In addition to using caps, baskets and survival periods to limit the scope and duration of indemnities offered by sellers in an M&A Transaction, contracting parties may also impose scrapes on the materiality qualifiers to indemnities in an M&A agreement. The use of indemnity scrapes is a useful contractual tool, and is particularly favourable for purchasers, to apportion risk and liability between the contracting parties. Scrapes are often included in the indemnity provision of an M&A agreement, or may be included as a separate provision.
The general effect of imposing a materiality scrape, both for single scrapes and double scrapes, is that materiality qualifiers in the seller’s representations and warranties (for example, the use of language such as “material” and “material adverse effect” in the representations, warranties and covenants) are struck out or disregarded for the purposes of the indemnity.
While most purchasers will advocate for the inclusion of materiality scrapes in an M&A Transaction, sellers will try to limit the use of scrapes (particularly double scrapes, as discussed below). Where indemnity baskets and minor caps are already used to impose thresholds on the indemnity available, purchasers want to include materiality scrapes in order to avoid the “double protection” that sellers may achieve by using both:
- materiality qualifiers in their representations and warranties; and
- indemnity caps and baskets.
Without materiality scrapes, the purchaser would have to clear two hurdles to demonstrate both a material breach and that their damages or losses incurred are above the caps or baskets established in the indemnity.
Recent trends indicate that the use of double scrapes is increasing, and that double scrapes are now included in the majority of private M&A Transactions. Despite this, materiality scrapes are often not properly understood by the contracting parties or their transaction teams.
Double Materiality Scrapes
In a double scrape, materiality qualifiers are disregarded in order to determine both:
- whether a breach has occurred of a representation and warranty under the M&A agreement; and
- the determination of damages or losses that qualify for indemnification under the agreement.
Single Materiality Scrapes
In a single scrape, materiality qualifiers are only disregarded when determining the amount of damages or losses for a breach of a representation and warranty; materiality qualifiers are not scraped for determining whether a breach occurred. In other words: where a material breach is found to have occurred, no materiality qualifiers will be imposed in determining the damages to be indemnified. Single materiality scrapes may be included as a compromise and an alternative to the double scrapes advocated for by purchasers. The use of a single scrape combined with a deductible or non-tipping basket is a favourable combination of negotiated terms for sellers.
The use of knowledge scrapes in M&A agreements is not as common as the use of materiality scrapes. Under a knowledge scrape, the use of qualifiers related to the seller’s knowledge in its representations and warranties (and sometimes covenants) is eliminated or disregarded for the purposes of determining the indemnity. Similar to the materiality scrape, a knowledge scrape is a term favourable to the purchaser. A knowledge scrape applies only to the determination of whether a breach has occurred, not to the calculation of the damages or losses eligible for indemnification.
Carscallen LLP’s M&A Experience
Carscallen’s team of experienced M&A lawyers can assist both buyers and sellers in an M&A Transaction. We have extensive experience in advising on a wide range of purchase and sale transactions for both private and public companies and can help you understand your options, identify potential issues and how to overcome them, and to negotiate the most beneficial terms for your position.
*This update is intended for general information only on the subject matter and is not to be taken as legal advice.