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Introduction
Negotiating purchase agreements in private mergers and acquisitions ("M&A") transactions can often be an extensive and potentially contentious undertaking. Although vendors and purchasers are typically aligned on general commercial terms, each party needs to consider its own interests when negotiating the specific details of a purchase agreement, particularly when it comes to the allocation of risk.
On one hand, vendors often seek to reduce risk following completion of an M&A transaction and therefore negotiate provisions to limit that risk, which in many instances will involve reducing the circumstances in which vendors are responsible for breaches and damages in the purchase agreement. On the other hand, purchasers intend to get the full benefit of the representations, warranties and covenants of the vendors in the purchase agreement, which typically seeks to allocate risk to the vendors for the pre-closing aspects of the business being acquired.
This risk allocation exercise is reflected in the scope and breadth of the representations and warranties, as well as in the indemnification provisions in the purchase agreement. Common ways that parties address risk allocation include the use of "de minimis"1 provisions, "deductibles"2 and "tipping baskets."3 Another way in which vendors and purchasers address risk allocation is through the inclusion of provisions within a purchase agreement that effectively eliminate materiality qualifiers in the vendors' representations and warranties. These provisions are known as "materiality scrapes," and they are becoming increasingly common throughout private M&A transactions in both Canada and the United States.
This article explores materiality scrape provisions in private M&A transactions and outlines the perspectives of both vendors and purchasers with regard to the inclusion of such provisions in purchase agreements. The article also investigates potential positions of compromise between vendors and purchasers when negotiating purchase agreements. Finally, the article illustrates the increasing prevalence of materiality scrapes in Canadian and U.S. private M&A transactions. The ability to identify and effectively negotiate provisions relating to materiality scrapes is increasingly important for vendors and purchasers, and their respective counsel, in both the domestic Canadian M&A market and in cross-border transactions involving Canadian vendors or purchasers.
What Is a Materiality Scrape?
A materiality scrape in a purchase agreement is a generally purchaser-friendly provision which states that any materiality, material adverse effect or similar such qualifiers in a vendors' representations and warranties can be "scraped," or disregarded, if the representation or warranty is found to be inaccurate.4
There are two typical criteria to which materiality scrapes apply: first, in considering whether "materiality" should be disregarded when determining if representations or warranties were breached and, second, in determining the quantum of damages owed for the inaccuracy of a representation or warranty. In a "single" scrape scenario, a purchaser would only get the benefit of one of the criteria. In a "double" materiality scrape, purchasers get the benefit of the read-out of materiality qualifiers in the vendors' representations and warranties for the purposes of determining whether a breach occurred, as well as the amount of indemnifiable losses resulting from such a breach.
Positions of the Parties
Purchasers
Purchasers typically rely on some form of a variant of the position that not including a scrape in the purchase agreement would subject the purchaser to a double materiality standard. With the double materiality standard, the purchaser would first need to demonstrate that a non-material breach occurred, and then demonstrate that the breach exceeded the minimum amount as established in the indemnity provision.5 Additional justifications from purchasers for the inclusion of materiality scrapes include efficiencies in the negotiation of the purchase agreement given the "scraping" of materiality language, while also limiting post-closing disputes over materiality language with respect to breaches of representations, warranties and resulting indemnities.
Vendors
On the other hand, vendors generally rebut purchasers' arguments by relying on some form of a variant of the position that materiality scrapes limit the relevance of the materiality qualifiers in representations and warranties, and that the negotiation of representations and warranties should be undertaken for all purposes associated with the purchase agreement.6 Additional justifications from vendors for the exclusion of materiality scrapes include that materiality scrapes may defeat the purpose of some portions of the risk allocation indemnification package and can lead to purchasers making "kitchen sink" claims, regardless of size, under various representations and warranties to exceed indemnification thresholds. It is much more difficult for purchasers to reach the "tipping basket" for breaches if "materiality" is read into vendors' representations and warranties.
Vendors also argue that the inclusion of materiality scrapes is inefficient and can increase transaction costs. In an attempt to offset the materiality scrape, vendors may undertake the burdensome approach of increasing their disclosure obligations by over-disclosing information, regardless of materiality. Further, negations regarding materiality become amplified where there is a double scrape.
Positions of Compromise Between Purchasers and Vendors
As a result of the above, in purchase agreement negotiations, purchasers and vendors generally have different perspectives as to the inclusion of a materiality scrape provision. Unless there is a clear "balance of power" in negotiating the purchase agreement (e.g., vendors are eager to complete a sale or purchasers are eager to complete an acquisition), positions of compromise are often required by the parties.
One potential area of compromise is to permit materiality scrapes from specific agreed-upon representations and warranties, and exclude them from others. This could allow purchasers to rely on a double scrape for certain provisions, but a single scrape or no scrape would be applied to other representations and warranties, to the benefit of the vendors. While this approach might give both parties certain benefits, negotiations over which representations and warranties receive a materiality scrape, or not, and whether that materiality scrape is a single or double scrape could prove difficult and cause delay in the negotiation of a purchase agreement.
A more common area of compromise between purchasers and vendors is the inclusion of a single materiality scrape to all representations and warranties. This results in materiality qualifiers only applying either when determining whether a material breach occurred or when determining the amount of losses resulting from a breach, but not both. As a result, purchasers will not be limited by materiality qualifiers for certain representations and warranties, and vendors can mitigate the prevalence of "kitchen sink" claims following closing. Data from Thomson Reuters' 2023 "What's Market: Legal Trends in Canadian Private M&A" study (the "Canadian Study") demonstrates that this approach is typical in purchase agreements with materiality scrapes, as approximately two-thirds of agreements reviewed with materiality scrapes were limited to single scrapes.7
Other potential ways to close the gap between purchasers' and vendors' positions in terms of risk allocation in the purchase agreement are:
- inclusion of language to address key elements of risk allocation (e.g., scrapes, baskets, caps, etc.) in the letter of intent to avoid potential disagreement during the purchase agreement negotiations;
- the use of a "de minimis" claims provision and potentially increasing the threshold of those claims in an attempt to mitigate "nickel-and-dime" claims by purchasers;
- the use of tipping baskets and potentially increasing the threshold in an attempt to mitigate "nickel-and-dime" claims by purchasers; and
- the use of a deductible to require the indemnifying party to only indemnify in excess of a threshold amount, as opposed to from the first dollar of the aggregate of claims, as would be done with a tipping basket.
Increased Prevalence of Materiality Scrapes
Materiality scrape provisions have become increasingly common in private M&A transactions in both Canada and the U.S., and we expect the prevalence of these provisions to continue to increase in Canada in the foreseeable future.
Canada
Whereas only 11% of private M&A purchase agreements reviewed in Canada in the American Bar Association's (the "ABA") 2016 Canadian Private Target M&A Deal Points Study including an indemnity basket also included a materiality scrape in 2012,8 according to the Canadian Study data, the proportion of deals has gradually increased to approximately 32% in 2018 and, further, to approximately 42% in 2022.9 Of these deals, 14% included a double materiality scrape, 23% included a single scrape provision for damages only, and 5% included a single scrape only for breach of representations and warranties.10 Although 59% of reviewed transactions remained silent with respect to materiality scrapes in 2022, this represented a 9% decrease from 2018. This decrease is generally consistent with the increase of transactions including double materiality scrapes since 2018, which increased from 9% to 14% over the same time period.11
United States
While trends relating to materiality scrapes are increasing in private Canadian transactions, despite recent reductions in scrapes in the U.S., they remain much more prevalent in the U.S. compared to Canada according to the ABA's 2023 Private Target M&A Deal Points Study (the "U.S. Study").
In 2023, 79% of transactions that included indemnity baskets also included materiality scrape provisions, representing an increase from 28% based on similarly reviewed U.S. transactions in 2012.12 Further, double materiality scrapes are much more common in the U.S. deals studied than in Canada, being included in 70% of agreements in 2022.13
Despite the strong presence of materiality scrapes in transactions reviewed in the U.S. Study, there has been a recent softening regarding the inclusion of such provisions, as well as the presence of double scrapes, in purchase agreements. The inclusion of materiality scrapes peaked in 2022 whereby 93% of reviewed agreements with indemnity baskets included such provisions. The presence of double scrapes peaked in 2021 at 88% of reviewed agreements with materiality scrapes in the U.S. Study including a double-scrape provision.14 Although there has been a recent downward trend, the total percentage of deals including materiality scrapes as a whole has remained consistent over the past five years in the U.S., with the presence of double-materiality scrapes increasing by 12% over the same time period.15
Conclusion
Based on the above, we expect to experience further increases in the inclusion of materiality scrapes in Canada, including double scrapes, or at least additional time negotiating these types of provisions in purchase agreements, as Canadian M&A activity continues to evolve for the balance of 2024 and into 2025. Purchasers, vendors and their respective advisors should also be mindful of the presence of representation and warranty insurance ("R&W Insurance") as an effective tool in mitigating the potential risk of parties to purchase agreements with respect to materiality scrapes. R&W Insurance is a tool that can alter the risk allocation discussed between vendors and purchasers, potentially offsetting some of the risks related to representations and warranties to be passed on to a third-party insurer.16
Having an understanding of the repercussions of materiality scrape provisions in purchase agreements is particularly important, given the increased prevalence of such provisions in North American M&A transactions.
Footnotes
1. A de minimis provision in the context of a purchase agreement typically states that the purchaser is required to "absorb" (i.e., is not permitted to make any claims) for immaterial breaches of representations and warranties by the vendors below an agreed-upon dollar threshold.
2. A deductible in the context of a purchase agreement is much like a deductible in other contexts, such as in insurance policies, and typically states that the purchaser is required to "absorb" (i.e., is not permitted to make any claims) for breaches of representations and warranties below an agreed-upon dollar threshold, but upon the dollar threshold being exceeded, the purchaser is entitled to claim all (or, less frequently, a portion of) the damages suffered by the purchaser (up to an agreed-upon "cap") as a result of breaches of representations and warranties by vendors in excess of the threshold amount.
3.A tipping basket in the context of a purchase agreement typically states that the purchaser is required to "absorb" (i.e., is not permitted to make any claims) for breaches of representations and warranties below an agreed-upon dollar threshold until that dollar threshold is exceeded, after which the purchaser is entitled to claim all (or, less frequently, a portion of) the damages suffered by the purchaser (up to an agreed-upon "cap") as a result of breaches of representations and warranties by vendors, including those below the threshold amount and up.
4. Thomson Reuters, "What's Market: Legal Trends in Canadian Private M&A," (Oct. 17, 2023) online: What's Market: Legal Trends in Canadian Private M&A | Practical Law (thomsonreuters.com).
5. The persuasiveness of the purchaser's position and, frankly, the vendor's position will depend, in part, upon the other elements of the indemnification package. In other words, in our experience, the inclusion or not of materiality scrapes are typically not argued in isolation but are rather addressed as part of a holistic risk allocation (i.e., indemnification) package.
6. See also note 5 regarding the totality of the indemnification package being an important factor when considering the inclusion of a materiality scrape, and whether that materiality scrape should be a single or double materiality scrape.
7. Supra, note 4.
8. American Bar Association, "2016 Canadian Private Target M&A Deal Points Study," online: Digital Asset Abstract (americanbar.org).
9. Supra, note 4.
10. Ibid.
11. Ibid.
12. American Bar Association, "2023 Private Target M&A Deal Points Study," (Dec. 18, 2023) online: Digital Asset Abstract (americanbar.org).
13. Ibid.
14. Canadian advisors will continue to monitor trends in materiality scrapes in the U.S. to observe if these figures will rebound to prior peak levels.
15. Supra, note 12.
16. R&W Insurance provides for transaction insurance in M&A transactions whereby a third-party insurer, irrespective of deal structure, will assume the risk for breach of certain representations and warranties made by purchasers, vendors, or both. For further information regarding R&W Insurance, please see our article titled Addressing Risk Allocation in M&A Transactions Through the Use of Transactional Insurance: A Primer on Representation and Warranty Insurance in the Canadian M&A Market.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.