M&A Vocabulary – Understanding Experts: “Knowledge Scrape vs. Materiality Scrape”

This is not about scientific-legal precision, linguistic subtleties, or exhaustive presentation, but rather about conveying or refreshing the basic understanding of a term and providing some useful insights from consulting practice.

In M&A transactions, securing potential liability risks is of central importance. Warranty & Indemnity (W&I) insurance has established itself as an effective instrument and is now indispensable in today’s M&A market. So-called synthetic W&I insurance policies have become standard in the German market. This means that W&I insurers cover risks to a certain extent independently of the wording of the underlying share purchase agreement. A particularly relevant term in this context is the so-called “knowledge scrape.” This refers to a provision whereby subjective knowledge qualifiers that are specified for certain seller warranties in the share purchase agreement are disregarded for W&I insurance purposes. Typically, various warranties in the share purchase agreement are given “to the best knowledge” of the seller. A knowledge scrape removes this knowledge component. As a result, the seller—or in the case of W&I insurance, the insurer—is liable for the inaccuracy of a warranty, regardless of whether the seller had knowledge of the relevant circumstances or breach of warranty. The knowledge scrape thus transforms subjective, knowledge-based warranties into objective warranties.

This conversion has significant implications for risk allocation in the transaction structure. While subjective warranties often prove ineffective in practice—because they are tied to the actual knowledge or negligent ignorance of one or more defined persons—an objective warranty claim with a knowledge scrape means that the buyer can actually claim coverage from the W&I policy in the event of an insurance claim. This simultaneously increases the risk for the insurer. The insurer responds with higher due diligence requirements, potentially higher premiums, and possibly exclusions for particularly high-risk warranty content. From the buyer’s perspective, the knowledge scrape is advantageous because it shifts the discovery risk for unknown or undisclosed defects to the insurer. Since knowledge qualifiers are often highly contentious in purchase agreement negotiations, a knowledge scrape can expedite the process by creating additional security for both the seller and the buyer.

In addition to knowledge scrapes, there are also so-called “materiality scrapes.” A materiality scrape removes materiality qualifiers from warranties. The seller typically seeks to avoid liability for “immaterial” breaches by limiting the scope of individual warranties in the share purchase agreement (e.g., compliance with all “material” legal requirements) or the scope of corresponding disclosure (e.g., disclosure of all “material” contracts). Particularly without precise definitions, such qualifiers can lead to disputes after the transaction about what is “material” and what is not. Furthermore, the materiality criterion is typically used in share purchase agreements to determine losses from a breach of warranty, for example by excluding de minimis damages. Such materiality qualifiers can weaken the buyer’s position by either excluding a breach of warranty altogether or preventing its enforcement due to thresholds. Materiality scraping offered by W&I insurers can eliminate both the materiality qualifiers in individual warranties and thresholds agreed in the share purchase agreement.

From a legal perspective, early coordination with the W&I insurer is of central importance for both types of scrapes. Insurers usually only accept comprehensive knowledge scrapes or materiality scrapes if comprehensive due diligence has been conducted on the buyer’s side and a vendor due diligence report or fact book is available on the seller’s side. In addition, consistency between the warranties in the share purchase agreement and the insurance terms should be carefully reviewed to avoid coverage gaps.

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