape”. These are clauses that scrape “materiality” in determining both whether a breach has occurred, and the amount of losses resulting from the breach. They may look something like this:
“For the purpose of determining whether there has been a breach of a representation or warranty, and for determining the amount of damages arising, all qualifications or exceptions in any representation or warranty with the term ‘material’ shall be disregarded.”
Essentially, a single materiality scrape means that materiality qualifiers will apply for the purpose of determining whether there was a breach of a representation, but not in determining the amount of losses arising. A double materiality scrape means that materiality will not be considered at either stage.
Why do we have them?
Materiality scrapes are pro-buyer clauses. From the perspective of a buyer, indemnity baskets and materiality qualifiers mean that vendors are afforded double protection when it comes to claims. With no materiality scrapes, in order to prove a breach in a representation or warranty, a buyer would both need to prove that the breach was material and that the damages were over the threshold set by the indemnity basket in order to get a remedy. Materiality scrapes are intended to mitigate against this double protection.
What should I do if I am considering selling?
Materiality scrapes are becoming increasingly more common in Nova Scotia purchase agreements. If you are considering entering into a share purchase or asset purchase agreement as a vendor, you should always be aware of the possibility that a materiality scrape clause will be included in your agreement. A 2017 survey of deals in Canada indicated that 26% of the purchase agreements included some form of materiality scrape.
As a general note, a vendor may want to consider the following:
- A single materiality scrape is often a compromise. In an agreement with an indemnity basket, a vendor may consider negotiating to a scrape that applies to the calculation of losses arising from a breach, but not determining whether there has been a breach.
- Using a deductible indemnity basket instead of a tipping basket as a pro-vendor clause can be used in negotiations. In any purchase agreements, once the basket amount is reached, the purchaser can claim the entire amount of the loss from the vendor, including the basket amount. With an indemnity form of basket, the purchaser can only claim for losses in excess of the basket amount (i.e. the basket effectively acts as a deductible).
- If there is no indemnity basket in your agreement, a single materiality scrape may read out materiality for the purposes of determining whether a breach has occurred, thereby completing eroding the protection that the materiality qualifier offers.
Our recommendation-always consult a lawyer before signing any agreement to ensure you understand broadly all the rights and the obligations a purchase agreement contains.
For further queries on what a materiality scrape might mean for you, contact Mohammad Ali Raza and David Reid, partners in the Business Group of Cox & Palmer’s Halifax Office. This article was written with contributions by Sarah Dobson, a law student currently working at Cox & Palmer.
This article originally appeared on The Lawyer’s Daily website published by LexisNexis Canada Inc.