Materiality Scrapes in Health Care Transactions: Why They Matter More Than You Think

Negotiating materiality scrapes in health care transactions, such as those involving closely held physician groups and private equity platforms, is commonly viewed as a routine part of the deal. Sellers should be mindful of the practical implications of materiality scrape provisions, especially when considered in the context of complex regulatory and operational diligence matters in the health care industry.

A materiality scrape is a provision in the definitive transaction agreement (such as an asset purchase agreement or an equity sale agreement) that provides that materiality qualifiers embedded in the representations and warranties in the agreement are disregarded for purposes of calculating losses under the indemnification provisions and, in some cases, in determining breaches of the representations and warranties in the first place. When a materiality scrape applies to both calculation of damages and determination of the accuracy of representations and warranties, it is a “double scrape.” Buyers favor double scrapes because they reap the benefit in indemnification disputes. However, sellers must carefully evaluate the consequences of a double scrape before accepting it as a deal term.

The Hidden Cost: Disclosure Schedule Burden

The force of a double scrape becomes obvious to a seller when preparing the disclosure schedules to the definitive agreement. Health care practices operate in a heavily regulated environment, with matters such as licensure, payor arrangements, HIPAA compliance, fraud and abuse considerations and billing practices imposing substantial requirements.

If a double scrape could cause materiality qualifiers in representations and warranties to have no force or meaning, sellers who operate within this stringent regulatory framework on a daily basis become incentivized to disclose any possible iteration of an exception to a representation – a time-consuming and costly exercise.

Preparing and finalizing the schedules to the definitive agreement requires significant client time and energy. A double scrape exacerbates this dynamic, as a seller would need to schedule items that it would not otherwise need to disclose if negotiated materiality thresholds applied (i.e.,if there was only a “single scrape” or no scrape at all). Sellers will broadly disclose exceptions to limit the risk of indemnity obligation. This increases both cost and execution strain on provider clients who are already balancing clinical operations.

Indemnification Risk: Aggregation of De Minimis Claims

Double scrapes also create an opportunity for buyers to aggregate a series of minor, otherwise insignificant issues to reach an indemnification basket. While trustworthy buyers may develop a relationship with the seller that alleviates seller concerns to a degree, in the health care regulatory environment conducive to technical compliance issues (e.g., an isolated documentation deficiency or minor billing errors), the aggregation risk under a double scrape remains regardless of strong buyer assurances.

Indemnity structures with a “tipping basket” enhance this risk. With a tipping basket, the seller is responsible for reimbursing the buyer for all losses from the first dollar incurred if the indemnification threshold is reached.

Practical Solutions in Health Care Deals

While buyers may insist on a double scrape, there are several equitable compromises that can help the parties achieve balance in risk sharing. For instance:

• Increase the Basket Threshold or Shift to a True Deductible Model: If a buyer views a double scrape as non-negotiable, meaningfully increasing the dollar value of the basket mitigates the aggregation risk.Further, shifting from a tipping basket to a “true deductible” model forces the buyer to have a financial stake in the indemnification process and provides a level of protection in instances in which minor compliance issues are expected.
• Negotiate a “Single Scrape”: If a materiality scrape is only employed for purposes of calculating losses after a breach has been determined while giving effect to materiality qualifiers, then buyers and sellers are arguably in balance in risk sharing – sellers are not burdened with substantial scheduling responsibilities and buyers can recover losses for consequential seller breaches.
• Special Treatment for Certain Representations: For matters that lend themselves to a greater likelihood of de minimis breaches (e.g., regulated areas such as billing compliance or privacy matters), parties could negotiate specific dollar thresholds or exclude the associated representations from a double scrape. This exercise requires focused negotiation and high levels of detail from a seller, as the seller must be comfortable with the representations to which the double scrape will still apply, and accept the potential double scrape consequences with respect to those matters. Similarly, the seller needs to prepare for buyer demands that certain known, significant issues or high-risk matters be subject to no scrape at all – that is, receiving treatment as specific indemnity items or excluded liabilities.

Materiality scrapes in health care transactions are extraordinarily meaningful to a seller’s potential post-closing financial exposure. Careful, considered negotiation that accounts for the operational realities of health care providers can provide a seller with a level of comfort once the deal closes.