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Vetting a Target’s ESG Strengths and Weaknesses to Assess Value, Go-Forward Risks and Disclosure Requirements – Cooley M&A

The corporate sector’s approach to environmental, social and governance (ESG) issues – or “ESG” (the shorthand by which they are commonly referred) – has risen in prominence in recent years as investors have become increasingly socially conscious. It’s clear that what was once just an industry buzzword is here to stay, and companies must do more than pay lip service to ESG issues to satisfy critical investors. As ESG has come into investor focus, we have also seen increased attention to ESG issues in M&A due diligence, especially in public company deals. Buyers appreciate that a target that lacks a comprehensive approach to ESG may have a higher risk profile from a litigation and regulatory perspective compared to targets that have embraced ESG-related governance in a meaningful way. At one extreme, we could point to a company such as Enron, but we have also witnessed major governance and workplace failures at companies such as Boeing that have contributed to the creation of major liabilities down the road.

Recognizing the financial implications of ESG factors on a business is one thing, but how does a buyer assess (and quantify) the ESG-related risks and benefits of a potential transaction? ESG as a comprehensive diligence matter remains an evolving area, and in this post, we discuss potential ways buyers can use the due diligence process to evaluate a target’s approach to ESG. Additionally, we note that the current ad hoc approach to ESG public disclosures will soon be replaced by considerably more stringent reporting guidelines – in fact, on March 21, 2022, the Securities and Exchange Commission proposed a set of rules requiring public companies to make extensive climate-related disclosures in their public reports. This trend further highlights the need for a buyer to understand a target’s ESG activities to avoid inaccurate or misleading disclosures.

Undertaking ESG due diligence

Although there is growing acknowledgement of the importance of ESG to the financial outlook of a business, buyers may struggle with the task of assessing a target’s ESG value and risks. By focusing on the big picture question of whether the target’s business has good processes in place to mitigate ESG-related risks and take advantage of ESG-related opportunities, buyers can determine whether ESG has the power to help or hurt the target.

How does the target approach corporate governance?

In today’s seller-friendly and fast-moving environment, buyers may not be in the position to dig into the nitty-gritty of a target’s ESG issues. But, as a threshold matter, buyers can ask how the target addresses ESG matters at the board level. For example, how does the board taken steps to address oversight of ESG issues and related risks, whether through some combination of the audit, nominating or compensation committees or via a separate committee? Moreover, it will be important to understand what information is being provided to the board or relevant committees on a regular basis to make ESG assessments. From there, buyers can discuss what policies and procedures the board has implemented in response to ESG findings. As regulatory bodies adopt specific ESG-governance requirements – such as the diversity requirements for public company boards located in California and the new (as of 2022) Nasdaq rules requiring listed companies to have a certain number of diverse directors on the board and include information on the board’s gender and racial diversity in the annual filings – buyers need to consider compliance for those subject to the rules, and whether targets that are not subject to the rules have taken steps to diversify their board.

Overall, a buyer’s goal is to understand the governance framework being applied to ESG matters to understand both what is being looked at and what may have been overlooked. This inquiry shouldn’t be viewed as overly broad by targets in light of the general M&A diligence that buyers do around board and committee minutes in “traditional” diligence.

What is management’s attitude toward ESG?

By taking the temperature of the target’s management toward ESG matters generally, a buyer can get a sense of whether ESG items are a priority or an afterthought. Getting management’s views is often best accomplished in informal conversations, but buyers can also review the topics discussed in board minutes, the workplace environment and the target’s position toward environmental initiatives to evaluate whether there is any substance behind management’s claims.

What is the target’s workplace culture?

A review of a target’s internal policies regarding feedback should help a buyer assess how dissenting and critical views are treated in the business. A culture that doesn’t permit dissent or value the feedback of employees of all levels is at risk of having more hidden issues. As the high-profile case of Theranos exemplifies, an isolated management team or founder unwilling to hear criticisms raises the risks of concealed problems. In addition to considering the structure of the management team, buyers should review the target’s whistleblower program and whether the target has other formal processes for management to receive upward feedback.

How does the target approach sexual harassment and potential #MeToo issues?

As the #MeToo movement exposed, it is important that a company take seriously and address claims of sexual harassment. Increasingly, diligence is undertaken to understand a target’s sexual harassment policies, procedures and claims. Further, this is one area where there is growing acceptance of including a representation in the purchase agreement. According to the American Bar Association’s 2021 Private Target Deal Points Study, 37% of surveyed deals included a “#MeToo Representation” – an increase from 13% in the prior year. These representations typically cover the existence of allegations of, and settlement agreements related to, sexual harassment or misconduct, and may be limited to the target’s knowledge. The quick rise of sexual harassment claims, and cultural awareness surrounding such issues, serves as a strong example of the need to assess culture risks as part of due diligence.

How does the target promote a diverse workforce?

Buyers may also want to use the due diligence phase to gather information on the diversity of a target’s workforce. While general statistics may shed some light on the target’s diversity efforts, buyers also can get a sense of the value a business places on diversity by examining the diversity in management positions, and the formal diversity and inclusion initiatives at the company. For example, does the company have a diversity committee or a diversity officer to address concerns? Does it recruit at historically Black colleges and universities or engage in other recruiting designed to attract underrepresented employees? And has it previously been subject to claims of discrimination? The answers to these questions will help a buyer understand if diversity efforts have been taken seriously by the business – and if the workplace is accepting of diverse views and individuals.

What does the target do to retain employees?

In today’s changing workplace climate, the ability of a target to retain workers, especially compared to its industry peers, may provide some indication of any hidden ESG issues in the workplace. At the very basic level, buyers should closely review retention statistics. Savvy buyers may also want to review more “soft” indicators of employee satisfaction. This includes a review of the scope of the benefits available to employees – from parental leave, miscarriage and/or surrogacy/in vitro fertilization support to work-from-home flexibility policies – and an examination of the ways in which management values and considers the views of employees. For example, does the company have a formal review process? Are there town hall meetings with management? And in what ways do employees participate in the success of the company? The overall satisfaction of employees may indicate whether the company is at risk of floundering in an environment where workers have growing power.

What is the target’s impact on the actual environment?

A traditional but increasingly important focus of ESG-related inquiries is often the target’s impact on the environment. While many buyers conduct traditional environmental due diligence focused on the release of hazardous chemicals and other pollution risks, buyers may also want to take a step back and consider the target’s attitude toward sustainability and environmental impact plans. For example, does the target have a sustainability program or take actions internally to monitor waste? And is the target meeting the bare minimum requirements or taking actions with an eye toward future regulations? Given the variation on environmental impact across industries, it is often helpful to also compare the target’s environmental activities to similar businesses to better assess the underlying risks. As discussed below, assessing a target’s environmental impact is not only important from a valuation perspective, but is increasingly likely to be necessary for a public buyer to make accurate disclosures under evolving proposals.

What are the geopolitical risks?

As companies exit or pause operations and adapt to new sanctions in the Russian market due to the invasion of Ukraine, now more than ever it’s clear that unexpected geopolitical events can have major impacts on certain businesses. While it is difficult to evaluate for the unexpected, a buyer can assess risks by considering the location of the operations and key business markets. For example, buyers should consider whether suppliers or consumers are in allied markets or if the business is dependent on markets with uneasy relationships with the US. Understanding the risks and the target’s mitigation strategies can help prevent losses resulting for the changing geopolitical environment.

Looking ahead to potential ESG-related scrutiny and regulations

Diligence of ESG-related items helps buyers unlock value and protect against risks in acquisitions, but it is also important as regulators eye ESG-related disclosures. The set of proposals announced on March 21 by the Securities and Exchange Commission will require public companies to make extensive disclosures regarding what climate related-risks they face, how they manage those risks, their climate goals and climate governance policies. In particular, the proposed rules require disclosures in financial statements describing how the company’s financials are affected by climate risks, as well as information regarding greenhouse gas emissions. European governments also are starting to establish more formal – and mandatory – requirements. Public corporations in the European Union must provide ESG information under the EU Corporate Sustainability Reporting Directive, and the UK is in the process of putting together sustainability disclosure requirements.

Companies that embrace the continued focus on ESG and undertake diligence to understand the value and risks of a potential acquisition may not only be able to avoid ESG issues, but also may be in a position to use ESG disclosures to highlight their socially conscious actions and attract investors and consumers.


Ian Nussbaum

Barbara Borden

Jason Kent

Jenna Miller

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