Materiality Provisions in Purchase Agreements
It is important for parties to a transaction who come from other less-litigious business environments to know that U.S. buyers and sellers operate in an environment where litigation is far more frequent, and even a single word can affect the outcome of a dispute. We believe that the example below (just one of many that could be described) can help to introduce these concerns to a non-U.S. business, and illustrates the need for careful coordination with the company’s U.S. counsel.
Two of the most important and highly-negotiated sections in a purchase agreement are (1) the representations and warranties section and (2) the indemnification section. In a purchase agreement in which literally even a seemingly insignificant provision can play a critical role in resolving disputes that could involve millions of dollars, it comes as no surprise that these two sections occupy so much time during the drafting of the agreement. The representation and warranties sections include statements made by the Seller regarding its business, financial conditions, assets, existing, potential or contingent liabilities, and the validity and enforceability of the transaction. Often times these are limited by dates, such as “since January 1, 2016, the Company has been in compliance with all applicable laws.” Exceptions to these statements will be listed in a separate disclosure schedule. The indemnification section spells out how post-closing disputes with respect to losses suffered as a result of any such statement being untrue are handled. For instance, what if it turns out that on April 1, 2016, the Company violated a relatively minor environmental law, and this violation was not disclosed on the disclosure schedule? Since the parties do not want to end up in litigation over the smallest matters, there will often be a basket of a certain amount of losses that must be exceeded in order for the Buyer to make a formal claim against the Seller.
Now let’s assume the violation causes the Buyer to pay $5,000 to the relevant authorities in a case where the basket is $10,000, in this event the Buyer will have no further claims to the Seller. But had there been no basket in place, the Buyer could have brought a claim against the Seller even for the $5,000. It is thus clear how the interplay between the two sections is so crucial, as failures by the Seller with respect to the representations and warranties section may lead to disputes that are handled pursuant to the indemnification section.
In the example above, the Seller limited the representation by a specific date. In addition, the Seller will often times want to further limit the representation by writing “since January 1, 2016, the Company has been in compliance in all material respects with all applicable laws.” The materiality qualifier eliminates the need to list immaterial exceptions to the representation. The usage of the word “material” is often not used as a defined term, although in these instances the usage of the term introduces a level of speculation as to what is in fact “material.” Assuming that “material” is used in this vague manner, the question is now whether the Buyer can bring a claim for a $5,000 violation that was not disclosed (assuming there is no $10,000 limitation in place). The Seller will say that given the materiality qualifier it was not required to disclose a $5,000 violation as such violation was immaterial. The Buyer could avoid this issue by insisting on removing the materiality qualifier or by pushing to provide a dollar threshold definition of what materiality is. For instance, if the materiality threshold was $3,000, then the $5,000 violation claim would certainly be able to be brought by the Buyer. The Buyer can respond to the materiality qualifier by inserting a materiality scrape, which is a provision that typically reads as follows: “in determining whether any breach of any representation or warranty of the Seller has occurred, the term ‘material’ shall be disregarded.” The Seller would thus be liable for any losses that occur, even if the loss was considered to have occurred due to an immaterial event, subject to any basket that is included in the purchase agreement.
The examples discussed above show the need for reviewing an agreement in its entirety to fully understand the interplay between sections. While the representations and warranties section and the indemnification section are often many pages apart, there is a direct interplay between the sections that is fundamental in understanding the agreement. Further, the usage of deliberately subjective words such as “material” add another level of complexity that may prevent the Buyer from recovering certain losses. It is no wonder that Buyers will often push back either directly or indirectly against materiality qualifiers and attempt to introduce additional language, such as the materiality scrape, that provide greater certainty to addressing post-closing claims and allocating any loss between the seller and the buyer.