Scraping materiality: “…where we’re going, we don’t need roads.”*

Despite its name, a ‘materiality scrape’ is not what happened to Marty McFly in Dr. Emmett Brown’s DeLorean.

In fact, it is a tool that is becoming more popular among counsel for the purchaser in commercial transactions, as a counterbalance to the use of materiality qualifiers by counsel for vendors.  The purpose of the tool is to “scrape out”, or exclude, concepts of materiality, material adverse effect, or similar qualifications from representations and warranties made by a vendor in a purchase agreement.  Depending on whether a lawyer acts for the vendor or the purchaser in the transaction, the materiality scrape either strengthens or restores the indemnity provisions of the purchase agreement.

An example of a materiality scrape might look something like the following:  “For the purposes of this Article ___ [Indemnification], the representations and warranties of the Target given in this Agreement will be deemed not to be qualified by any references to materiality or Material Adverse Effect.”

The importance of materiality scrapes becomes even more pronounced for a purchaser’s counsel when the vortex of “double materiality” is considered.  Double materiality arises when the use of materiality and similar qualifiers in representations and warranties are combined with an “indemnity threshold” or “de minimus damages” provision.  Such provisions are based on the concept of materiality (at least in a financial sense), in that the parties to the transaction will have agreed upon a threshold for damages, and losses below that threshold will not be pursued by the purchaser as they are immaterial.  As a result, the combination of materiality qualifications and such an indemnity threshold make it more difficult for the purchaser to recover losses which (absent such a combination) would otherwise likely be recoverable.

The counter arguments to the use of materiality scrapes often focus on the question of what a reasonable allocation of risk between the vendor and purchaser is.  Commonly, the vendor’s position is that it is extremely difficult to understand and evaluate possible risk and exposure given the far-reaching nature of the representations and warranties commonly found in a purchase agreement, and that the removal of materiality qualifications for the purposes of indemnifying the purchaser defeats the very purpose of having such qualifications in the first place.

Because lawyers are creative and vendors and purchasers often have a level of commercial flexibility, there are a number of possible ways to arrive at a solution with which both parties are comfortable with, such as limiting the scrape to the purposes of determining losses (and not for the purpose of determining whether or not there was a breach of a representation and warranty), excluding certain representations and warranties, or adjusting the value of the indemnity threshold.

So, the increased use of materiality qualifiers to limit the risk of vendors has given rise to more requests for materiality scrapes to limit the risk of purchasers.  Back to the Future.

*Dr. Emmett Brown – “Back to the Future” (1985).  Yes, I’m that old.