Delaware Law Alert: Delaware Case Applying Indemnification Materiality Scrape Creates Risks for the Unwary
In a recent post-trial opinion, the Delaware Superior Court, applying a representations and warranties materiality scrape under an M&A purchase agreement indemnification provision, held that the seller breached its absence of changes representation that no event had occurred that had or reasonably could have an “adverse effect” (as opposed to a material adverse effect) on the acquisition target. In addition, the Court considered the buyer’s claims for fraud and willful misconduct for the representations that were determined to have been breached after applying the materiality scrape. This Legal Update examines in detail the Court’s analysis of the purchase agreement and its application of the materiality scrape and discusses considerations for parties when negotiating materiality scrape provisions.
Background
JanCo FS 2, LLC v. ISS Facility Services, Inc.1 involved the sale of a business division pursuant to an asset purchase agreement. After closing, the revenues generated by the business were significantly less than the buyer had anticipated, and the buyer alleged that certain changes in the business resulted in increased labor costs and operational issues in connection with the rollout of a new human resources system. In the litigation before the Delaware Superior Court, the buyer asserted contractual indemnification claims and tort claims for fraud and willful misconduct based on several alleged breaches of the seller’s representations and warranties.
The purchase agreement included an indemnity for breaches of representations and warranties2 that was subject to a minimum loss threshold to be met before indemnification would be payable (the “basket”) and a maximum loss amount that the buyer could collect under the indemnity (the “cap”). The purchase agreement provided that the basket and cap would not apply in cases of fraud or willful misconduct. As is typical in representation and warranty indemnities,3 there was a “materiality scrape” that, in relevant part, provided that “all qualifications and limitations set forth in the [p]arties’ representations and warranties as to ‘materiality,’ ‘Material Adverse Effect,’ ‘Material Adverse Change’ and words of similar import shall be disregarded in determining whether there shall have been any inaccuracy in or breach of any representations and warranties.”4 Several of the representations at issue contained materiality qualifiers, and the Court assessed how the materiality scrape should be applied.
Absence of Changes Representation
The buyer alleged that the seller breached the absence of changes representation, which provided in relevant part:
Since June 30, 2021, Sellers have operated only in the Ordinary Course of Business and have not:
[(1)] suffered any damage, destruction, or Loss to any asset or suffered any other change, development, or event (individually or in the aggregate) that has had, or could be reasonably expected to have, a Material Adverse Effect on the Target Accounts; [or]
[(2)] suffered or experienced any other event or circumstance which has resulted in a Material Adverse Effect on it [sic] or which is reasonably expected to result in such a Material Adverse Effect.
In analyzing the absence of changes representation, the Court cited Delaware Chancery Court precedent for the proposition that a defined term incorporates the entire definition5 and stated that the “proper order of operations” is to (1) replace the defined term “Material Adverse Effect” with the text of the entire definition of Material Adverse Effect6 and then (2) employ the materiality scrape to remove the materiality qualifiers from the text of the definition of Material Adverse Effect. The representation, as set forth in the Court’s opinion after applying this order of operations, is as follows (with italic type indicating the Court’s insertion of the Material Adverse Effect definition and strikethrough text indicating its removal of Material Adverse Effect and materiality qualifiers):
Since June 30, 2021, Sellers have operated only in the Ordinary Course of Business and have not:
[(1)] suffered any damage, destruction, or Loss to any asset or suffered any other change, development, or event (individually or in the aggregate) that has had, or could be reasonably expected to have, any effect, condition, circumstance or change that individually or when taken together with other conditions, effects or circumstances in the aggregate has had a material an adverse effect on the Target Accounts;[or]
[(2)] suffered or experienced any other event or circumstance which has resulted in any effect, condition, circumstance or change that individually or when taken together with other conditions, effects or circumstances in the aggregate has had a material an adverse effect on the Target Accounts, Purchased Assets (including intangible assets), liabilities, condition (financial or otherwise), properties or results of operations of the Sellers relating to the Target Accounts in the aggregate, or to the ability of any Party to consummate timely the transactions contemplated hereby on it or which is reasonably expected to result in any effect, condition, circumstance or change that individually or when taken together with other conditions, effects or circumstances in the aggregate has had a material an adverse effect on the Target Accounts, Purchased Assets (including intangible assets), liabilities, condition (financial or otherwise), properties or results of operations of the Sellers relating to the Target Accounts in the aggregate, or to the ability of any Party to consummate timely the transactions contemplated hereby.7
In support of its analysis, the Court noted that if it did not insert the text of the definition of Material Adverse Effect and simply removed the words “Material Adverse Effect” from the text of the absence of changes representation, the result would be “nonsensical.” The Court went on to state that inserting the text of the definition of Material Adverse Effect before the materiality scrape prevented the representation from becoming “illegible.”
The Court’s modifications generally caused the seller to represent that no “adverse change” of any kind had occurred. The seller objected that the modifications made the representation overly broad, but the Court noted that the basket and cap put limits on the seller’s indemnification exposure. In addition, the Court stated that the existence of the basket and the cap indicated that the parties did not intend for the buyer to prove a material adverse effect to obtain indemnification. The Court reasoned that since the material adverse effect standard sets a high bar, requiring that the buyer’s damages be comparable to a 40% decrease in profits or a 50% decrease in revenues (as prior Delaware cases have suggested in determining whether a material adverse effect had occurred), then any damages satisfying that standard would also be large enough to both exceed the value of the cap and render the basket threshold irrelevant.
The Court then held that the buyer easily cleared the “low hurdle” presented by the modified absence of changes representation with evidence that between June 30, 2021, and the closing of the transaction, the business experienced (1) a significant labor shortage, requiring the business to rely on temporary labor and overtime, and (2) a number of operational issues due to complications in implementing a new human resources system. However, the Court ultimately declined to award damages because the buyer presented only an “all-or-nothing damages calculation” that did not “attempt to tie a damages calculation to a particular breach.”
The buyer also asserted willful misconduct and fraud claims, to which the cap and basket did not apply, alleging that the seller knew the absence of changes representation was false. In analyzing the willful misconduct and fraud claims, the Court assumed that the absence of changes representation was breached by the seller, in light of the Court’s application of the order of operations and the materiality scrape.8 On the willful misconduct claim, the Court held that the buyer failed to prove that the breaches were knowingly committed by the seller or its employees. Buttressing this conclusion, the Court pointed out that, because neither of the parties to the purchase agreement knew how to correctly apply the materiality scrape, the seller’s executives could not be expected to have understood the breadth of the modified representation in such a way to enable the seller’s knowing breach of the representation. The Court also rejected the fraud claim, holding that the buyer could not justifiably rely on a representation that the business had not declined at all between June 30, 2021, and the closing of the transaction because it had been informed before and after it entered into the purchase agreement of the issues arising from the shortage of labor and the implementation of the human resources system.
Other Representations
The Court also applied the materiality scrape to the seller’s financial statements and “full disclosure” representations. This proved to be an easier case of simply removing the word “material” from the representations as follows (with strikeout text showing the Court’s changes):
The Financial Statements are true, complete and correct in all respects, and present fairly in all material respects the financial condition and the results of operation of the Target Accounts as of the dates of such statements and for the periods then ended and have been prepared in accordance with International Financial Reporting Standards.
No representation or warranty made by Sellers in this Article 4, nor any schedule attached hereto contains any untrue statement of fact or omits to state a fact necessary to make the statements contained therein not misleading.
The buyer alleged that the seller’s financial statements were false because they failed to accurately reflect actual labor costs and include certain employee salaries. Although the materiality scrape expanded these representations, the Court held that the buyer failed to prove any breach at trial.
Discussion
Parties’ Expectations of the Operation of the Materiality Scrape Probably Differ. Although materiality scrapes have long been a feature of M&A agreements, their application is not as straightforward as parties might expect. In a sobering statement, the Court noted that “even after post-trial briefs, oral argument, and supplemental briefs, neither party explained the application of the Materiality Scrape to the Absence of Changes Representation with complete correctness” (emphasis in the original). In other words, both parties failed to anticipate how a court would interpret and apply the materiality scrape they had drafted. Notably, the JanCo materiality scrape followed a conventional formulation, but it still resulted in significant confusion for the parties throughout the litigation.
The Case Provides Guidance on the Application of the Materiality Scrape to Certain Materiality Qualifiers. The JanCo opinion offers important guidance on how a Delaware court will apply an order of operations for interpreting materiality scrapes for certain representations, in the absence of more specific drafting that provides for the parties’ desired application of the materiality scrape to the representations. In its decision, the Court made clear that the word “material,” when used in the customary phrase “in all material respects” and when used as an adjectival modifier (e.g., “material fact” in the full disclosure representation), will simply be struck and the representation will stand “flat” (i.e., unqualified). In addition, as in the case of the absence of changes representation, with respect to Material Adverse Effect references in a representation, the Court makes clear that the text of the defined term is to be inserted and then the materiality references are to be struck.
Did the Parties Intend to Scrape the Material Adverse Effect Reference in the Absence of Changes Representation? The text of the materiality scrape provides, in relevant part, that “all qualifications and limitations” as to materiality and Material Adverse Effect are to be disregarded in determining whether there has been a breach of a representation for purposes of indemnification. In applying the materiality scrape to the absence of changes representation, the opinion did not address whether or not the term “Material Adverse Effect” was used in the representation as a “qualification or limitation” subject to the materiality scrape. Perhaps the seller could have argued that the intent of the materiality scrape was to eliminate materiality references that served as qualifiers or limitations, such as, “except as would not reasonably be expected to have, individually or in the aggregate, a Material Adverse Effect” (in which case the entire phrase should be struck) and “in all material respects” (in which case the word “material” should be struck). In contrast, the seller might have argued that “Material Adverse Effect,” as used in the absence of changes representation, did not operate as a qualifier or a limitation and was not intended to fall within the scope of the materiality scrape.
Insertion of the Text of the Material Adverse Effect Definition Did Not Provide for Exclusions. Although the Court’s interpretive order of operations requires inserting the entire definition of Material Adverse Effect into the absence of changes representation, the Court inserted only part of the text of the definition. Notably, the Court omitted the definition’s proviso listing events that specifically would not constitute a Material Adverse Effect, such as effects arising from general financial and banking conditions, the seller’s industry, and COVID-related disruptions.9 Including the proviso would have given the seller the opportunity to argue that certain adverse effects were to be excluded for purposes of the representation. For example, the business’s experience with high employee turnover, which resulted in increased temporary labor and overtime costs, was, according to one of the buyer’s advisers, consistent with the market. If the exclusions in the definition of Material Adverse Effect were inserted into the absence of changes representation, then the seller would be able to argue that under the industry conditions exception of the Material Adverse Effect definition,10 high employee turnover was a condition that affects the industry of the business generally and should be excluded for purposes of determining whether an adverse effect had occurred.
Applying the Materiality Scrape to the Fraud and Willful Misconduct Claims Raises Risks that Sellers Must Address. Although by its terms the materiality scrape applied only to contractual indemnification (the lead-in text of the materiality scrape provides, “[f]or purposes of the indemnities . . . all qualification and limitations . . . .”), the Court applied the materiality scrape to evaluate the buyer’s non-contractual tort claims of fraud and willful misconduct. Even though the Court ultimately rejected the fraud and willful misconduct claims, applying the materiality scape to those claims raises serious concerns for sellers because one of the several purposes of the representations in an M&A purchase agreement is to induce the buyer to enter into the agreement. In that regard, there may be potential issues with the business that the seller knows (or should know)11 of that would result in the seller not being able to provide flat representations. The seller obtains a measure of relief by using materiality qualifiers in the representations, including, as appropriate, Material Adverse Effect qualifiers, to permit it, with some degree of confidence, to make the representations in the agreement without the risk that every potential issue it is (or should be) aware of could be the subject of a post-closing fraud or willful misrepresentation claim. To apply materiality scraping to the representations for purposes of determining whether the seller committed fraud or other deceit-based torts—when the very representations that the seller made in the purchase agreement to induce the buyer to transact included materiality qualifiers—puts the seller at significant risk for such claims for matters the seller knew (or should have known) of that do not reach the Material Adverse Effect or materiality threshold (as applicable). Therefore, sellers should be particularly attentive to the enhanced risk of fraud claims arising from broad or imprecise materiality scrape language.
Practice Points
It Is Time for a New Indemnification Materiality Scrape Formulation. Drafting a materiality scrape to simply provide that certain words and phrases will be “disregarded” may not be enough to make clear the parties’ intentions for the application of the materiality scrape for all representations. Instead of relying on the conventional formulation of an indemnification materiality scrape, parties should review the package of representations in the purchase agreement, paying particular attention to the specific drafting of the materiality qualifiers (including within defined terms used in the representations), and tailor the materiality scrape so that it applies to only those representations, and only in the manner, that the parties intend. Parties should draft for clarity and certainty in the language they use to provide for the materiality scrape and specifically address in the materiality scrape the treatment for each qualifier. For example, the provision could state that the qualifier “in all material respects” shall be deemed to be “in all respects” for purposes of the materiality scrape. Certain qualifiers, such as “except as would not be material to the company” and “except that are not material in amount” would be “nonsensical” under the JanCo construct, if the word “material” were to be struck from the text (and there is no defined term like “Material Adverse Effect” to fall back on to insert additional text). To avoid this ambiguity, parties should make clear that for these qualifiers all of the words in the phrase are to be struck. Similarly, with respect to the customary qualifier, “except as would not reasonably be expected to have, individually or in the aggregate, a Material Adverse Effect,” if parties want the materiality scrape to strike all of the text of the qualifier (instead of inserting the text of the definition of Material Adverse Effect and then scraping materiality), they should indicate that all of the words in the phrase are to be struck.
Carve Out the No Material Adverse Effect Representation. The No Material Adverse Effect representation in the bringdown closing condition is typically without any materiality qualification or materiality scraping because it is simply a standalone representation that no Material Adverse Effect has occurred. Similarly, to avoid the result that neither party in the JanCo case correctly anticipated, clarify that the materiality scrape does not apply to the No Material Adverse Effect representation.
Carveouts for Other Representations. Consider what other representations should be carved out of the materiality scrape. For example, the materiality qualifiers for the financial statements representation and the full disclosure representation were scraped in JanCo. Given that materiality is built into the preparation of financial statements under GAAP and financial accountant audit opinions are materiality qualified, it might be difficult for a seller to give a financial statements representation flat for indemnity purposes, especially as the financial accounting concept of materiality is different from the concept of materiality for the indemnity (i.e., the basket). Similarly, consider whether the full disclosure representation, which is typically drafted to track the securities law concept of full disclosure used to determine securities claims liability, should also not be subject to materiality scraping so a seller does not have to disclose immaterial facts about all of the representations in the purchase agreement in order to reduce the likelihood of indemnity claims under the full disclosure representation.
In addition, often a seller is required to represent as to categories of items that are material, such all “material permits” or “material licenses.” These items are typically listed on the disclosure schedules. Sellers should consider whether scraping the materiality qualifiers for these representations would result in a breach where the seller has relied on the materiality qualifier to prepare the list of items to disclose and omitted immaterial items.
Limiting the Purpose of the Materiality Scrape. Make clear that the sole purpose of the indemnification materiality scrape is to apply to the indemnity for representation or warranty breaches and it does not apply for other purposes, including for any fraud, willful misconduct or other deceit-based claims. In addition, if the purchase agreement contains a defined term for “Fraud,” parties can specify in that defined term that the representations are to be read without any materiality stripping.
Disclosure Schedules and Internal Due Diligence. JanCo demonstrates how a materiality scrape can fundamentally change the scope of a seller’s representations. As a practical matter, in private M&A transactions, sellers include in their disclosure schedules all matters they have knowledge of, big or small, because the indemnification materiality scrape makes it more likely that a seller will be liable under the indemnity. Sellers should ensure that once the parties have negotiated any carveouts to the materiality scrape, their disclosure schedules for the representations for which materiality is scraped, in particular, cover all matters that could form the basis of an indemnification claim under those representations when read flat. Sellers should also ensure that their internal due diligence process is adequate to identify all such disclosable matters.
Negotiation of the Basket and Cap. A seller should consider the effect of the materiality scrape it has negotiated on the potential for post-closing indemnity liability. In this regard, a seller should consider whether the basket and cap are in line with an acceptable level of indemnity risk and negotiate the basket and cap appropriately. In addition, while not mentioned in the JanCo case, sellers should consider negotiating for a minimum “per-claim” amount for each breach of representation indemnity claim to ensure that it does not have to indemnify for or defend de minimis claims, particularly in light of the representations being subject to a materiality scrape.
Representation and Warranty Insurance (RWI). As RWI policies have evolved over the RWI product’s lifespan, materiality scrapes have become standard provisions of RWI policies, thereby matching the terms of traditional purchase agreement indemnities that buyers have come to expect in such agreements. Many of the issues and considerations with respect to the Court’s order of operations and application of the materiality scrape in the JanCo case will be equally relevant in the context of RWI claims, and buyers will want to negotiate their RWI policies accordingly.
1 344 A.3d 1009, C.A. No. N23C-03-005 MAA CCLD (Del. Super. August 21, 2025) (Adams, J.) (post-trial opinion). This Legal Update focuses on the Court’s analysis and decision with respect to claims relating to the indemnification materiality scrape of the purchase agreement. Other claims in the litigation that the Court ruled on in its opinion are not addressed in this Legal Update.
2 While the opinion does not state that the indemnity was for breaches of representations and warranties as of the signing of the purchase agreement and as of the closing of the transaction, the Court’s analysis follows an approach where the seller would be liable under the indemnity for a representation or warranty that was breached as of signing or as of closing.
3 The SRS Acquiom 2025 M&A Deal Terms Study reports a materiality scrape in 86% of private M&A transactions in 2024.
4 While the majority of materiality scrape provisions apply for purposes of determining whether a representation has been breached and for determining the amount of damages attributable to a breach, some materiality scrape provisions apply for one but not both such purposes.
5AB Stable VIII LLC v. Maps Hotels & Resorts One LLC, C.A. No. 2020-0310-JTL (Del. Ch. November 30, 2020), aff’d 268 A.3d 198 (Del. 2021) (“In a contract, a defined term simply serves as a convenient substitute for the definition.”).
6 The opinion states that “Material Adverse Effect” is defined in the purchase agreement as “any effect, condition, circumstance or change that individually or when taken together with other conditions, effects or circumstances in the aggregate has had a material adverse effect on the Target Accounts, Purchased Assets (including intangible assets), liabilities, condition (financial or otherwise), properties or results of operations of the Sellers relating to the Target Accounts in the aggregate, or to [sic] the ability of any Party to consummate timely the transactions contemplated hereby; provided that none of the following shall be deemed to constitute, and none of the following shall be taken into account in determining whether there has been, a Material Adverse Effect or Material Adverse Change: (a) any adverse change, event, development, or effect arising from or relating to: (1) financial, banking, or securities markets (including any disruption thereof and any decline in the price of any security or any market index), (2) the industry in which Sellers operate and the United States economy as a whole, to the extent such change, event, development or effect described in this clause does not directly impair or render Sellers substantially inoperative or have a disproportionate effect on Sellers (relative to other participants in the industry), (3) the taking of any action contemplated by this Agreement and the other agreements contemplated hereby or (4) any business disruption or material Losses as a result of COVID-19, or expenses and costs incurred in complying with COVID-19 Control Measures; provided, further, that, the expiration or termination of any contract with any customer listed on Schedule 4.22 shall be deemed to be a Material Adverse Effect and Material Adverse Change.”
7 The Court stated that this formulation of the absence of changes representation, which was advocated by the buyer, skipped “the key step of implementing the full definition of Material Adverse Effect before scraping ‘material.’”
8 While the buyer brought contractual claims for breaches of several representations, because the Court ruled that only the absence of changes representation was breached, the Court considered willful misconduct and fraud claims for only that representation.
9 See the definition of Material Adverse Effect, supra note 6.
11 For a common law fraud claim, knowledge as to the falsity of a representation can be imputed if the representation was made recklessly.
