OpEd: ESG in Due Diligence Is Not Just Another Box to Check
The following article was written by Cahill Gordon & Reindel LLP partners Helene Banks and Brockton Bosson and associate Jennifer Potts.
Corporate focus on environmental, social and governance issues, largely driven by investor, customer, and other stakeholder demand, has been growing over the past decade, and, if the past year is any indication, this focus shows no sign of slowing down.
In March 2021, the U.S. Securities and Exchange Commission announced the creation of a Climate and ESG Task Force within the Division of Enforcement and is currently analyzing public comments on whether current disclosure rules are sufficient with respect to climate change issues and risks. Also earlier this year, the European Union’s the Sustainable Finance Disclosure Regulation came into effect, which mandates certain ESG-related disclosures for financial services institutions.
Given that ESG is now a day-to-day focus for management and directors across industries, companies would be well-served to undertake a thoughtful assessment of ESG risks when evaluating potential targets in M&A activities. Incorporating ESG into M&A due diligence enables companies and their counsel to evaluate the legal and reputational risks that may accompany the acquisition of new operations and facilitates the integration of the acquired company into the buyer’s own ESG program.
ESG is often used as shorthand to refer to the non-financial metrics for measuring a company’s performance. The following are examples of key elements of each of the “E,” “S” and “G” factors, though for each company, the relative importance of these elements may vary depending on the particular nature and risks of the company’s business:
- Environmental: climate change and carbon emissions, air and water pollution, soil contamination, supply chain sustainability, biodiversity, deforestation, energy efficiency, waste management, water scarcity.
- Social: human rights, labor standards, workforce diversity, employee engagement, community and other stakeholder relationships, charitable giving programs.
- Governance: board oversight of environmental and social issues, board diversity, bribery and corruption, executive compensation, lobbying, political contributions, ethics and compliance program.
Prior to an acquisition or other investment transaction, the acquiring company should have an understanding of the target company’s ESG risk areas to assess potential legal and reputational exposure.
Practically, ESG-related issues have the potential to impact the value and price of the acquisition and, therefore, may impact whether the deal should go forward. While historically there has been the possibility of regulatory scrutiny in ESG-related areas, e.g., violations of environmental or worker safety laws, the global attention to ESG matters by a range of stakeholders establishes ESG deficiencies (even if those deficient operations are acquired through M&A) as a prime reputational risk for parent companies that could lead to swift and significant value erosion.
Incorporating ESG into M&A Due Diligence
Where and How to Incorporate ESG
At the outset of the due diligence process, acquiring companies generally should assess potential ESG risks associated with the transaction to appropriately tailor the ESG due diligence approach. Some threshold questions to consider include:
- Nature of the target’s business: What is the nature of the target’s business? Is the industry one that is perceived to have significant environmental impacts or to employ vulnerable workers? Is the industry known for a high incidence of bribery and corruption?
- Location of the target’s operations: Is the target a purely domestic company or does it have international operations or other foreign touch points such as an international supply chain or cross-border labor sourcing? If there are international operations or other such touchpoints, are the relevant jurisdictions perceived to have limited human rights or labor rights, or be at risk for heightened environmental impacts? Are any relevant jurisdictions at increased risk for bribery and corruption?
- Responsible sourcing: Does the target’s business rely on supply chains that employ vulnerable workers, present environmental risks and/or involve hazardous conditions?
- Public disclosures: Has the target made public disclosures (in regulatory filings or through other public channels, such as its website) on ESG-related topics, including its environmental impact, responsible sourcing practices, commitment to diversity and inclusion, sustainability programs, or community engagement initiatives?
By understanding the key potential risk areas, an acquirer and its counsel can ensure these risks are appropriately evaluated during the due diligence process. The realm of ESG is broad, and seldom will a company have exposure to all ESG risk areas. Therefore, pre-acquisition ESG due diligence is not a one-size-fits-all undertaking and, for the sake of efficiency, each transaction requires a customized approach.
In addition to enabling an acquirer to conduct the pre-acquisition due diligence process under legal privilege, legal counsel also should keep apace of the latest ESG standards (both legal and reputational), which should be considered in the due diligence process. At this early stage of a potential transaction, ESG counsel may be retained to provide overall context from which the diligence can then proceed.
Once the threshold questions are considered, the company must assess how to dig deeper most efficiently.
Depending on the extent of the issues, the existing work streams, and any overlap of issues, the company should create a tailored approach for each transaction.
One approach the company may choose is to leverage discrete due diligence work streams to gather relevant ESG-related information where possible. For instance, it may be appropriate to include issues like responsible sourcing practices and community engagement initiatives as part of the anti-bribery and corruption, or ABC, work stream, which, depending on the target’s bribery and corruption risk, may be its own standalone work stream or incorporated into a broader regulatory work stream.
Poor controls and oversight relating to areas such as sourcing and community engagement often correspond with greater potential for ABC risk in the target’s operations, so consolidation into the same work stream can build on existing subject matter synergies and leverage the particular knowledge of legal and other specialists.
The target’s ethics and compliance program — which feeds into the governance component of ESG — can also be evaluated as part of the ABC or regulatory work stream. Similarly, it may be appropriate to include as part of the labor and employee benefits work stream, issues of board diversity and composition, executive compensation and other labor and workforce issues, any of which may raise ESG-related issues.
In some transactions, however, various ESG components may need to be reviewed by more than one team. For example, ESG components related to worker safety measures could be addressed by the labor and employment diligence work stream but may also benefit from review by the environmental diligence team, as well as the regulatory team.
Where there is much overlap or there are complicated issues that can go to the heart of the value of the deal, it may be appropriate to develop a standalone ESG work stream to oversee all of the ESG aspects to ensure coordination and a thorough review. ESG counsel can assist in coordinating the various work streams and in developing a comprehensive due diligence work plan.
Obtaining Relevant ESG Information
Once an acquirer and counsel determine the particular ESG-related risks that should be evaluated and how best to allocate due diligence activities among the work streams, ESG due diligence can be embedded in the acquirer’s broader due diligence process. Information relating to ESG risk and controls should be obtained through document and information requests and interviews with the target’s management. Counsel well versed in ESG issues can provide questions tailored to the particular risks of the target and help eliminate the potential for duplicative or overlapping requests being made to the target.
If ESG-related disclosures have been made by the target, either in public filings or through other public channels, such as the target’s website, document review and interviews with management present an opportunity to validate both the content of the disclosures and how the information was obtained and verified.
As ESG-related disclosures become more common in public filings, they are often used by companies to highlight the ways in which they are responsible corporate citizens. This desire to highlight positive attributes runs the risk of companies providing inaccurate or incomplete information. One of the specific initiatives of the new SEC Climate and ESG Task Force is to evaluate potential misstatements in public companies’ disclosures. Counsel can help acquirers develop a good understanding of the process used to gather and vet the ESG information the target has disclosed. As ESG-related disclosures continue to be an area of interest to the SEC and other regulators, inaccuracies in disclosures is a potential source of legal and reputational exposure for acquirers.
Using ESG Findings
Counsel should document the relevant ESG findings identified during the due diligence process and provide an analysis of potential legal or reputational risks and exposure associated with any identified ESG-related issues.
The ESG analysis can then be used by the acquirer to:
- Evaluate the potential transaction as whole, including a reassessment of the potential value and price of the transaction; and
- Negotiate the representations, warranties, covenants or other provisions in the transaction documents to address the identified ESG issues or other findings and allocate risk between the counterparties.
Importantly, the ESG analysis also should be used to plan for remedial measures to be implemented at the target post-acquisition to address ESG risk. Counsel well-versed in ESG compliance can provide an analysis of target’s existing compliance program as it relates to ESG issues, identify gaps, and propose strategies for implementing potential remedial measures. The acquirer can then consider these remedial measures as part of its post-closing plan for integrating the acquired business into its own.
The acquiring company generally assumes liability for the target upon the closing of the transaction, and having a clear and detailed roadmap of changes to be implemented helps to facilitate the integration period and minimize the potential risk of continued misconduct that could give rise to legal or reputational issues post-acquisition. Fully understanding the ESG risks of an acquired business is an ongoing process that will continue post-acquisition, and gaining a comprehensive understanding of key ESG risk areas and touchpoints during due diligence accelerates that process.
Although ESG is often framed in terms of risk and exposure, a strong record on ESG matters brings the promise of competitive advantage. As companies face swift retribution for their ESG faults, investors and customers are increasingly showing their support for companies that are genuine leaders in the ESG space. Thoughtful and appropriately scoped incorporation of ESG matters in M&A due diligence can do more than stave off scrutiny and scorn — it can enable an acquirer to harvest even more value from its target.
* * *
Editor’s Note: This article was sponsored by Cahill Gordon & Reindel LLP