Buyers need to ensure that the targets they acquire correspond to their ESG profile by identifying the key risks and opportunities prior to signing. This requires the parties involved to change the due diligence and deal documentation.
Legal ESG-aspects are crucial for successful M&A deals
A KPMG survey recently showed clearly that ESG issues are gaining prominence in M&A deals and that deals can fall through if ESG issues crop up. Our recent experience on several Swiss transactions strongly supports this finding from a legal perspective.
Therefore, companies are advised to place special emphasis on legal ESG aspects during their due diligence examinations and incorporate those ESG findings into the transaction documents, such as the share purchase agreement.
A thorough due diligence leads to ESG findings
So far, ESG due diligence is not yet a market standard, even though several ESG issues are part of traditional due diligence, such as environmental damage, compliance, data protection and risks from contractual relationships. However, the pressure to investigate sustainability aspects of the target company in the run-up to a corporate transaction is increasing: social pressure is growing, as are the expectations of customers and employees. ESG aspects are increasingly being litigated. Lending banks and financial investors are also increasingly concerned about ESG issues.
To gain an early understanding of these requirements and to scrutinize a potential target company for legal ESG issues, it is recommended to conduct a thorough and more detailed due diligence examination. Specifically, within the due diligence process, it is advised to incorporate a new scope of work focusing on ESG aspects and divide these aspects into the relevant legal ESG subtopics.
Subject matter of an ESG due diligence
What exactly needs to be investigated as part of an ESG due diligence largely depends on the ESG topics that are likely to be material in the context of an individual transaction – which depends on the target company’s risk profile (given its activities and geographical locations) as well as on the investor’s ESG strategy and the topics typically considered to be material by the investor. Generally speaking, it should be carefully examined to what extent the company is in line with environmental, social and governance aspects. Are there likely to be government sanctions, loss of reputation, further investment costs or loss of market share? In general, it is advisable to look at the following topics from a legal perspective:
- Environmental: subtopics that could be identified and reviewed are contamination, waste and water (shortage) and/or noise pollution.
- Social: the subtopics to consider in this area are labor law and human rights compliance (e.g. living wages, modern slavery, child labor), fair trade and supply chain, equity pay as well as diversity and inclusion.
- Governance: possible subtopics include ethics and integrity, corporate governance structures (e.g. management roles and responsibilities, link to executive pay etc.), anti-corruption processes, transparent reporting and/or sustainable corporate strategy.
Due to this new focus on ESG topics in the due diligence examination, it allows for a comprehensive assessment of environmental, social and governance aspects. This enables companies to identify potential risks and opportunities, align their practices with sustainable principles and enhance their overall performance. By highlighting the ESG findings, companies can protect themselves legally and demonstrate their commitment to responsible and ethical business practices.
Implementing ESG aspects in Share Purchase Agreements
As a second step, it is essential to incorporate the ESG findings from the due diligence examination into the contract negotiations, in particular within the share purchase agreement. This can be done in different ways:
- Identify deal breakers that would cause you to walk away from negotiations; identify possible alternatives such as carve-out scenarios;
- Adjust the purchase price based on investment needs or identified specific ESG risks or upsides;
- Include legal ESG issues in guarantees and representations;
- Include indemnification clauses for certain potential sustainability risks;
- Define closing actions with respect to the implementation of certain ESG structures.
Currently, ESG findings have not yet given rise to truly novel or standardized share purchase agreement clauses. However, as the relevance of ESG risks and issues continues to increase, it is only a matter of time that such clauses will be addressed in the transaction documents in a deeper and possibly tailored manner.