ESG: Legal Strategies for Mitigating Risk and Creating Value in M&A

Introduction

It is now widely accepted that the Environmental, Social, and Governance (“ESG”) performance of a business critically impacts its financial value. Companies with strong ESG performance are perceived as more valuable than companies that give less thought to their ESG risks, even if the premium commanded by the former is not always capable of precise quantification.

Singapore Exchange listed companies have been required to submit sustainability reports since FY2017, and listed companies and large non-listed companies will also be required submit climate reports from FY2025 and FY2027 respectively, driving up the transparency of corporates’ ESG performance.

ESG risks are also a matter of interest to lenders. They are keen to allocate financing to sustainable activities or to incentivise ambitious improvements in sustainability performance, and at the same manage the EG risks of their loan portfolio. Supply chain ESG due diligence has also been on the rise, with the ESG performance of suppliers put under intense scrutiny by corporate buyers.

Decision makers for acquirers and lenders increasingly care about a potential target’s or borrower’s ESG performance, where financially material to the acquirer or lender, not least because of the potential personal liability of decision makers for breach of fiduciary duty to the acquirer or lender when making investment or financing decisions. For example, legal opinions have been released in various jurisdictions to the effect that directors owe their companies a fiduciary duty to consider and manage material and foreseeable climate risks affecting their companies; and legal opinions are also emerging to the effect that directors owe a similar fiduciary duty exists to consider and manage material and foreseeable nature-related risks affecting their companies. Similar fiduciary duties are likely owed by asset managers to asset owners.

ESG Due Diligence

It is important to include ESG due diligence (“DD”) in mergers and acquisitions (“M&A”). This helps the acquirer understand the ESG implications of its potential acquisitions, including ESG risks presented by the target and the impact of the transaction on the acquirer’s own ESG risks, so that appropriate preventive and remedial measures can be implemented. Conducting ESG DD before an M&A also advances the acquirer’s own ESG goals, such as enhancing the sustainability of its portfolio and addressing the concerns of its stakeholders. This includes corporate customers and institutional investors who conduct and report on their own value chains and investment portfolios. Financiers are also increasing their focus on ESG issues and may soon require borrowers to conduct ESG DD on their investments for which investments are sought. Currently, signatory financial institutions (“FIs”) to the Equator Principles already require borrowers to conduct environmental and social risks analysis for in-scope project financing. Vendors or targets preparing for an issuance or sale of shares in their company often also look to brush up their ESG credentials with a pre-issue/sale ESG DD to anticipate potential issues and avoid potential liability that stem from a lack of disclosure or subsequent breaches of warranty.

ESG legal DD is a subset of ESG DD. While there has yet to be a market standard, some ESG issues, such as environmental compliance and liability, are already covered under conventional legal DDs. Lawyers are already adjusting to clients’ demands to deal with ESG issues during legal due diligence and during the drafting of the share subscription agreement/share sale and purchase agreement. This also helps the acquirer gain insights on the target that are not usually available in a regular DD exercise, providing opportunities for value creation.

Scope

There is currently no market consensus on the scope of a legal ESG DD, and ESG materiality may also vary from sector to sector and company to company within the same sector. ESG covers a multitude of considerations, so a materiality analysis of prevailing and emerging concerns will be needed to help identify factors material for the target as well as factors material to the acquirer. Consideration should be given to the target’s specific nature of business, geographic regions, and business model. References to standards such as sustainability reporting standards can help in understanding the material ESG factors of a specific sector. Materiality can also be gleaned from desktop searches on the target’s websites, public filings, relevant claims and litigation, industry data, press coverage and other pertinent information.

A variety of other factors are also relevant, including deal timing or urgency, risk tolerance, the structure of the transaction (whether a share acquisition or subscription, or asset acquisition, and in the case of the former, whether there will be change of control over the target post acquisition), and the nature and industry of the underlying entities.

The acquirer’s ESG goals and priorities are also highly relevant. Is the acquirer concerned only about the financial impacts of ESG risks on the target and the acquirer, or is it also seeking to identify the environmental and social impacts of the target and its supply chain?

A 2023 review by the SGX and the National University of Singapore on SGX-listed issuers that have published sustainability reports (available as of 31 July 2023) found that the most often reported material ESG factors include:

1. emissions;
2. supplier environmental assessments;
3. water;
4. waste and effluents;
5. energy;
6. diversity and equal opportunities;
7. occupational health and safety; and
8. labour practices and relations.

The SGX’s recommends 27 Core ESG Metrics as guidance to assist issuers in providing, and investors in accessing, an aligned set of ESG data. This also provides a helpful reference for on the common material ESG factors in the Singapore context:

1. greenhouse gas emissions;
2. energy consumption;
3. water consumption;
4. waste generation;
5. employee gender diversity;
6. employee age-based diversity;
7. employment turnover;
8. employee training and development hours;
9. occupational health and diversity;
10. board independence and gender diversity;
11. management of gender diversity;
12. extent of implementation of corruption risk assessment, communication and training on anti-corruption policies and procedures, and confirmed incidents of corruption and actions taken; and
13. relevant sustainability and ESG-related certifications.

Legal Compliance and Liability Risks

At a minimum, a thorough understanding of the legal framework is important as this serves as a ‘bottom-line’ for the target’s ESG performance. An ESG legal DD must at least identify and address the target’s legal non-compliance and liability risks regarding the in-scope ESG factors. In the Singapore context, this could mean paying attention to and drawing up the relevant DD questions to elicit information on and request documentary evidence of compliance by the target per the requirements under various statutes/rules:

1. ESG:

1. SGX Listing Rules on sustainability reporting by listed issuers, including disclosures of sustainability training for board members and board diversity policy and mandatory climate reporting.

2. Environment:

1. Carbon Pricing Act 2018 on reporting of greenhouse emissions and payment of carbon tax;
2. Energy Conservation Act 2012 on the reporting of energy use and production, adoption of energy management systems, and conduct of energy efficiency opportunities assessments and plans;
3. Public Utilities (Water Supply) Regulations 2002 on the reporting of water consumption and water efficiency plans;
4. Environmental Protection and Management Act 1999 on reporting of impact analysis studies for activities involving the storage, handling, and use of hazardous substances;
5. Environmental Public Health Act 1987 on the reporting of waste generation and waste reduction plans; and
6. Resource Sustainability Act 2019 on the reporting of use and import of packaging and plan for reducing, re‑using or recycling packaging in Singapore; and the amount of food waste treated.

3. Social:

1. Employment Act 1968 on employee records and retrenchment reports; and
2. Workplace Safety and Health Act 2006 on the reporting of accidents leading to death or injury, occupational diseases of employees, and dangerous occurrences and accidents in a workplace; workplace risk assessment and reviews, reviews and audits of safety and health management systems, and health and safety committee meeting minutes.

4. Governance:

1. SGX Listing Rules on reporting of board diversity by listed issuers.

Attention should also be paid to the contractual commitments of the acquirer and the target in respect of ESG factors included in their respective constitutional documents, shareholder agreements, supply contracts, financing and insurance underwriting contracts, and leases. Failure to consider these commitments may result in an acquirer being in breach of its contractual commitments, post-completion. These could include the target’s potential liability in negligence, private or public nuisance, trespass, or other forms of civil liability for workmen injuries, pollution and land contamination, or climate change or nature-related harm, including those caused or contributed to by the target’s independent contractors and supply chains.

Standard legal DD already seeks to review regulatory permits and licences and material contracts, e.g., the review of financing agreements, lease agreements, insurance policies, employment agreements and policies, regulatory compliance, litigation searches, and data privacy policies. Such review can be extended to ESG issues and concerns.

Additionally, the target can also be requested for its sustainability reports, ESG-related policies, ESG committee board minutes, ESG-related audits, and other public ESG-related public statements can also be requested from the target. Information on relevant claims and litigation, job advertisements, and documents or data that back up the target’s public ESG statements may also be sought for the purpose of mitigating greenwashing risks.

ESG regulations and litigation risks originating from other jurisdictions may also have extra-territorial effect, in which case they cannot be ignored if relevant. ESG regulations on disclosures, supply chain due diligence, and carbon levies in some jurisdictions, such as the EU Corporate Sustainability Reporting Directive, the EU Deforestation-Free Regulation, the EU Carbon Border Adjusting Mechanism Regulation, and draft EU Corporate Sustainability Due Diligence Directive; and proposed South Korean legislation on mandatory human rights and environmental due diligence, not only directly applies to companies domiciled within jurisdiction and in some cases companies engaged in activities in or marketing to the jurisdiction, but are also designed to indirectly cover companies anywhere in the world operating upstream or downstream in the value chain of the directly affected companies. Multinational enterprises may also be subject to court orders or the risk of court orders emanating from other jurisdictions to limit or cause to be limited the climate or other environmental impacts arising from the activities within their group and supply chains as well as from the end-use of their products, regardless of where in the world these impacts occur.

Voluntary ESG Standards

An extended ESG legal DD may go beyond identifying prevailing legal compliance and liability issues and seek to shed light on commercial ESG risks. Here, the focus would be on obtaining evidence of compliance with and/or the attainment of relevant voluntary ESG standards, as well as reports and disclosures made in furtherance of such compliance. A target’s failure to comply with or attain such standards may expose the acquirer to transition risks as more jurisdictions begin to adopt or contemplate adopting legislation incorporating such standards. Contracts which the acquirer or target is a party to may sometimes give such legal force through incorporation by reference in the contracts.

Many companies also view the adoption of relevant voluntary ESG standards and certifications that go beyond the prevailing legal requirements as an opportunity to set themselves apart from competitors. Stakeholder expectations in respect of such standards and certifications may also change over time. Non-compliance with or failure to attain relevant voluntary standards or certifications may therefore still pose reputational risks for the acquirer, particularly if the acquirer or target has explicitly committed to such standards.

Pertinent certifications may include:

1.      ESG:

1. OECD Guidelines for Multinational Enterprises on Responsible Business Conduct (2023) on disclosure of responsible business conduct information; and
2. B Corp Certification.

2.      Environment:

1. ISO 14001:2015 Environmental Management System;
2. Science Based Targets Initiative (SBTi) Certification;
3. Science Based Targets for Nature Certification; and
4. Green Mark Certification.

3.      Social:

1. ISO 45001:2018 Occupation Health and Safety System.

4.      Governance:

1. ISO 37001:2016 Anti-Bribery Management System.

An acquirer may also glean from a ESG legal DD, information about the rights and obligations related to the target or the management of the target which may be affected by non-legal ESG risks. For example, the value of a right to purchase supplies and cost of producing such supplies may be affected by climate physical risks, including warmer annual mean temperatures, more intense rainfalls, and more frequent and longer dry periods, and rising mean sea levels; and climate transition risks such as changes in consumer preferences for the target’s products or changes in insurance premiums related to the production of the supplies.

Information made available during the DD about the target’s ESG risks may also affect the ability of the acquirer to meet its own ESG targets post-acquisition. This information about the target’s vulnerability to climate physical or transition risks may necessitate additional provisions for post-closing capital expenditure to improve its climate resilience. Otherwise, the acquirer may risk affecting the availability or cost of financing available to purchase the target, or the availability or cost of relevant insurance coverage for the target, and consequently, its market value.

ESG Opportunities

Beyond risks, an ESG DD can assist in uncovering hidden opportunities for long term value creation from which to generate ideas for and drive post-closing plans and measures, including where there is under-performance of certain material ESG factors that can be levelled up to best practice at concessional costs, to reap the benefits of cost reduction or alignment with national priorities, such as those detailed in the Singapore Green Plan 2030, or to be an early responder in anticipated shifts in societal norms and stakeholder responses, and regulatory developments.

Acquirers may also wish to tap on governmental incentives for improving aspects of weak ESG performance including:

1. the Enterprise Development Fund to co-fund sustainability projects involving the assessment of sustainability risks and opportunities, strategy development, governance framework, or setting of metrics and targets;
2. the 3R Fund to co-fund projects to increase the quantity of solid waste recycled or reduce the quantity of solid waste generated;
3. the Energy Efficient Fund to co-fund the adoption of energy efficient or other energy-saving technologies, installation of energy management information systems, energy audits, or design workshops to improve resource efficiency;
4. the Resource Efficiency Grant for Emissions to co-fund projects resulting in carbon abatement for manufacturing or data centre activities;
5. the Investment Allowance (Energy Efficiency) Scheme to co-fund capital expenditure for energy efficient or green data centre projects;
6. the Water Efficiency Fund to co-fund water efficiency assessments, implementation of water recycling plants, or adoption of water efficient equipment;
7. the Green Mark Incentive Scheme for Existing Buildings 2.0 to co-fund capital costs for carbon emission reductions achieved through energy improvements works;
8. the Green Ship Programme for reduced initial registration fees and annual tonnage tax for green Singapore-flagged ships; and
9. the Sustainable Loan Grant Scheme and Sustainable Bond Grant Scheme to offset expenses for qualifying green, social, and sustainability-linked loans and bonds.

Where the target has ESG policies and/or performance that are more robust in certain areas compared to those of the acquirer, this also presents an opportunity for a one-off bump up of the acquirer’s post-acquisition overall ESG performance.

Leading with ESG Legal DD

For a more holistic assessment, ESG consultants may need to be engaged for onsite inspections or assessments, and reviews that go beyond the scope of an ESG legal DD or a lawyer’s technical competencies to flag out areas that require further scrutiny. This can include potential noncompliance or misalignment with prevailing legal requirements under the

1. Consumer Protection (Fair Trading) Act 2003;
2. Environmental Public Health Act 1987;
3. Environmental Protection and Management Act 1999;
4. Employment Act 1968;
5. Workplace Safety and Health Act 2006; and
6. Prevention of Corruption Act 1960;

and voluntary ESG standards such as the

1. OECD Guidelines for Multinational Enterprises on Responsible Business Conduct (2023);
2. UN Guiding Principles on Business and Human Rights (2011);
3. International Finance Corporation Performance Standards on Environmental and Social Sustainability (2012);
4. World Bank Environmental, Health, and Safety Guidelines (2007); and
5. the Tripartite Guidelines on Fair Employment Practices (2023);

as well as prevailing ESG best practices; and the acquirer’s and/or target’s own internal ESG policies and contractual commitments. Consideration should be given to whether consultants can or should be engaged on terms that bring communication to or from them under legal advice privilege with the ESG legal team.

Contractual Strategies

Pre-Contractual Documents

It is useful to at the outset to raise ESG considerations as part of the commercial purpose of the transaction. This means engaging early with the vendor and/or target through commercial discussions and negotiations to establish clarity on the parties’ respective ESG ambitions and expectations to increase the likelihood that the parties will be able to reach an agreement on ESG issues in the subscription agreement or share purchase agreement, rather than raise these issues as an afterthought after all other negotiations have satisfactorily concluded. ESG considerations can also be embedded into pre-contractual documents, such as the memorandum of understanding and heads of terms to formalise these considerations and help set the tone and expectations for subsequent negotiations.

Representations and Warranties, and Indemnities

The conventional method for mitigating unknown ESG risks is to look to representations and warranties from the target. The usual representations and warranties cover the accuracy and completeness of any reports or information prepared by the vendor and/or target and provided to the investor during the ESG DD. This includes compliance with all applicable laws and contracts, possession of all necessary permits and licences, absence of litigation, etc. The target may also be required to give ESG-related warranties and indemnities on the compliance with specified non-binding ESG standards and principles of conduct; and possession of and compliance with specified ESG certifications or maintenance of specified ESG ratings or scores. It would also be prudent to require representations and warranties about the accuracy and completeness of all information provided to regulators or third parties for the purpose of complying with the law and contracts or obtaining certifications.

A broader catch-all ESG warranty may cover the vendor or target’s absence of knowledge of ESG-related situations, events, or conditions other than those in the public domain or disclosed to the acquirer whose existence or occurrence is reasonably expected to have a material adverse effect on the target’s assets, financial results, or reputation.

For ESG issues that are of elevated importance to an acquirer, more focused warranties can be crafted to target specific requirements. This may include ESG issues relevant to the acquirer, its jurisdiction or industry, or risks revealed during due diligence and other matters that come to light. Specific ESG warranties may take the form of a confirmation that certain ESG policies have been adopted by the target, that the target complies with specific ESG voluntary standards or that there have been no adverse ESG incidents during a specific period.

An acquirer may also seek to allocate ESG risks to the vendor or target by including indemnity protection in the share subscription agreement or share purchase agreement in respect of any area of risk it has identified or discovered in the DD that has yet to crystallise, such as an ongoing piece of litigation involving the target. Whereas a breach of warranty will only give rise to a successful claim and remedies if the acquirer is able to show that the warranty was untrue and, as a consequence of the breach, it has suffered a loss, an indemnity acts as a promise to reimburse the acquirer upon a specific event occurring, so there is no onus on the acquirer to show that a breach has arisen. Identified and known ESG risks, such as an ongoing piece of litigation may be addressed through indemnities. Indemnities are for particular and specific areas of risk which have been identified in due diligence.

A common problem with ESG-related warranties, representations, and indemnities is that they may be too vague or aspirational in language. Much ESG contractual language is relatively new and has not been tested or interpreted in courts. This makes it potentially difficult to prove a warranty has been breached. Care should be given to make provisions as clear and precise, using reference to objective standards as far as possible. Consideration may also need to be given to what constitutes a material breach of warranty that may trigger remedies provided for in the contract.

Covenants

Known and quantifiable ESG issues can also be factored into the purchase price. Risks that are not quantifiable or difficult to quantify may instead be addressed through conditions precedent or subsequent if significant to the acquirer or where the risk is difficult to quantify, e.g., reputational risk. Covenants can take the form of obligations placed on either the target or the vendor to ensure that the target fulfils specific due diligence requirements, such as establishing ESG policies, governance structures, risk management processes, and internal and external reporting mechanisms. They may also entail commitments to attain predetermined objectives or procure requisite insurance coverage within a specified timeframe post-acquisition, exercises specific due diligence, e.g., putting in place ESG policies and governance structures, and risk management and internal and external reporting processes or obligations to achieve specific outcomes, or acquiring the necessary insurance coverage, within a certain timeframe after the acquisition. Another approach is to require the amendment of the target’s constitution to entrench its ESG targets and the preparation of ESG targets and implementation plans to achieve such targets.

Like warranties and indemnities, covenants should avoid using vague or aspirational language. Specific and measurable obligations, such as metrics and targets, that can be monitored and verified objectively, or certification to external industry standards e.g., ISO 14001, preferably by including the relevant standards in the agreements itself, e.g., as an annex, or by providing a copy of the documents to the or the achievement of ESG ratings, e.g., MSCI ESG scores should be adopted where possible.

Covenants could also provide for periodic reporting using predefined methodologies and reporting requirements, including metrics and formats, and a right to audit the target and/or its contractors and subcontractors. To facilitate the early detection of potential ESG risks, vendors and/or targets may be required to put in place grievance mechanisms and to a policy of non-retaliation for whistleblowing. Vendors and/or targets may also be required to notify the investor of adverse events that may impact the target’s ESG performance and/or inability to comply with its ESG-related obligations to the acquirer. Provision may also be made for flexibility to account for changes in stakeholder expectations and regulatory requirements.

In some cases, the vendor and/or target may also be required to cascade the covenants to third parties, particularly their contractors and subcontractors, where their cooperation is required for achieving the desired outcomes. It may however not be enough to require the target to contractually cascade the relevant representations, warranties, and covenants to downstream suppliers. Upstream procurement practices also play a critical role in protecting and harming workers up their supply chain. For certain ESG objectives to be achieved across supply chains, and in order for targets as upstream purchasers in supply chains to conduct proper due diligence on their supply chains, they must also identify and rectify their own irresponsible procurement, in terms of production timelines, pricing structures, or post contract change of circumstances, and ensure their procurement terms are fair and enable suppliers to comply with their supply responsibilities without having to resort to cutting corners on human rights or environmental compliance.

Remedies

Post-acquisition, if the acquirer experiences no loss or incurs no monetary or monetisable loss due to a a breach of warranty or covenant, or where the trigger event of an indemnity has occurred, it may not be possible to claim damages or to quantify the damages arising from the breach. Liquidated damages based on genuine pre-estimates of losses may likewise prove difficult. In such situations, the share subscription agreement or share purchase agreement which does not involve a change of control may instead provide for obligations on the part of the vendor and/or target to agree to a corrective action plan with milestones and deadlines to take action to prevent or mitigate potential adverse impacts and remediate actual adverse impacts of ESG-related harm, with a view to restore, to the extent feasible, the affected environment or persons to the situation they would have been in had the warranty or covenant not been breached. Remediation may take the form of apologies, restitution, rehabilitation, or financial or non-financial compensation to affected stakeholders or their representatives. Similar remedies involving remediation may also need to be cascaded to relevant third parties.

Provision may be necessary for seeking court orders for specific performance, compelling the vendor and/or target to take the agreed-upon actions aimed at preventing, mitigating, or remedying potential or actual harm. In this regard, the vendor and/or target may for example be asked to acknowledge that the acquirer is committed to being a long-term and responsible investor based on certain ESG-based principles, and if the target operates in a manner that violates these principles, the vendor and/or target may be in breach of the subscription agreement or share purchase agreement and may expose the acquirer to significant regulatory and/or reputational risks which may not be adequately compensated for with monetary damages. Another contractual approach would be to require the inclusion of third-party beneficiary clauses in the target’s contracts with suppliers to enable workers or community members adversely impacted by supply chain activities due to a breach of buyer or supplier responsibilities or obligations under the supply contracts to enforce such responsibilities or obligations against the buyer or supplier.

Key Takeaways

ESG considerations have become a growing focus for businesses and their stakeholders and are increasingly critically important to the success of M&A. A holistic ESG due diligence that includes:

1. a review of a target’s regulatory and contractual compliance,
2. its ESG performance, and
3. how physical and transition ESG risks may affect the target’s rights and obligations in material contracts;

together with the deployment of appropriate contractual strategies to take into accounting the peculiarities of ESG risks, including:

1. pre-contractual engagement,
2. representations and warranties, and indemnities, and
3. remedies;

are both critical steps for the acquirer and the vendor and/or target to proactively take to mitigate and allocate ESG risk and reap mutually beneficial ESG outcomes and synergies that contribute to the value of the target in the long term.