How to minimize ESG risks in M&A | Representations and Warranties

The Importance of ESG
Environmental, social and governance (ESG) factors are a set of standards that can influence the performance of companies. ESG criteria are especially used in the financial industry to assess how well a company performs on ESG metrics that the investor or financial institution considers favorable. A successful ESG strategy promotes positive stakeholder engagement and is increasingly viewed as a significant driver of value.

In this article, we highlight how ESG risks can be minimized in M&A (documentation). If you are interested in how ESG risk and value are assessed, we have a separate article on our website for you.

E - The E in ESG, environmental criteria, covers the energy a company takes in and the waste it puts out, the resources it uses, and the consequences it has on living things.  So, the E is about a company's compliance with environmental laws and permits.

S – The S in ESG, social criteria, addresses the relationships a company has and the reputation it fosters with people and institutions in the communities where they do business. S includes labor relations and diversity and inclusion.

G – The G in ESG, governance, is the internal system of practices, controls, and procedures a company adopts in order to govern itself, make effective decisions and comply with the law.

How to minimize ESG risks in M&A | Representations and Warranties

How can buyers reduce their exposure to ESG risks and how can sellers reduce their exposure to ESG related post-acquisition liability?

If ESG risks have been identified, it must be assessed whether the risks are covered by standard comprehensive warranties. If the risks result from breaches of hard law, e.g. non-compliance with anti-bribery or environmental legislation, standard comprehensive warranties should provide a sufficient means of contractual protection. If the risks result from undesirable conduct or omission for which the target, however, cannot be held legally accountable, standard warranties may be too narrow in scope to provide protection.

Buyers should expand the scope of sellers’ representations and warranties to make sure that specific ESG risks are fully covered. The expanded scope of the “ESG reps” is a tool to obtain better disclosures by the sellers as a way to gain knowledge of all ESG related conduct by the target. Although specific representations and warranties on ESG related matters are rarely agreed, standard representation and warranties (health & safety, labour, environmental) may be reinforced by ESG content.

• Absence of certain changes Rep – buyer
  As stated above, an ‘absence of certain changes’ representation provision can include specific reference to ESG related disclosure obligations, such as those outlined hereinbefore. Buyers may expand the provision relating to the target or its sellers to cover claims of sexual harassment or misconduct against the targets’ employees and/or executives (the so-called Weinstein clause), or reputational harm arising from slavery or child labour allegations in the supply chain.

• Absence of certain changes Rep – seller
  In contrast, sellers may seek to reduce its exposure by means of an ‘absence of changes’ representation, in which a seller represents except as contemplated by or as disclosed in the transactional agreement the target was run in the ordinary course of business between the date of its last financial statements and the signing date. This would limit the seller’s exposure to ESG liabilities to those that are disclosed.
   
• Compliance with Laws Rep and MAE
  A ‘compliance with laws’ representation provision can be formulated to the extent that except as set forth in the relevant disclosure schedule, the seller represents that the target complies with all laws applicable to it or its business, properties or assets, except where the failure to be in compliance would not have a Material Adverse Effect (MAE). To complement this provision one can, expand the language of the MAE definition in the relevant transactional document to cover scenarios where ESG related risks materialize.

• Price ESG into transaction
  A possible downside is the difficulty to establish breaches of ESG specific warranties, for example, due to the lack of evidence. Hence, buyers can also opt for factoring ESG risks into the purchase price.